ESG integration in investments in relation to investors fiduciary duty

By Neha Malhotra, Partner, Nangia Andersen LLP

In the modern investment system, financial institutions or individuals, known as fiduciaries, manage money or other assets for the best interests of the beneficiaries.
Today, “best interests” are undeniably defined in financial terms. While some institutional investors view ESG as part of their fiduciary duty, others believe that ESG factors are outside of the financial spectrum and should not be included in their investment considerations.

In spite of the dissension, both value-motivated and values-motivated investors already approach ESG factors as part of their overall decision-making process and investment decisions.

Institutional investors, particularly in Europe and North America are very receptive to the idea of using their investments to promote their values alongside providing a financial return. It’s a paradigm shift as investors seek to achieve both financial and non-financial returns.

The US SIF Foundation’s Report on US Sustainable Investing Trends identifies “climate change and carbon reductions” as a top priority of US-based institutional investors. The US sustainable investment assets under management at the beginning of 2022 were $8.4 trillion representing 13 percent of the total US assets under professional management. This demonstrates a growing focus on the inclusion of ESG factors in sustainable investing.

Investors are increasingly demanding companies to disclose how they plan to achieve net-zero emissions from their operations. Investors now call for more integrity in transition plans, accountability, and transparency in implementation. This is essential to ensure that mainstream net-zero pledges and targets do not suffer from credibility issues.

With growing awareness, such an approach in making investments is no longer a niche concept, but a globally recognized strategic primacy.

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Return on Sustainable Investing

There is a range of beliefs about the purpose and positive value to investors of integrating ESG considerations into investment decisions. From a slightly granular perspective, a strong ESG proposition can enhance investment returns by allocating capital to more promising and more sustainable opportunities. It can also help in avoiding stranded investments that may not pay off because of longer-term environmental issues.

Today, there is an increased understanding that the current global position of the environment (water scarcity, climate change, and depletion of natural resources in general) will weaken the economy -exposed to sustainability-led bubbles and spikes.

Social stress, “income inequality amongst the planet’s population” importantly, also has a significant impact on the wider economy.

Large institutional investors have holdings, which, due to their size, are highly diversified across all sectors, asset classes, and regions. Their portfolios are representative of global capital markets and accordingly, the investment returns are dependent on the continuing good health of the overall economy. Hence, it becomes imperative for them to act to reduce the economic risk presented by sustainability challenges.

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Incorporating ESG criteria into investment decisions make good sense financially, as well as from an impact perspective. This view has been long established by acclaimed studies. For instance, Morgan Stanley analysed over ten thousand funds using data on exchange-traded and open-ended mutual funds active from 2004-2018. It was found that in years of turbulent markets, sustainable funds’ downside deviation was significantly smaller than traditional funds’. In the last quarter of 2018, when U.S. stock market volatility spiked, despite negative returns for nearly all funds, the median sustainable fund outperformed the median traditional fund by 1.39% in U.S. Equity returns and had a narrower dispersion.

Another study revealed that US sustainable funds outperformed traditional funds by 4.3 percentage points in 2020-a year of extreme volatility and recession. Put simply, there is a multitude of implications for the emerging sustainability megatrends. Being able to integrate a response to these trends into business operations can be a success factor for an investee firm. From the investor perspective, these megatrends can be part of a successful portfolio construction strategy.

Issues around ESG Integration

Despite the growing importance of ESG, there is no denying that some challenges are likely while incorporating ESG considerations in investing. Apparently, “reliable ESG data is not yet widely accessible”, which may prevent institutional investors from being able to assess and analyse ESG factors and opportunities. Presently, mandatory corporate disclosure provides limited information on ESG-related risks and opportunities. The ESG-related disclosure may also be released at a different time than the regular financial statements, making integration harder.

In the case of voluntary disclosures, on the other hand, companies may divulge and exaggerate only what reflects well on them and downplay or not disclose what does not. Such disclosure may also possibly be unverified and non-standardized.

Another structural challenge is that ESG analysis often takes the form of a qualitative input that is used alongside traditional quantitative models since it is “difficult to assign a monetary value to ESG issues.” Further, “cost implications” also need to be taken into account. ESG integration entails some costs for institutional investors, which are likely to be ultimately borne by the beneficiaries.

Nevertheless, there is growing recognition in the industry and academia that ESG factors indeed influence financial performance in positive ways in the long term. The modern interpretation of “fiduciary duty” put forward by top-tier asset managers such as “Blackrock”, also recognizes that considering long-term investment value drivers in investment practice is an incontestable fiduciary duty.

Emerging responsible investment regulations, availability, consistency, and quality of ESG information are all set to help the industry to move toward an integrated approach over the next few years.

(With inputs from Paridhi Sen)