The three P’s of integrating ESG issues into portfolios

Today we are going to hear about the three ‘P’s’ — principled, pragmatic and practical — which pretty much describe the UN’s Principles of Responsible Investment (PRI).

If the recent 2008 UN PRI Progress Report is anything to go by, even to the unskilled eye, the principles seem to be working.

The doubling in the number of PRI signatories from 180 to 381 over the past year alone sends a message, loud and clear, that sustainable investment is here to stay.

“The increasing percentage of PRI asset owners that are looking at environmental, social and corporate governance (ESG) issues when selecting mainstream investment managers should be sending a clear signal to the market that responsible investment capability is becoming core to the way investment is done,” PRI executive director James Gifford said.

If you think that 381 companies doesn’t sound like very much, we are talking about the global giants of investment managers, asset owners and professional service partners, with combined assets under management of over US$14 trillion — that’s enough to make anyone sit up straight and pay attention.

According to the report, of the US$14 trillion, European investors continue to lead the way, representing US$9.7 trillion in assets under management, followed by the US with US$2.3 trillion, Asia with US$1.46 trillion, Oceania with US$570 billion, Africa with US$232 billion and Latin America with US$107 billion under management.

So, what exactly is the UN PRI, what progress does its latest report reveal and why would financial advisers be ignoring it at their peril?

Principled

Launched in 2006 to encourage the investment community to incorporate ESG issues into their investment framework, the UN PRI group kicked off with just 20 founding members.

Members declare: “As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that ESG issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time). We also recognise that applying these principles may better align investors with broader objectives of society.”

With up to 15 new organisations joining every month, there’s no doubt ESG, or sustainable investment, could grow to become the single biggest influence upon investment approaches and stock selection analysis in the 21st Century.

Pragmatic

The UN PRI is pragmatic in that it advocates, rather than prescribes, behaviour that is dictated more by practical consequences than by theory or dogma.

It states: “The principles are voluntary and aspirational. They are not prescriptive, but instead provide a menu of possible actions for incorporating ESG issues into mainstream investment decision-making and ownership practices. Signing represents a very real commitment to the principles, demonstrating support from the top-level leadership of the whole investment business.”

Monash Sustainability Enterprises director Doug Holmes said: “It is hard to say at this stage how seriously some of the fund managers will embrace those commitments and how extensively they will attempt to manage these types of issues. Some may take a cursory approach to spreading their portfolios, others may go a lot deeper, but it depends very much on each manager. I think there’s a real spectrum out there.”

Practical

The practical consequence of adopting a sustainable approach to stock selection is the potential for enhanced performance.

There is a growing view among investment professionals that environmental, social and corporate governance issues can positively affect the performance of investment portfolios.

Applying the principles should not only lead to better long-term financial returns, but also a closer alignment between the objectives of institutional investors and those of society at large.

Dr Leeora Black, founder and managing director of the Australian Centre for Corporate Responsibility, said: “We understand now more than ever before about the relationship between social and environmental performance and financial performance and the roles of environmental and social risk factors in contributing to company performance. It makes sense to incorporate these things that in the past have been regarded as intangible or voodoo.

An important driver has been the UN PRI, which has had rapid acceptance by mainstream investment managers and trustees.”

The 2008 progress report

As the UN’s principles are voluntary and aspirational rather than prescriptive, each year it produces a progress report that captures in significant detail how investors are integrating ESG issues within investment decision-making and ownership practices.

While some may feel that this carrot approach is a weakness of the principles, its latest report reveals that almost all signatories who participated in the 2007 survey have a formal policy or statement regarding integration and most of the remainder plan to adopt one in 2008.

What’s more, 75 per cent of investment managers are reporting their ESG-related engagement activities with companies and a further 18 per cent plan to do so in 2008, while 76 per cent of asset owners are already reporting, with 6 per cent planning to do so in 2008.

Encouragingly, more than two-thirds of signatories — 70 per cent — now ask companies in which they invest to produce standardised reporting on their ESG policies, practices or performance.

Nearly one-third of respondents — 33 per cent — said they would now revisit relationships with service providers in light of ESG issue-related capabilities, representing a massive two-thirds increase — 68 per cent — on the number of signatories willing to do so last year.

Furthermore, three-quarters — 76 per cent — of signatories report engagement in dialogue with policy makers and industry regulators on ESG issues, an increase of 29 per cent in such activity compared to last year.

While companies are finding it difficult to incorporate ESG issues into investment analysis and decision making — principle 1 of the PRI — an increasing number of asset owners are becoming involved in collaborative engagement.

Nearly half of all asset owner signatories — 47 per cent — said they engage with companies to a medium or large extent, up from 38 per cent in 2007.

The impact upon financial advice

The focus on the UN PRI and the ripple effects it is having throughout the investment community are important for advisers in a number of ways.

Firstly, the investing public is becoming increasingly aware of the socio-political issues of climate change, water and food scarcity, peak oil and rising petrol prices, clean energy and so on, and the financial impact these issues can potentially have upon the companies in which they invest.

What’s more, investors are keen to avoid such scandals and shocks as HIH, James Hardie and WorldCom and a growing number of consumers are seeking professional financial advice in order to do so.

Secondly, industry participants believe a performance differential between ESG and non-ESG funds will open up over the longer term, where those funds that take ESG issues into consideration will outperform.

Not only is investing with a fund manager who takes ESG issues into consideration a prudent move, but there will come a time when ignoring ESG issues in the investment process will be considered foolhardy.

Zurich Financial Services Australia believes it is the latest Australian signatory to the principles.

Mathew Drennan, director of investments, said: “Sustainable investing has taken on much more of a mainstream character and can be managed with a much more sensible and commercial focus.

“It involves identifying value and growth opportunities that are not currently taken into account in the market and avoiding risks in companies that have not been recognised by the market. Outperformance comes from many factors — sustainability is one of those factors,” he said.