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ESG, the Sustainable Investment Strategy in Capital Markets

  • Date:
    01 Sep 2020
  • Author:
    KEHATI

ESG is the fastest growing investment strategy and product worldwide in recent years. ESG investment has a long history and only started with investments that are considered ethical, such as avoiding investing in tobacco or liquor companies. Then, in the last 10 to 15 years, it has developed to adopt various aspects of sustainability and gave birth to multiple innovations in the capital market.

 

Sustainable investment is basically an investment made by considering environmental, social, and corporate governance aspects, in addition to financial factors, of course. Therefore, current sustainable investment, especially in the capital market, is better known as ESG (environmental, social, governance) investment.

 

The environmental factors (E) including things like carbon emissions management, energy conservation, biodiversity, waste management, pollution, and so on. Social factors (S) including promoting gender equality, empowerment and community involvement, being fair to employees, maintaining customer integrity and confidentiality, and so on. Meanwhile, in terms of governance (G), companies can be assessed by the independence of the board of commissioners and directors, fair and transparent management compensation, and other aspects of governance.

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Reciprocal Relationship Between the Investment Portfolio with Environmental and Social Aspects

There are two perspectives on the relationship between ESG and investment, namely the perspective of “impact OF portfolio” and “impact ON portfolio.”

 

Impact OF portfolio looks at how the investment portfolio has an impact, particularly negative ones, on the environment and society. Sustainable investment initially took this perspective, and most communities, regulators, or NGOs saw it from this perspective. The goal is so that investment and business do not harm the community nor the environment.

 

While the ON portfolio impact sees the opposite, how environmental and social issues have an impact, positive or negative, on the investment portfolio. For example, suppose the company doesn’t care about the impact of pollution. In that case, the company will eventually have financial consequences, whether it is from society, regulators, consumers, or changes in the business landscape.

 

There are not only risks but also opportunities. Energy companies that align their business with climate change trends, for example, will take the opportunity to invest in renewable energy and leave the coal business, as this fuel will be abandoned by consumers and limited by regulators.

 

So, the recent rapid development of ESG investment has been driven more by the second approach, as investors want to avoid risks and seek opportunities from ESG factors; this is a fiduciary duty, or the responsibility of an investor or fund manager to the owner of the funds they manage.

 

In conclusion, these two approaches coming from different directions converge in the middle. In other words, if you do not harm the environment and society, if you do good to the environment and society, they will somehow reward you. Various studies and research have shown that companies and investments that adopt ESG principles will be better than market performance in the long run.

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Understanding the Various ESG Investment Strategies

In general, the ESG investment strategy or sustainable investment falls into two broad categories. First, responsible investing; prevents negative impacts on the environment and society (do no harm). Second, investment aims to positively impact the environment and society (do good), or impact investing.

 

Let’s identify one by one of the seven ESGs commonly practiced in the capital market, which sometimes overlap.

  1. Exclusionary

This strategy, which sometimes is referred to as negative screening, is quite simple, and was the earliest used by investors but is still quite dominant today.

As the name implies, this strategy excludes or screens out companies or investment objects whose businesses have a negative environmental or social impact. Businesses that are usually considered environmentally and socially negative are cigarettes, coal, weapons of mass destruction, gambling, etc.

Investors can also define how they filter companies that are considered to have negative social and environmental impacts.

 

  1. Best in Class

The second strategy is best in class or positive screening. As the name implies, this strategy assesses and ranks companies based on ESG, environmental, social, and governance factors. Then, investors choose to only invest in companies with high ESG value.

What is the difference between this strategy and the first one? This strategy may invest in sectors that are considered “negative”, such as coal, but only coal companies with the highest ESG value. On the other hand, investors do not necessarily invest in all companies whose business is considered “positive”, such as renewable energy companies, if their ESG ranking is low.

 

  1. ESG Integration

ESG integration is the strategy that is developing the fastest lately. As the name implies, investors or investment managers “integrate” various environmental, social, and governance factors when they analyze a company in this strategy.

Analysts or investment managers will look at the ESG aspects of a company, and then make adjustments before making investment decisions. High ESG risk will have the potential to reduce sales and/or increase costs, so that the sales and profit forecast must be adjusted accordingly.

It is possible that this risk cannot be accurately reflected by adjusting sales forecasts or costs. In this situation, an adjustment is usually made to the valuation, for example, by lowering the PE target while increasing the risk premium.

The practice of ESG integration differs from one fund manager to another; it can be done quantitatively or qualitatively. In general, they are not as systematic as strategies number one and two.

The first three strategies are classified as responsible investing / do no harm. Although in practice, investors’ considerations to do this is often to optimize the risk and potential returns of the portfolio, especially strategies number two and three.

 

  1. Sustainability Theme Investment

Basically, this is a thematic investment, but specifically in the context of sustainability. It’s an investment strategy that focuses on stocks or companies with a specific theme related to ESG. For example, an investment strategy that targets companies in the renewable energy sector, or companies that focus on providing financial services to low-income people.

This strategy can be classified into the “do good” category, which is an investment that targets financial gain and expects social or environmental impacts. Investing in renewable energy companies, for example, is expected to have an impact on reducing pollution and greenhouse gas emissions.

 

  1. Green Bond

The green bond is similar to strategy number four; sustainability theme investment. The green bond is an investment in the form of debt given to companies or projects that support “green” agendas, for example, clean energy companies, electric vehicles, energy conservation, green buildings, and others. What distinguishes it from the previous strategy is the use of funds in the issuance of special green bonds for financing that has been agreed with investors and must be related to “green” businesses or projects. While strategy number four is usually an investment in stocks (although sometimes bonds), and is usually done in the secondary market. This means that fund managers choose companies that have listed their shares on the stock exchange based on predetermined criteria, for example, renewable energy or microfinance. The company does not have a specific agreement with investors regarding its business model.

With the same concept, bonds whose funds are used for businesses or projects with a positive social impact, are called social bonds. Meanwhile, for business and project purposes that positively impact the environment and society, it is called a sustainability bond.

 

  1. Impact investment

As the name implies, this investment strategy specifically targets positive environmental and/or social impacts.

What is the difference between a green bond? Impact investment does not only provide debt funding as in green bonds, but also in the form of shares. However, the main difference is, in impact investment, each investment object is specifically required, measured, and evaluated for its social and environmental impacts.

For example, investing in wastewater treatment companies, or companies targeting gender equality. So in an impact investment strategy, companies must state specifically how much waste they will process, or how many women they will empower. And this will be monitored and measured by investors.

Meanwhile, in green bonds, it is usually only regulated in general terms. For example, if it is a green bond to build a solar power plant, all the funds must be used to construct solar power plants, not for other purposes. But usually, there is no requirement that a specific positive impact is required; such as the number of houses with clean electricity, a reduction in pollution in a certain area, and so on.

As impact investment requires a particular and measurable social impact, this investment strategy is usually carried out for small and medium-sized companies or startups whose business model has the potential to have social and environmental impacts. Therefore, investors in impact investment are usually venture capital firms or sometimes private equity firms. Meanwhile, investors in strategies one to five are usually investment managers who invest in investment instruments offered through public offerings or listed on the stock exchange.

 

  1. Stewardship & Engagement

In the context of investment, Stewardship is an initiative carried out by fund managers in supervising and directing company management to protect investors’ rights in the company. Or in other words, so that the management of the company provides optimal benefits to shareholders. The interaction between fund managers and company management is usually called “engagement”.

In the context of ESG, the engagement between fund managers and company management focuses on environmental, social, and governance aspects. It is because investors believe that the ESG factor is essential for company performance.

The stewardship strategy can be a specific investment strategy, but it can also complement other strategies. All of the investment strategies we discussed above, except strategy no.1, often involve engagement in practice, significantly impact investment.

 

Adopting the ESG Investment Strategy and the ESG Index

In general, based on GSIA (Global Sustainable Investment Alliance) data, the most widely used ESG investment strategies are the first strategy; exclusionary, and the third strategy; ESG integration. Meanwhile, impact investment accounts for less than 1% of total ESG investment funds, but is growing rapidly. This is natural, because impact investment usually focuses on small and medium-scale companies.

The ESG stock index is also growing rapidly. Investors who do not have the resources in the ESG field or decide to invest in ESG passively / systematically usually use the ESG index as a reference. Active investors also use the ESG index as a reference in compiling portfolios and comparing their investment performance.

Most of the ESG indexes use strategy number one and/or strategy two. Several ESG indices are also available for strategy number four (sustainability theme investment). The SRI KEHATI index, the first ESG stock index in Southeast Asia, and the only one in Indonesia, uses a combination of exclusionary and best-in-class strategies.

This article has been published on katadata.com