ESG and Impact: Blurring The Boundaries

Fiona Frick - Group Chief Executive Unigestion

  • Impact investing has evolved and can be applied to core blocks of asset allocation such as equities or bonds
  • The costs associated with the impact a company has on society will increasingly be felt directly by corporates and reflected in financial statements
  • To have the biggest impact, we need to engage with companies, not just exclude them from portfolios


In this second part of my series on sustainability in asset management, I focus on how responsible investment has evolved: from its roots in the 18th century, to ESG integration and now to impact.

The last decade was all about ESG becoming mainstream. Now, in our view, it’s the turn of impact. Over the coming decade, investors will be assessed not only on the financial return they deliver but also on their societal outcome; the impact they have.

In becoming mainstream, impact will have to be scaled up and move from a niche capability to a way of investment that can be deployed in core portfolios across the main asset classes, whether equities, bonds, private equity or private debt. For investors, the development of the UN Sustainable Development Goals in 2015 provides a helpful framework for the kind of societal outputs an investment in a public or private company can achieve.

But it is not investment alone that will achieve impact: active engagement is critical. Investors need to work both with companies that are changing and encourage those who are not. As some of the big oil companies have found in recent times, shareholders can, and increasingly will, act in concert to force change where required.

And what about the long term? In my view, ESG (which is more inward-looking), and impact (which is more output-related), will morph to the point that sustainability considerations will affect the way a company operates and its financial results. This creates both risk and opprtunity for investors.

From ESG process to sustainable outcome

Responsible investment has come a long way from its early roots in the Methodist and Quaker movements in the US during the 18th Century when religious leaders set out guidelines on the types of companies their followers should invest in.

While the first Responsible Investment fund was launched in the 1920s and Socially Responsible Investment (SRI) slowly gathered pace in the ensuing decades, it has only really been in the past decade that responsible investing has truly hit the mainstream through the emergence of Environment, Social and Governance (ESG) investing.

The clear differentiator however was that investing based on ESG criteria had to make financial sense in terms of investment return. The evidence for a relationship between the consideration for ESG issues and investment performance became clear thanks to a broad range of academic literature issued on the subject. Numerous studies show that shares of companies which score highly on ESG matters close to their business tend to have better risk adjusted performance than their peers. It is however important to take into account materiality of ESG criteria by sectors such as shown in the Harvard Business School 2015 article i.e. Corporate Sustainability: First Evidence On Materiality, Khan, Serafaim, Yoon.

One peculiarity of ESG is that it is very much focused on internal business practices. It provides information on how a company operates to ensure it manages its activity in a responsible way in regards to its business practices.

The integration of ESG criteria is consistent with an asset manager’s fiduciary duty to consider all relevant information and material risks in investment analysis. The study of ESG data enables investors to differentiate leaders from laggards within an industry and allocate capital accordingly for the benefit of the portfolio performance.

The second wave: from ESG to impact

And then came impact investing; a term that has evolved beyond its early origins of describing investment into co-operatives in emerging markets.

Today, impact investing is moving from a niche to a mainstream investment phenomenon, but at the same time its meaning is evolving. It no longer necessarily forms just a small component of asset allocation, but it can also be applied to core blocks of asset allocation such as equities or bonds.

In contrast to ESG considerations, impact investing has more intentionality: it is more output orientated. It relates to the purpose of a company in relation to society, how good or bad this purpose is, and whether the business is making money in a way that contributes to the common good of society. It reflects more on the business model and the “raison d’être” of a company.

Investment will increasingly be seen as a way to generate returns but also to drive change. Therefore as an investor, we need to evolve the way we allocate capital in order to invest for a sustainable future. We will need to integrate impact considerations on top of ESG criteria. . We will need to measure the intentionality of the investment we put to work, on top of performance.

As impact focuses on a company’s core business as opposed to practices, it has the potential to reveal deep shifts in industries and business models. In a period where each company or sector needs to justify its purpose to society, impact analysis allows us to assess if a company or a sector is adapting to the changes our world is facing.

Good businesses are forward looking. Their impact on society will influence their future cash-flow and therefore their share price. So an investor taking care of impact should generate a sound investment for clients.

One way to measure impact is by analysing the contribution of products and services provided by a company revenues and capital expenditures to achieve the UN Sustainable Development Goals (SDGs). The 17 SDGs, established in 2015, provide a framework for identifying sustainable themes and initiatives to help solve the many and varied sustainability challenges facing the world.

A blurring of the concepts

In our view, ESG which is more about identifying companies’ processes, and impact, which is more about understanding companies’ purpose, will morph over the long term. We will reach a point where sustainability considerations will affect the way a company operates and the financial results delivered.

While contributing to growth of the economy and generating wealth for its investors, a company also creates externalities or impacts on our society or our planet, such as environmental pollution, loss of biodiversity or social inequalities. These externalities have associated costs that are not wholly borne yet by the entity that creates them. We believe this is likely to change in the coming decade and that governments will move to issue new legislation and taxation on these externalities.

Such policy change is increasingly likely to require companies to reflect the cost of these factors in their business models. Furthermore, the risk of adverse impacts is already very damaging to the corporate’s reputation.

One of the most visible externalities making its way into the internal reporting agenda of companies is climate risk. An example of this trend is the Carbon Disclosure Project (CDP) aimed at driving corporate transparency and helping investors assess and incentivise environmental action. In 2020, a record-breaking 9,600+ companies disclosed through CDP. That is 14% more than in 2019 and 70% more than when the Paris Agreement was signed in 2015. Disclosing companies now represent over 50% of global market capitalisation.

The Sustainability Accounting Standards Board (now the Value Reporting Foundation), founded in 2011 to improve specific disclosure standards across financially material ESG topics, has also made great strides. Its recent work with PwC to develop a draft version of the taxonomy that encompasses the Foundation’s 77 industry standards will go one step further by integrating ESG consideration into the common language for business reporting.

Now, board members of companies are coming under pressure from asset managers to consider issues from climate change to diversity when fixing KPIs for Executive Committee members. Recent research by ISS ESG highlighted that the number of companies including environmental or social metrics when deciding executive pay has doubled since 2018. Nestlé, for example, factors staff health and safety into remuneration packages while Microsoft includes diversity.

The shareholder primacy approach espoused by Milton Friedman, which argued that shareholders are the only group to which a company is socially responsible, clearly has less validity in the modern world where the definition of capitalism is evolving as well as the social duty of its participants.

Companies’ business models will evolve to ensure they have a net positive impact on society and reduce negative externalities. Companies will be forced to adapt the way they operate, aligning their practices to deliver on their impact they have decided on, while negative and positive externalities will be directly accounted for in financial results. This creates both a risk to future returns for investors and also opportunities. Investors will need to understand long-term trends that are sustainable and how companies or countries adapt to them. It will also unlock investment opportunities in innovation projects that will help tackle the challenges society faces.

Exclusion is too easy: play the power of engagement instead

What role and responsibility do those of us in the asset management sector have? Is our responsibility to simply eliminate from our portfolios those companies who do not meet our responsible investment criteria? Or is it, instead, to invest and encourage change?

The answer, for me is somewhere in between. There are, without doubt, some companies and sectors that are unlikely to ever have their place in our portfolios as the nature of their businesses pose too great an investment risk on top of ethical considerations: coal producers, arms dealers and tobacco producers for example.

But beyond this black and white exclusion, there exists many shades of grey: to have the biggest impact, we need to encourage the greatest change. There is a role for exclusions and there is a role for engaging with companies which are perhaps not yet best in class and influence them to bring solutions to the negative externalities they produce.

With this principle in mind, we try to remain constructive and not exclude too many companies. The MSCI World Index, for example is comprised of around 1,600 stocks and out of these we exclude fewer than 100 companies.

Our approach is to classify companies within deciles. We exclude companies that are in the worst decile and that have shown no improvement over the previous two years. But, we do want to keep investing in companies that are in the some of the worst deciles and are showing a positive trend of improvement. If we engage with a company that has a poor score, it is crucial to have a credible escalation strategy, which, if all else fails, may result in divestment.

We will engage with these companies on the basis that we have seen evidence that they are trying to improve, that we have evaluated their issues and assessed the potential for further change. It is promising to engage with these companies as we already own them and value them in other respects. We also believe that if their ESG score improves, their risk score goes down and that should have a positive effect on their long-term performance.

Simply not holding a sector or an industry is, in many cases, just removing ourselves from the debate. While there are sectors that we do exclude completely, we believe it is best as far as possible to stay in the debate, to engage with corporates, and lobby for improvements from an investment point of view. We can debate whether it is right, for example, to buy airlines or oil companies but we recognise that today they are part of our economic landscape and that we need them to transform themselves to remain part of that landscape, but in a more sustainable way. In that sense we have an active part to play to ensure companies in those sectors constantly improve.

Companies will be forced to adapt the way they operate, aligning their practices to deliver on their impact they have decided on, while negative and positive externalities will be directly accounted for in financial results.

I believe that if sustainability-orientated investors and stakeholders withdraw from the fossil-fuel industry entirely, they would lose the ability to influence such companies in a more positive direction, placing this power in the hands of other potentially “less responsible” investors.

If we take the broad global equity index and calculate its constituents’ trajectory in temperature by 2050, the world we live in is heading for a lot more than a 1.5° rise in temperature over pre-industrial levels: the global temperature is already 1.2° higher and it is more likely to be over 4° higher by 2050. Exclusion doesn’t solve that problem; it just means that our portfolio might be a bit better than the index at this point of time. There is social value for the world and a financial benefit for investors in making sure the index is moving toward a temperature trajectory well below 2°.

We want to keep investing in those areas of the energy sector that have demonstrated its efforts to aid the transition to a low carbon economy by investing in or implementing alternative energy sources. We believe that green energy investments are unlikely to serve as the sole tool for the transition given their scale and that the big energy conglomerates will play an important role in managing the transition to more sustainable energy sources as they move to producing energy in a climate-neutral way.

The changes forced on some of the world’s largest oil companies in May 2021 highlight how remaining a shareholder can result in change. As members of the Climate Action 100+ we, together with our peers, voted to replace two ExxonMobil directors with replacements put forward by activist investor Engine No. 1. We also supported initiatives put forward at Chevron’s AGM.

Furthermore, we will need, as investors, to engage not only with public companies but also with the private companies we own. We must avoid the private market becoming a ‘free rider’, able to act in ways that would be prohibited for public companies.

Asset managers still have a great deal of work to do in order to steer public and private companies towards making the changes necessary to support the move to a more sustainable capitalism. In that sense, engagement means having an impact and we have all become activists. It is our duty to further this role collectively as investors: we will be judged by future generations on our ability to succeed.

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