Funds are now considering environmental, social and governance issues
The recent turmoil in the financial market has been so forceful and painful that almost all market participants are passing through a very challenging time. It is usually believed that during the time of distress, when appetite for even mainstream investment goes down, sustainable and responsible investment (SRI) is bound to be a casualty. However, a new report from the International Finance Corporation (IFC) and Mercer finds that investment in emerging market SRI funds has reached $300 billion in 2008, a more than five-fold increase since 2003. Out of this, $50 billion reflects funds which are specifically branded as socially responsible or sustainable, while the remaining amount represents mainstream managers who take environmental, social and governance (ESG) issues into account.
According to this study, almost half of the managers investing in emerging markets (46 per cent) had a policy regarding the integration of ESG issues in their investment processes. This is a pointer to the fact that increasing number of asset managers are recognising that ESG issues are material to the performance of their portfolio companies and other assets they hold, and, therefore, must be factored into investment analysis and decision-making. And for investors, this clearly is not an act of philanthropy. Instead, it's an act to maximise medium-to-long-term investment returns with purpose.
While it is true that most of the emerging market equity products that use SRI approaches are mainly managed by global asset managers who have taken an ESG-integrated approach in their equity mandates and are currently driving the growth of SRI in emerging markets, this is a trend local asset managers will not be able to ignore for long. Sooner or later, they will have to integrate ESG issues in their investment strategies as these issues are going to take centre stage with each passing year. The factors that are driving SRI growth are increased social awareness, media attention, increasing prices of energy and raw materials, and changing legislations such as mandatory CO2 reductions etc.
Let us just look at the world population. It is expected to grow from 6 billion to 9 billion by 2050. This dramatic demographic change along with increased globalisation, accelerated industrialisation and resource consumption will bring about exploitation of resources at a rate that has not been witnessed in the human history so far. This will not only have far-reaching consequences on our environment and society, but also on the capital market. Therefore, the asset management industry will have to create and develop products that are shaped by these concerns.
The asset management industries in the US and Europe have already taken a lead in this regard by allocating roughly 11 per cent ($ 2.71 trillion) and 17 per cent (€2.66 trillion) of the total assets under professional management in SRI funds in the US and Europe, respectively, in 2007. The trend to embrace SRI in investment practices is only going to accelerate in the coming years. A recent study by Robeco and Booz & Company (Responsible investing: A paradigm shift, October 2008) based on interviews with more than 50 market participants reports that investment in SRI funds is likely to reach $25 trillion by 2015. This means more opportunity for players in the financial sector to develop SRI products that fit the growing needs. Moreover, increasing need and reach of SRI products will also lead to standardisation of SRI frameworks that will facilitate creation and solutions in all asset classes. The United Nations' Principles for Responsible Investment (PRI), which provides a common framework for integrating ESG issues, is a good example in this regard. Launched in April 2006 by the then UN Secretary General Kofi Anan, this global initiative has by now more than 360 signatories, representing asset owners with over $14 trillion committed to adhering to these principles.
There has been a substantial growth in institutional investor activity and the mutual fund industry in India during the past few years. While there seems to be some awareness about ESG issues among local asset managers, its incorporation into the investment process is still a far cry. The IFC and Mercer study found that of the four emerging markets—China, India, South Korea, and Brazil—India has the lowest standards of ESG implementation. As of now, Brazil has 28 signatories (18 pension funds, eight asset managers and two professional service providers) to the UN PRI, whereas India has none.
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Better integration of ESG issues into investment processes leads to a more resilient and efficient market. Clearly, the recent Satyam episode and the difficulty Tata Motors faced in Singur have reinforced the necessity for the financial industry to actively evaluate and manage risks associated with ESG issues. A financial system that is short-sighted and unaware of the impact of ESG issues on the financial prospect of a company will fail to avoid or reduce the risks posed by it. ESG integration, in fact, is all about investors taking a longer-term view and incorporating the full spectrum of future risks and opportunities into their investment/ownership practices. Going forward, asset managers, therefore, will need to develop and distribute ESG investment strategies and services as a tool for improving risk-adjusted returns. Similarly, regulators will have to formulate policies and regulations that promote greater transparency on ESG integration. A good beginning in this direction can be made by the Pension Fund Regulatory and Development Authority (PFRDA) by bringing ESG-related guidelines into the New Pension Scheme (NPS). The NPS allows 50 per cent of the fund to be invested in the stock market. Thus, by guiding the fund managers to invest in companies that follow better ESG practices, it will not only help bring ESG issues into mainstream investment decision-making and ownership practices in India, but also promote investment that differentiates between companies that follow sustainable and inclusive practices and that do not. A number of European countries (the UK, France, Germany, Sweden, Belgium, Norway, Austria and Italy) have already developed ESG-related requirements for their public pension systems.
Though the current financial turmoil triggered by credit quality may tempt market participants to think of ESG as ‘tomorrow’s issues’, in my view, it is precisely because of such a crisis that there is an even greater urgency and need to understand and manage the risks posed by it, lest this should trigger another crisis.
(The author is head and senior economist at Crisil. Views expressed are his own)