Why institutional investors must be engaged in ESG investing

They can use their rights and position of ownership to influence companies to improve their sustainability DNA

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The importance of embedding environment, social and governance (ESG) principles within sovereign investor strategies has been gaining traction rapidly over the past several years. While perspectives were polarised as recently as 2017, by 2020, Invesco's sovereign report shows a clear decarbonisation focus for investors through North Africa and Europe, with their counterparts in the Middle East and Asia also preoccupied with mitigating the effects of extreme weather on their portfolio.

Clearly, concerns about climate-based risks and environmental protection have emerged as an important issue for regional investors – a trend exacerbated by the Covid-19 pandemic.

When it comes to demand for ESG investing opportunities, the numbers speak for themselves: ESG assets have grown to more than $40 trillion – totalling approximately one third of investments globally. According to Morningstar, the number of US mutual funds that consider ESG principles to be relevant in investment analysis quadrupled (from less than 20 to 81) during 2018, then skyrocketed to 564 in 2019, with assets increasing nine-fold.

Sustainable ESG funds (which use a stricter adherence to ESG principles) have exhibited similar popularity with investors. Between 2010 and 2014, just 27 sustainable ESG funds were launched, compared with 164 between 2015 and 2019. Even more telling, these funds recorded net inflows of $21.4 billion in 2019, four times the result from 2018.

As investors become more sophisticated in ESG investing, they are beginning to understand that an ESG-friendly company is one that has sustainability embedded in its DNA, and not one that is simply classified in a “green” sector. The need for improved ESG disclosures and a comprehensive reporting framework are becoming increasingly important to investors who base capital allocation decisions on ESG metrics and factors to create long-term value.

What does this mean? For one, as investors become more active shareholders, they must also recognise their fiduciary duty to clients and beneficiaries, and use the rights and position of ownership to influence the activities of investee companies to enhance ESG-related practices and improve ESG metrics.

This is in sharp contrast to investors who may just follow a certain ESG-labelled index or invest on the basis of exclusion. We believe that the use of exclusion-based models could even fail to align investment decisions with the best interests of clients if, for example, it led to the avoidance of capital-generating investments.

The need for improved ESG disclosures and a comprehensive reporting framework are becoming increasingly important to investors

To date, the ability of ESG engagement to create value, as found in research commissioned in 2018 by the United Nations Principles for Responsible Investment, remains underappreciated on the part of investors. Too often, engagement is considered a “box-ticking” exercise, rather than a real engine for change.

Institutional investors and sovereigns with long-term horizons and high-conviction strategies are well placed to unlock potential value through a philosophy of responsible investment. Institutional investors own about 80 per cent of US public equities by market capitalisation. And with current US market capitalisation at $36.3tn as of September 2020, it gives a relatively small number of organisations enormous power in terms of helping to shape corporate practices and behaviour for the greater good.

The UNPRI research, for example, found multiple avenues through which ESG engagement creates value for investors and shareholders. For one, it found that reinforcement of communications through ESG engagement creates new and varied opportunities to spread awareness of ESG issues on the corporate side. This dialogue enables the exchange of information, promotes learning dynamics and can help investors anticipate new ESG trends in the marketplace.

Within an organisation, this sort of communication engagement can help bridge the “sustainability-investment gap” that is often seen between ESG and financial experts.

Going forward, it is a fundamental reality that ESG risks are of historic global significance – and investors rightly demand that the ESG funds they invest in live up to their promise. Investment managers should look to ESG as a core part of long-term value creation, and investors should seek managers who are actively engaged in the investments themselves.

There is a journey to be made to achieve an engaged ESG ecosystem. Doing so will require various organisations – ranging from institutional investors to sovereigns, regulatory watchdogs and agencies – to work together, as well as various internal parts of organisations. As this market matures, discerning investors will select funds that don’t just “talk the talk” but also “walk the walk” – and in this case, walking the walk will mean “being engaged”.

Zainab Kufaishi is the head of Middle East and Africa at Invesco.