Responsible investing lifts governance expectations

The boom in responsible investing is changing the dynamics of governance. As scrutiny on corporate ethics intensifies, Environmental, Social and Governance (ESG) performance is moving from a risk-management issue to a fight for investable capital.

Almost half of all assets professionally managed in Australia – about $622 billion – are now put through broad responsible investment filters (ESG) or core filters (ethical investing), shows the latest Responsible Investment Benchmark Report 2017 Australia.

These assets grew 9 per cent in the year to December 31, 2016, according to the Responsible Investment Association Australasia (RIAA) report. Core responsible investment assets leapt 26 per cent in this period amid a resurgence of interest in ethical investment funds.

“Australia has hit a tipping point in responsible investing in the past 12 months,” says RIAA CEO Simon O’Connor. “Boards must be on top of this trend. Organisations that fall behind on ESG performance risk missing out on very large pools of global capital. Increasingly, institutional investors are buying or selling companies based partly on their ESG performance.

Although related, ethical investing and ESG are different concepts. Ethical funds avoid harmful sectors; ESG, a more holistic investment approach, integrates ESG principles into portfolio decisions. ESG investing is much larger than ethical investing in Australia, but the gap is expected to narrow as mainstream funds exclude a wider range of sectors.

Four factors explain the rise of responsible investing. The first is changing societal attitudes: more investors are aligning their investment values with their personal values. Just as they buy free-trade coffee and cage-free eggs at the supermarket, so too are they favouring investment and superannuation products that help rather than harm the planet.

The second factor is the investment industry’s response. As investors show greater interest in responsible investment, more fund managers are launching ethical managed funds or exchange-traded products, or incorporating ESG filters into their investment methodology. Large superannuation funds are increasingly offering ethical options in their funds.

AMP Capital, for example, this year introduced an ethical framework across its $165-billion portfolio that sets a new benchmark for responsible investing in Australia. AMP is excluding manufacturers of tobacco and weapons from its investable universe – a change that will lead to the divestment of about $570-million worth of stocks in these sectors.

The third factor is rising sophistication in ESG data and analysis. Market pressure from institutional investors is encouraging large listed companies to provide more quantifiable, comparable ESG data in areas such as occupational health and safety, employee turnover, human rights and supply chains, and climate-change exposures.

Most large investment banks in Australia now have analysts that produce research for fund managers on ESG issues. A new industry of ESG data provision and analysis that is influencing investment decisions is rapidly expanding.

The fourth factor is performance. Funds that are implementing core responsible investment strategies are outperforming equivalent Australian and international share funds, and multi-sector growth funds, over most time horizons, found the RIAA study. The myth that investing ethically means having to sacrifice fund returns is being shattered.

“Growth in responsible investing has a long way to run,” says O’Connor. “As more people choose to invest responsibly, more fund managers will incorporate ESG filters across investment portfolios and start to exclude sectors perceived to be harmful from their investable universe. A number of funds already exclude tobacco and weapons and it’s likely that will see a blurring of ESG and ethical investing strategies in more funds in the next few years.”

The Governance Leadership Centre asked O’Connor about the implications of growth in responsible investing for the governance community:

GLC: Simon, ESG has been around for a long time and boards of larger listed companies have produced extensive sustainability reports for the past decade. What’s changed?

Simon O’Connor: The big change is a new generation of investors who want to make a positive difference through their investments. This trend has gathered a lot of momentum in the past few years. It’s encouraging superannuation funds to respond with greater focus on ESG and product choice, which in turn is filtering down through intermediaries such as fund managers and investment managers. Responsible investing, once considered a niche, has very quickly gone mainstream.

For years, ESG was viewed as a non-financial issue or part of an organisation’s corporate social responsibility strategy. Today, ESG is very much a material issue that is influencing where global capital is invested. When considering organisation strategy and performance, boards must focus more on ESG metrics and how they relate to comparable organisations.

GLC: Is the Australian governance community responding quickly enough to growth in responsible investing?

SOC: Boards of large ASX-listed companies are clearly focusing on their oversight and understanding of how their organisations manage culture issues, bribery and human rights risks, and environmental issues around climate change.

Boards have broadened their stakeholder engagement to include non-government organisations (NGOs). They listen to their concerns and respond where appropriate. Nevertheless, there is a sense in the investment community that boards can move faster on ESG issues and investor engagement, apply a stronger ESG filter on governance decisions, and be more proactive on ESG risks.

GLC: What are the main risks for boards that govern ESG laggards?

SOC: Stakeholder activism continues to grow. In the past, NGOs were often on their own when they challenged companies about ESG issues. These days, institutional investors are a lot more open-minded to considered views from NGOs and willing to vote with them on issues that have merit. We continue to see NGO-led shareholder resolutions around ESG issues.

Another trend is institutional investors publishing their views on company ESG matters. BlackRock, for example, is outlining its rationale behind certain voting matters on ESG issues. That is a very important change: such matters traditionally have been decided behind closed doors, but institutional investors are becoming more public in their views on ESG performance. That has implications for boards and their stakeholder engagement.

Generally, listed companies that lag on ESG performance can expect to hear from NGOs and/or investors. Organisations that fail to communicate on these issues or provide an adequate response can expect an elevation in activism, possibly with stakeholders working together on issues. The last resort is voting against board recommendations at the Annual General Meeting. This form of activism can have a very material effect on the share price.

GLC: Where do you see the intersection between board oversight of an organisation’s ESG performance and growth in responsible investing heading in the next five years?

SOC: It can go one of two ways. The first is boards spending more time on ESG issues and broadening their stakeholder engagement. In this scenario, boards are a lot more open to the market’s views on the organisation’s ESG issues and proactive about addressing them. The board better incorporates ESG thinking into its oversight of strategy.

The second approach is boards taking a more defensive approach to ESG or treating it mostly as a risk-management issue. I don’t think this approach helps anyone: the investment community, NGOs and organisations and boards need to work collaboratively on the ESG issues and view them as a way to create sustainable, long-term value; not only as a risk to manage.

GLC: Is the composition of Australian boards sufficient to deal with the rise of responsible investing?

SOC: Yes and no. There are many listed-company boards that take ESG reporting, performance and stakeholder engagement very seriously, and do a good job on it. Equally, there are boards that arguably have insuffienct skills in ESG issues or they have directors who have publicly said climate change is a hoax. Some boards still pigeonhole ESG as an issue for their sustainability committee when it affects all aspects of the organisation.

The reality is ESG issues will become more complex in the coming decade; investor scrutiny on ESG issues will rise; and more funds will take a proactive, public stance on ESG issues. Boards must ensure they have sufficient skill and understanding of ESG matters that will continue to have more influence on the flow of investment capital and shareholder returns.