By Hortense Bioy, Eugene Visagie and Victoria Reuvers

How do publicly listed companies deal with environmental issues and climate change? How do they manage carbon risk? How do they treat their workers, and do they have effective health and safety policies? Do they manage their supply chains in a sustainable way? Do they have a corporate culture that builds trust and fosters innovation?

These are the types of questions increasingly being asked by South African investors as part of a growing trend towards sustainable investing, where investors and institutions look for strong ESG (environmental, social and governance) credentials as a key part of their decision-making.

In South Africa, ESG investing is still in its early days. But there’s no doubt that it’s here to stay and is only going to grow in importance. Globally, it’s estimated that ESG investing has more than $23-trillion in assets under management (AUM) – or around a quarter of all professionally managed assets around the world.

This is being driven by several factors. In many important markets, including the U.S. and the EU, ESG integration is increasingly seen as part of fiduciary duty. There’s also a growing body of research which suggests that good environmental, social and governance practices translate into good business results, and lead to more sustainable markets and better outcomes for societies. A company with good ESG credentials is a company that’s well-positioned to deal with the challenges of the future.

Increasingly, investors prefer to put their money into companies with a demonstrated social conscience—that may be a strong environmental record or companies that embrace other developments, such as gender equality.

Globally, this has been driven by millennials, an increasingly powerful investor segment with a higher level of confidence in the long-term investment value of strong ESG practices. As their investable assets grow, more assets are likely to move into sustainable funds. Asset managers are taking note of these dynamics and accounting for them in their investment processes.

Additionally, in the South African market, multiple corporate governance failures have fostered a growing awareness around the governance angle, resulting in more pressure on investment managers to incorporate ESG into their investment strategies. If the growth of ESG focused assets in the global market is anything to go by, the movement isn’t a fad—instead, we’re viewing it as a real opportunity for advisers to differentiate a client’s investment experience.

As ESG awareness grows, the industry is grappling with the best way to incorporate these preferences into previously standardised practices. In the US, we’ve observed that this isn’t just about meeting growing investor demand—instead, fund managers are incorporating ESG because they believe it can improve their overall investment process and results. As stakeholders hold public companies to higher standards for corporate behaviour and performance, these issues become central to a company’s sustainability and ethical impact.

Climate change is real, and it’s a serious challenge for investors who want to balance their desire for high returns with a commitment to a positive environmental impact. This means investors will need to be more precise than ever in analysing their portfolio exposures to ensure they meet the realities of a carbon-constrained future.

To help them gear up for this new reality, South African investment advisors and asset managers are going to have to raise their ESG capabilities. This is getting easier all the time, with several resources available to help investors determine ESG factors, like the potential carbon exposure in markets.

It’s important to note that individuals will prioritise ESG pillars/principals differently. Some investors won’t want any exposure to certain industries (tobacco, gambling, weapons), while others are more concerned about incorporating best practice values when it comes to board composition and staff wellbeing. A more recent wave of ESG, impact investing, looks at investing solely into projects that focus on renewable energy, recycling and similar.

Historically, ESG approaches have excluded companies with apparent shakier ethical standing: industries like gambling, weapon manufacturing, thermal coal, etc. Next, companies that didn’t incorporate best practices were screened out (i.e. companies lacking board diversity, such as ones with low female representation, or companies without independent boards).

As investors are increasingly led by their social values, more listed companies have been incorporating ESG principles (some even establishing an ESG sub-committees to the board) to address some of these concerns. This way, companies that operate in sectors that are perceived to be bad for the environment can get a more positive score by establishing practices that partially offset their carbon footprints.

This is broadly done in three ways:

  •  Values alignment: screening out or excluding certain stocks
  • ESG integration: mitigating risk and generating alpha
  • Impact or thematic investing: mission-driven companies searching for solutions to large-scale environmental and social issues.

 Sustainable funds and ESG integration come in several forms. As ESG considerations grow, more asset managers are starting to recognise sustainability issues in their investment processes. By contrast, ESG integration funds take a more thorough approach, building portfolios that reflect sustainability factors and often screen out certain industries or companies. Impact funds look at measurable social and environmental impacts alongside financial return, while sustainable sector funds focus on the growing green economy.

Going forward, we expect more conventional funds to move into the broader ESG consideration group and more ESG integration funds to move towards impact investing. Sustainable sector funds should also experience growth as more investors see opportunities in the low-carbon transition to a green economy.

ESG incorporation and sustainable funds have plenty of room to grow. Assets under management and flows, though both higher than ever before, remain tiny compared with the overall investment universe. While many financial intermediaries are yet to fully embrace sustainable investing, asset managers are recognising the fiduciary benefits – not to mention satisfying investor demand – that come from incorporating sustainable practices.

Ultimately, though, it doesn’t matter which tool you use. The bottom line is that ESG is coming, and local investment advisors and asset managers should make sure they’re up to speed. We’re already seeing instances in Europe and the US where institutions give their business exclusively to asset managers with ESG credentials and capabilities. This is not a boat we want to miss.

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