Principal Investment Consultant, Dynamic Planner
Sustainability: what is the role of the financial markets?
How are we able to satisfy the needs of the present without compromising the ability of future generations to meet their own needs?
Financial institutions such as banks, insurance companies and asset managers play a pivotal role alongside national governments and regulations, if we are to be successful in sustainably combining often-competing interests. These challenges can be collectively described as the three ‘P's’ – standing for ‘people: planet: profit’.
This is because the fundamental role of financial markets is to efficiently channel resources to the most financially viable companies, not just in the present, but even more critically, in the future. In a perfectly efficient market, those companies which are considered good or taking steps to improve their sustainability are rewarded by access to financial markets to fund their development at a lower cost compared to those that are not.
Global commitments to respond to the threat of climate change as outlined in the Paris Agreement of 2015 have placed the asset management industry at the forefront of delivering the improvements in corporate citizenship needed if we are to stand any chance in meeting them.
For asset managers, this process involves the careful assessment of environmental, social and governance (ESG) risk factors when making investment decisions about which stocks or bonds to buy/sell. ESG risk factors matter because they can have significant impacts on a company’s competitive position and its long-term financial performance as well as delivering positive outcomes for the environment and society. Many of these risks have yet to be fully understood and priced into the value of assets by the financial markets, thereby presenting both significant challenges as well as opportunities for investors.
Measuring ESG risk
A very wide variety of ESG risk measures can be used to assess the performance of a company and are calculated by many different independent research providers. Given the inherent complexity of this process, considerable care needs to be taken since there is no defined set of agreed measures or research methodologies, hence research opinions will inevitably differ. There is also a significant amount of ESG data that is self-reported by the companies themselves, which can lead to meaningful gaps in data availability, as well as issues around their consistency and reliability.
Whilst fossil fuel-related issues are one of the most common environmental considerations, other risk measures here can include usage levels of water and renewable energy as well as the existence of a specific environmental policy. Equally social and governance considerations are closely scrutinized.
Once the appropriate ESG risk factors have been identified for a specific company, investors need to determine how best to measure them in relative terms against their peers across the same or similar industry sectors.
Science based measures and targets should aim to be comparable over time to enable users of these disclosures to understand the firm’s direction of travel and ambition. Some sectors, such as energy, are prone to low overall ESG scores, while others such as technology, may have higher overall scores due to the nature of the underlying business models.
Different cultural biases and levels of transparency can also present significant barriers, often depending upon where the company is located.
The above can be found in Dynamic Planner’s “Sustainable Investing Discussion Guide”, along with numerous other articles and information. This can be accessed at: https://www.dynamicplanner.com/sustainable-investing-guide/