Sustainability in finance – ESG and Co.

What do ESG, SRI and impact investing stand for?

The term ESG is the abbreviation for Environment, Social and Governance. ESG is a framework for examining corporate activity in these three dimensions. Environment includes ecological aspects such as climate, pollution or biodiversity. Social includes social issues such as the treatment of employees, data privacy or the avoidance of child labour. Governance covers corporate management issues such as dealing with conflicts of interest or the design of compensation plans for top management. The focus is on the practices of companies with regard to critical issues that are recognised throughout the industry. Companies that manage these issues prudently are more likely to succeed in the long run than those that neglect them. In the sense of risk management (meaning both risk and opportunity management), risk indicators are thus recorded.

Investing on the basis of ESG information initially means only taking these ESG-based risk indicators into account in the investment process. This is referred to as ESG integration in the investment process. The investment universe, i.e. the securities that can be considered for investment, is only slightly restricted. The actual selection of securities is very much driven by the chosen risk and investment strategy. Personal values and norms play less of a role.

SRI stands for Socially Responsible Investing. SRI is also based on ESG information, but is more strongly driven by ethical considerations and specific values and norms of the investor. The selection criteria for investment stocks are stricter than with a pure risk view. Investing in assets with high emissions of pollutants or other misconduct is harder to justify under SRI, while the same investment may still be well justified under an ESG-based risk and investment strategy.

Impact investing aims at the desired impact through the activity of companies or projects. In its strict definition, the desired impact should only be made possible by the invested funds. This means that a simple purchase of shares or bonds on the stock exchange is not sufficient. These high requirements are met above all in the area of private equity (or private dept) and are accessible to investors through funds. In a somewhat less strict interpretation, investments in listed companies are also considered impact investments, provided the companies have a positive impact. A classification of the desired impact according to ESG is possible, but more often the SDGs, the UN’s Sustainable Development Goals, are used as a guideline.

All three terms can be assigned to one of the three main goals of sustainable investment:

• ESG the goal of managing risk,
• SRI the goal of investing in accordance with its values and norms, and
• Impact Investing the goal of direct positive impact on the environment and society.

The importance of ESG

It was the empirical evidence that a conscious approach to critical issues has a positive impact on corporate performance that led to this broad application of ESG information in the investment process. ESG information contains short-, medium- and long-term risk indicators and thus also financially relevant information. The consideration of ESG-based risk indicators represents a systematic extension of traditional financial analysis. It is thus obvious that the regulator increasingly requires the consideration of ESG in the investment business, for example in the management of pension fund assets and investor protection, as best practice. Even if the consideration of ESG in Switzerland is often still done on a voluntary basis, the consideration of risk aspects is already considered a fiduciary duty in the investment business, i.e. also the consideration of ESG-based risk indicators.

Even if it was ESG as risk management that helped the topic of sustainability to achieve this broad application, there still remains a certain area of tension between the pure risk view and the public understanding of sustainability. This is because the general public tends to understand sustainability as an orientation towards values and standards (more SRI) and positive impact (more impact investing).

How is sustainability measured?

In current practice, the first step in ESG is to identify the most pressing issues (hereafter referred to as ESG focus issues) for each industry sector, e.g. CO2 emissions in the cement industry, dealing with water scarcity in arid countries in the agricultural sector, or sales practices in the finance and insurance industry. An ESG focus issue is deemed relevant to business success, i.e. entirely in terms of opportunities and risks. In a second step, the exposure of the companies and their practices to the ESG focus issues are assessed and corresponding scores are derived. Thus, scores can be derived at different levels of granularity, i.e. the data points collected can be aggregated at different levels. On the basis of these scores, ratings, rankings and various categories can be formed. The same approach is also used for countries.

The ESG dataset is extended with information on how many scandals, court cases or to what degree companies are involved in controversial activities, e.g. in the business with handguns, tobacco, genetically modified products or pornography. There are also blacklists in use, i.e. of already sanctioned countries and offending companies. To support impact investing, SDG-aligned impact metrics are also recorded. In other words, indicators are provided that allow conclusions to be drawn as to whether a country or a company is contributing to the fulfilment of SDGs and how much.

An important circumstance here is that this ESG framework is neither regulated nor standardized. Complete standardisation is also not considered desirable, as the range of different methods and assessments is also an important source of information. ESG scores are qualitative in nature and will continue to differ between individual data providers. This is a circumstance that must be taken into account in ESG.

Sustainability strategies in investing

On the basis of ESG information, various sustainability strategies can be defined and pursued when investing. Here is an overview of the strategies:

• Exclusion: Exclusion of sectors
• Negative screening: Further exclusion, e.g. due to scores, involvement in controversial business activities.
• Positive Screening: Best-in-Class based on best scores
• Thematic Investing: Selection according to specific topics, sometimes used synonymously with impact investing
• Proxy voting: Voting on motions at AGMs with the aim of improving governance
• Engagement: Active influence on ESG-relevant practices by investor groups
• Impact investing: Focus on additional, but at least intended, positive impact

Very often, these sustainability strategies are combined. All of the sustainability strategies listed have in common that they also want to generate a positive financial return. They are therefore distinct from philanthropic approaches, which give greater weight to the ecological and social dimensions and thereby substantially forego returns or accept “losses”.

Greenwashing as a challenge to sustainable investment

There is often criticism of “greenwashing“, i.e. the marketing of traditional investments or those with dubious sustainability credentials as “sustainable”. It can also be observed for the entire investment market that the figures published for 2019 for sustainable investments have jumped. Even though the growth figures are actually likely to be in double digits: The sharp increase is largely due to the fact that more and more traditional investments are included in the figures as sustainable investments via exclusions of a few stocks or by taking ESG risk indicators into account. According to this method of counting, 30-40 percent of the investments made from Switzerland are already “sustainable”. Here, too, there seems to be a tendency to increasingly soften the definition of sustainability.

Regulators have also recognised this problem. The EU in particular is making far-reaching efforts to regulate the ESG environment in depth. The main goal is increased transparency and the redirection of financial flows into sustainable real economic activities. This is to be achieved through stricter regulation or clearer characterisation of which financial products may be marketed as “sustainable”, which only “with sustainable features” and which only as “traditional investments”. The definition of sustainability in the EU taxonomy, the framework for future regulatory steps, relies heavily on (intended or unintended) positive as well as negative impacts of corporate activity. It thus defines the term sustainability much closer to impact investing and thus much stricter than before. For comparison: with the stricter EU definition, only a fraction of the 30-40 per cent should be considered “sustainably” invested in Switzerland as well. The rest would only be allowed to be marketed as “with sustainable features” or as a “traditional investment”.

In parallel, the FIDLEG and MiFID provisions are being expanded in Switzerland and the EU. Preferences for sustainable investments must now also be documented and served accordingly. This means that the preferences expressed are binding and the client can demand that they be taken into account.

So what about the “sustainability” of ESG, SRI and impact investing?

ESG as a risk management approach is not hype, but is here to stay. Impact investing is also getting an additional boost from EU regulation, as impact investing products are officially allowed to call themselves sustainable in the EU area. More value-based SRI investments will also benefit from the current trend towards more transparency and a growing product range. The regulatory push towards standardisation and mandatory disclosure of ESG information is set and a trend reversal is not in sight. This is good news for investors: they can thus assess much better where regulatory risks lurk and where opportunities present themselves.

It seems that the financial world has been gripped by fundamental change. The financial industry is assigned an important role in the implementation of this global change. As the current experience of international financial service providers shows, the dynamic regulatory development and resulting adjustments and the depth and complexity of sustainable investing (risk management, values and impact) cannot be underestimated. If one wants

• fully exploit the potential of ESG integration for risk management,
• seriously distribute the sustainable product range,
• support customers with good advice and good action on the subject of sustainability,
• Access to the EU market and
• prepare for future Swiss regulations in this area,

you have to face this challenge at an early stage.

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