ESG (environmental, social and governance) is a generic term used in capital markets and used by investors to evaluate corporate behaviour and to determine the future financial performance of companies.
ESG factors are a subset of non-financial performance indicators which include sustainable, ethical and corporate governance issues such as managing the company’s carbon footprint and ensuring there are systems in place to ensure accountability.
The European Federation of Financial Analysts Societies (EFFAS) has defined topical areas for the reporting of ESG issues, and developed Key Performance Indicators (KPIs) for use in financial analysis of corporate performance. EFFAS has identified nine topical areas that apply to all sectors and industries:
1) Energy efficiency;
2) Greenhouse gas (GHG) emissions;
3) Staff turnover;
4) Training & qualification;
5) Maturity of workforce;
6) Absenteeism rate;
7) Litigation risks;
8) Corruption;
9) Revenues from new products.
Next to these nine areas sector-specific ESGs and KPIs (key performance indicators) have also been defined. [1]
ESG has quickly become part of investment jargon to describe the performance of investment and fund portfolios on environmental, social and governance criteria and the quality of their performance against measurable ESG factors that are reported to shareholders. ESG analysis can provide insight into the long-term prospects of companies which allows mispricing opportunities to be identified. Investors can find new market opportunities with companies that place the management of ESG factors at the core of the business.
Company-specific ESG factors offer a benchmark for investors to judge the overall quality of the board’s governance and risk management processes and their positioning within an industry sector. The UN-backed Principles for Responsible Investment (UNPRI) provides a voluntary ESG framework for companies and funds, from which investors can make informed investment decisions that relate to sustainability and governance practices.
The growing interest in ESG factors from institutional investors, in particular, reflects the view that environmental, social and corporate governance issues can affect the performance of investment portfolios and should therefore be given appropriate consideration by investors.
As of February 2014, 1,064 asset owners and asset managers and 183 professional service partners, representing combined assets of more than $34 trillion, had committed themselves to the six principles of the PRI.
The six principles of the PRI are:
1. We will incorporate ESG issues into investment analysis and decision-making processes
2. We will be active owners and incorporate ESG issues into our ownership policies and practices
3. We will seek appropriate disclosure on ESG issues by the entities in which we invest
4. We will promote acceptance and implementation of the Principles within the investment industry
5. We will work together to enhance our effectiveness in implementing the Principles
6. We will each report on our activities and progress towards implementing the Principles
Fund managers and financial analysts who can interpret and relate ESG factors to a company’s future prospects may potentially develop a competitive advantage should others fail to recognise the same risks or opportunities related to those factors.
The Association of British Insurers, in its guidelines to institutional investors, expects that a company’s annual report should include information on ESG-related risks and opportunities that may significantly affect the company’s short and long term value, and how such risks and opportunities might impact on the future of the business. The annual report should also set out how the board fulfils its responsibilities for ESG policies, procedures and verification. [2]
In October 2013 an FT columnist wrote that although the $34tn of assets backing the UN's Principles for Responsible Investment ought to be invested to take account of environmental, social and governance (ESG) factors that in practice it was hard to see what difference the UNPRI was making.
The piece drew a response from the managing director of the UNPRI who wrote that the organisation had developed a new framework which would require members for the first time to give evidence to demonstrate exactly how they were managing their investments in line with the Principles.
