Part 2: Primary Research on ESG
Primary Research on ESG: buy side perspectives
As outlined last week, we’re providing our thought leadership and perspective on ESG through a four-part miniseries with the objective of helping you “cut through the noise.” Building on last week’s refresher on ESG, this week we’re diving into the impact ESG is having on investment decisions, including our proprietary insights comprising views from over 1,150 institutional investors globally.
Investor Views
ESG Continues to Increase in Importance for Institutional Investors
One year ago, when we published our inaugural 2020 ESG miniseries, we laid out the generalist equity investor view, which found the percentage of institutional investors classifying ESG as Very Important to Critical to their investment thesis increased from less than one-third in 2018 to 42% in 2020.
Commensurate with significant flows into ESG funds and as we outlined last week, 9 out of every 10 investors globally incorporates ESG into their investment decisions to some extent, including more than 4 of every 10 noting ESG is Very Important or Critical.
In our recent survey of 133 investors globally with >$11 trillion in AUM, which was launched May 14, 2021, 69% note ESG has become a greater priority at their firm over the last 12 months or was already a high priority, demonstrating the continued momentum of the ESG megatrend.
While investment firms are in various stages of the ESG evolution, for those early in their journey, the consensus is ESG is becoming increasingly more important. Below are a selection of representative examples of this sentiment.
“It is not the key driver, but it is increasingly becoming important. It would never lead my investment decision, but it would certainly be something that could pull me back from where otherwise I would potentially invest. It is a minor point in the decision process, but it is certainly something that could make the difference with something that is on the border.” Capital World, $829B EAUM
“It is becoming more and more important. It used to be more governance but now we look at it broadly.” Wellington, $696B EAUM
“Internally our firm has made a significant incremental focus on that area over the last year. I am going to be increasingly focused on it for all investments and particularly for new investments.” Capital International, $438B EAUM
“ESG is important to us. We have always considered ourselves ESG investors as far as we want sustainable companies. We find those likely to outperform because you have to have a sustainable business model, or it is not going to work. ESG has some of those same type of objectives in mind.” Principal Global, $186B EAUM
“Regulators and investors are certainly pushing for ESG to be more a part of the process. Historically, we have not focused on ESG. The compliance team is now working with our PMs to put together more of an ESG approach for our funds. We will be incorporating that and be able to answer more effectively on it an ESG basis.” Mackenzie Financial, $102B EAUM
“Our team puts a lot of focus on that. We try to talk to management and make time to talk to management about these issues. It is increasingly becoming more and more important.” BMO Asset Management, $94B EAUM
“It is definitely a very strong consideration now. It went from average to more dominant.” Baron Capital, $50B EAUM
“We place more and more importance on ESG in our investment decisions. In Europe, all open-ended investment funds have to categorize themselves as ESG aware or not aware and the regulators are taking an increasingly stringent view of that, so you cannot just say, “we look at ESG.” If you claim to be an ESG-aware fund, you have to prove you are questioning companies on matters to do with ESG, monitoring them and eliminating companies which you feel are not doing as you would have liked in terms of ESG.” J.O. Hambro, $31B EAUM
“It is becoming more important. We do not hold ourselves out to be ESG compliant, nor are we, yet the protocols we put in place in terms of what we pay attention to leads us to companies that are good citizens.” Royce Investments, $18B EAUM
“We do not have an explicit mandate for ESG. We do consider ESG in our investment process. We focus more on the G of the equation. This includes a good board that holds the management team accountable, who asks the tough questions, are there to have some skin in the game and are there to add value, looking out for the long-term best interests of shareholders.” Clarkston Capital, $6B EAUM
“It is definitely getting more and more important. Like a lot of others, we are aware of ESG and some of the changes being made. We have adopted a more official policy around ESG within the past year. We tell our clients we have always taken it into consideration, just never had a formal process to incorporate into our investment process. It is not a completely separate function and has always been a factor. We just have not specifically documented companies and how we think about ESG. Before we invest in any company, we have to do an internal analysis from an ESG perspective and come up with a summary that we have looked at the company and some of the changes historically. The problem we are working through is that there are different vendors and ratings out there.” DePrince, Race & Zollo, $4B EAUM
“It is getting to be more and more important now. It depends on the cap size and also the space. The relevance or importance of ESG may vary sector to sector.” Granite Investment Partners, $3B EAUM
“…ESG is taking over the world. It is the tail wagging the dog. ESG has become very important and, in many cases, it is not so much you are doing huge amounts, it is that you have to say you are doing stuff. You have to be quantifying what you are doing and showing some progress. ESG hardly existed five years ago and today it is what everyone is talking about.” Cidel Asset Management, $3B EAUM
“We have always done the governance side but we had to build up on the environmental and social sides. It is becoming a bigger part of our process. It is still obviously not the main thing and the core fundamentals and operations of the business take precedence but it is in all our investment cases now.” Cramer Rosenthal, $3B EAUM
“We are a smaller fund and it is not as important for us as it is with some of the bigger funds but we are starting to look at that more as we go forward, so it will become more important because our investors will start asking us about it. We think about some of those things that ESG entails but it will become more important for everyone. We do not have a mandate so to speak.” Panoramic Capital, $0.3B EAUM
While a lot has been made about the true drivers of ESG-focused funds, our primary research finds that institutional investors believe the top driver of the prolific ESG focus today is shifting client preferences, more so than stricter regulation and increasing media coverage.
In a recent report, Deloitte noted ESG-mandated assets in the U.S. could grow almost three times as fast as non-ESG-mandated assets and comprise half of all professionally managed investments by 2025. This is driven by 72% of the U.S. population expressing at least moderate interest in sustainable investing, with one-third of millennials often or exclusively using investments that take ESG factors into account, compared with 19% of Gen Z, 16% of Gen X and 2% of Baby Boomers. This is critical given the upcoming $24T wealth transfer from Baby Boomers to Millennials.
More importantly, nearly 60% of investors believe companies that integrate ESG into business strategy will outperform over the long term. Medium-term views are mixed, while there is general agreement ESG will not necessarily impact short-term performance.
ESG Largely Remains One Factor as Part of the Overall Investment Thesis, though Investment Firms Are Becoming Increasingly Sophisticated
One year ago, our research found the majority of investors utilized service provider research and ratings as a starting point to a much more comprehensive analysis – both quantitative and qualitative as well as internal collaboration – and the overwhelming consideration was primarily one of risk / return.
For 45% of investors, ESG is again considered one factor as part of the overall investment process, while 34% assert ESG only matters if there is a red flag or for industries in which there are heightened concerns (e.g., chemical, oil & gas).
More than double our 2019 Inaugural Global ESG Survey findings and quantifying the inroads ESG has made at institutional investment firms globally over the last few years, 58% now have ESG-dedicated departments, with 70% needing approval before investing. Still, there is a long way to go for the U.S. relative to their European counterparts, as fewer than one-quarter have internal / proprietary matrices to evaluate ESG for issuers, indicating the approach remains collaborative and qualitative in nature.
While the approach for most is qualitative, 65% of investors assign some weighting to ESG as a factor in their investment process, with an average weighting of 15%.
Fewer Investors Are Precluded by Poor ESG Scores from Ratings Providers
As we noted, the majority of investors have utilized service provider research and ratings as only a starting point to a much more comprehensive analysis, though 54% in 2020 asserted the ability to invest if there was a poor ESG score was “case sensitive”. With increasing apprehension toward inconsistent ratings across providers, 60% now note they are able to invest in a company even with a poor ESG score, with significantly fewer noting it is case sensitive.
Still, ratings providers are an important part of the ESG ecosystem and, at this point in the ESG evolution, two clear leaders have emerged – MSCI and Sustainalytics, while others have developed a niche for specific sectors (e.g., GRESB for REITs).
There is Still A Long Way to Go for Standardized Reporting but Steps Are Being Taken
As our research has reported since the onset, the lack of standardized reporting has remained a prominent issue and the leading frustration for both investors and issuers alike. But, we continue to see steady steps toward standardization; just days ago, SASB finalized its merger with the International Integrated Reporting Council (IIRC) to form the Value Reporting Foundation, integrating their ESG reporting frameworks to provide more “holistic” and consistent ESG reporting.
And, as we highlighted in last week’s thought leadership, the Global Reporting Initiative (GRI) and Sustainability Accounting Standards Board (SASB) published A Practical Guide to Sustainability Reporting Using GRI and SASB Standards on April 8, 2021 in an effort to explain how the standards complement one another and how using them in tandem offers a more holistic picture of corporate performance and corporate social responsibility.
While almost 40% of surveyed investors report not utilizing standards and framework developers, SASB, CDP and UN SDGs continue to gain traction.
Environmental and Social Have Becoming Increasingly Important
Environmental
While the “G” remains the most important ESG element currently, per investors, as we’ve been reporting, focus is growing on the “E” and “S”. In line with 2020, more than 40% investors consider Environmental Very Important or Critical to their investment thesis, while just 10% do not at all.
Broadly, carbon footprint and emissions and Net Zero/Carbon Neutral goals remain the most important “E” considerations, followed by water management, energy intensity, and waste reduction. For the first time, revenue-generating opportunities are also identified. This is consistent with what we hear from corporate leadership in terms of ESG increasingly becoming a key requirement in the sales process as customers demand higher standards of actions and disclosure.
Social
Following last year’s COVID-19 pandemic and events of racial injustice, nearly half of investors now consider Social Very Important or Critical to their investment thesis, up from just one-third in 2019.
HCM and D&I remain the most critical focus areas, while supply chain management, pay equity and workforce productivity are also in focus.
Governance
Consistent with historical findings, three-quarters of investors consider Governance the most important component of ESG, with the hallmarks of good corporate governance being 1) executive compensation aligned with shareholder interests, particularly ROIC and TSR, 2) board composition; 3) diversity (gender identity, ethnicity); and 4) Board independence.
In Closing
Well, that was chock full of fun facts, figures, and thought leadership and we certainly hope you find our primary research insightful and helpful! You – our valued clients and supporters – are the reason we do what we do!