Delving into the world of ESG is an eye-opening investigation, as the wealth of data and content that is now being assessed and incorporated into modern portfolio investment practises is enormous.
ESG’s role in Responsible Investing has evolved over the past 15 years into one of the most significant investment trends for both the global and local investment community.
According to the Responsible Investment Association Australia, there was $630bln AUD invested in ESG attributed investments in 2014, which rose to 980bln in 2018.
RIAA also estimates that 44% of assets managed by professional investors in Australia incorporate some form of ESG criteria, which compares favourably to the US with 26% or slightly behind Europe with 49%.
Superannuation funds have taken Responsible Investing to heart as the hard evidence shows that ESG integration can increase the risk adjusted returns of investment portfolios.
Many of Australia’s larger asset allocators now employ sophisticated ESG integration for their internally managed funds, while enforcing compliance programs for external fund managers.
As significant shareholders, superannuation funds are now engaging directly with Australian companies on issues ranging from climate change, energy management, modern slavery and human rights.
The importance of ESG and its impact on investment was clearly articulated by Ian Silk, CEO of Australian Super, at the 2019 Australian Council of Superannuation Investors Conference.
“Failure to properly manage ESG risks can lead to reputational damage, regulatory scrutiny, civil and criminal litigation, profit downgrades and ultimately poor investment results.”
More than just a trend
Responsible Investing was for many years considered a trend within the overall big picture of a growing domestic economy.
Australia has enjoyed an extraordinary run of consecutive quarterly GDP growth over the past 25 years.
Rising household debt, a softer housing market and an increasing reliance on China, whose economy was also slowing have put pressure on Australia’s economy.
Even before the onset of COVID-19, Australia’s economic growth prospects were under the pump.
Responsible Investing and ESG are not a one stop panacea but according to Australia’s CSIRO, in its Australian National Outlook 2019, “Australia is at risk of falling into a slow decline of no action is taken on its most significant economic, social and environmental challenges.”
Responsible investing and ESG criteria will likely assume a more prominent role from the professional investment community in years to come.
Australian GDP Growth 1995 to 2020 (%, per annum)
Sustainalytics, a subsidiary of Morningstar, looks at ASX 200 companies in terms of “unmanaged ESG risk facing a benchmark investor in Australia.”
According to Sustainalytics, there are two ways to measure unmanaged ESG risk of an equity market:
1) an average ESG risk rating score which represents the simple average of the benchmark company’s ESG Risk rating scores, or
2) a weighted ESG Risk rating score which takes into account each company’s weight in the benchmark index.
Sustainalytics believes the weighted ESG risk rating score is more appropriate (option 2) and when compared to similar indexes globally, Australia’s ASX 200 rates favourably.
Comparing the FTSE All-World to the ASX 200 highlights the variability on the companies that make up each index.
The FTSE All-World index series is a stock market index that covers over 3,100 companies in 47 countries starting in 1986.
The following chart compares the unmanaged risk facing sectors in the same market and highlights differentiation in industry practises across regions.
From the ASX 200 perspective the clear takeaway is the weak performance of the 39 stocks that make up the materials sector which have an average ESG risk score of 36.5 v 32.1 for the 231 companies that make up the FTSE All-World material sector.
This gap can be put down to the average size of companies that make up the ASX 200 Material sector being USD 9.5bln v USD 12.4bln for the FTSE All-world as the smaller companies have less financial resources and organisational to develop their ESG file compared to their larger cap peers.
The following table looks at the key sectors within the ASX 200 and the companies with the highest and lowest ESG risk rating scores.
Looking at the same data set for the ASX 200 but from a weighted ESG risk rating perspective, the numbers change as the industry composition varies significantly.
The ASX 200 is heavily overweight financials at 32% while materials make up another 18%.
Investors have concentrated their risk in just 2 sectors which has implications for the amount of unmanaged ESG risk investors take on the ASX 200.
The reality for investors benchmarked to the ASX 200 is that this concentration works in their favour.
Australian financials tend to be lower risk from an ESG perspective overall, and compared to financial stocks in other markets, which more than offsets the impact of the materials sector which is the weak spot from an ESG risk perspective.
Sustainalytics investigates 20 material ESG issues which are the central building blocks to their ESG Risk Rating for each company:
• The environmental & social impact of products and services
• Human Rights
• Data privacy and security
• Business ethics
• Bribery and corruption
• Access to basic services
• Community relations
• Emissions, effluents and waste
• Carbon- own operations
• Carbon-products and services
• Human rights and supply chain
• Human capital
• Land use and biodiversity
• Land use and biodiversity- supply chain
• Occupational health and safety
• ESG integration- financials
• Product governance
• Resource Use
• Resource Use –supply chain
Sustainalytics methodology combines thousands of data points for each company and bring this data back to a single unit (score).
The ESG Risk Ratings provides a powerful signal of a company’s absolute ESG risk that is comparable across peers and subindustries while allowing for aggregation at the portfolio level.
Below is the ESG rating of BHP.
The impact of ESG on responsible investing is becoming increasingly relevant to investors globally and the tools required to measure a company’s ESG credentials and risks will also become more important.
Otherwise, executive management of companies will need to be aware and adapt to changes in investor behaviour, lest they see higher costs of capital if they don’t meet a large cohort of investors criterium, based on ESG scoring.
This incremental improvement should also assist financial performance, creating a positive cycle that also rewards investors with better risk adjusted returns.
The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.