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The role of the investment industry is key to changing ESG matters, however the processes involved are complex and have far reaching effects.

“Environmental”, “Social” and “Governance” – three words that investors hear more and more often, and with good reason. Together they define the attitude towards the broader impact on society when allocating capital. Pension fund trustees and other custodians of long-term savings need to consider carefully how much they can provide their members in retirement – the return – against the type of world those beneficiaries would end up living in. A large pension is all very nice unless the only place to spend it is a polluted, corrupt, unsustainable world.

By 2030, the world population is projected to reach eight billion and 60% of us will be living in cities. Meeting our needs, let alone those of our children, will require significant investment in new buildings, transport, training, social services and energy supplies.

Not many people would question that building a school or hospital makes a positive contribution to society. However, even such ‘obvious’ cases may negatively impact the community or environment: Where will it be built? What was there before? Where will the materials come from? The energy to run it? Besides considering the full macro context, as asset owners concerned about ESG, where should we focus – at our local community? within our country? somewhere far away where the human benefit may potentially be greatest?

Clearly ESG and the reach of ESG mean different things to different people. Even the impact on a portfolio is open to debate. One perspective claims that ESG constraints which avoid investments with a low ESG score will lead to lower potential returns because a smaller universe results in compromised choices compared to an unconstrained, larger universe. Even if a reduction in performance is anticipated, the investor may conclude that this is acceptable if they achieve other benefits like generating a measurable social benefit alongside the financial return (so-called “impact investing”). A competing perspective is that selecting investments with strong ESG credentials tilts the portfolio towards companies or projects which may be more successful in future (or stay in business for longer) so the ESG constraints act like a filter to identify long-term profitable enterprises. A complication here is that, unlike public equities, real assets are largely privately owned, and it is therefore more difficult to show the extent to which positive ESG screening creates value.

An ESG policy is likely to have a greater impact if it focuses on those aspects which local culture, regulation and resources are not already addressing. For example, if environmental protection legislation is already strong, emphasising the “E” of ESG may yield only marginal benefit. Not that investors should ignore it – rule changes will happen like we are seeing in the USA right now where environmental protection is being rolled back and asset owners may need to exert shareholder or project sponsor pressure to restore their chosen protection level. Receptiveness to change also plays a big part, as does the local perception of which area is weakest or where the largest impact can be made. Across sub-Saharan Africa for example a shortage of access to education and basic human needs – water, shelter – tends to dominate ESG conversations. This suggests that projects emphasising “S” may gain more traction with easier local approvals and more willing local partners in this region. Or take China, where there have been numerous cases of accounting fraud and minority shareholder oppression, “G” remains the key focus for investors. Despite recent regulatory reforms, it is still critical for an active manager to incorporate corporate governance standards into its due diligence process. 

It is also worth remembering that many of the issues are cross-border problems. Pollution in one country can easily affect its neighbours. Poor governance and regulation in one industry can attract less scrupulous operators from around the world to establish a local presence. A lack of social development or opportunities causes people to migrate to places where these are more accessible, which in turn may cause issues in the ‘recipient’ country.

The role of the investment industry is key as it can exert considerable influence in the way that assets are built and operated, and determining which projects are greenlighted and which are not. However, evaluating projects is often a complex process, involving potentially conflicting factors – for example, creating jobs and enhancing services, but also impacting local ecosystems. Once up and running, even factors like assessing energy efficiency – which seem straightforward – might depend on cost sharing and data availability.

The intricacies and geographical reach of an ESG policy can be very large indeed. Fund trustees will have their work cut out in this area over the next few years.

– Lars Hagenbuch,
Consultant, RisCura

* This article first appeared on Pension Funds Online.