What is Responsible Investment?
Responsible investment (RI) refers to the incorporation of environmental, social and governance factors (ESG) into the selection and management of investments.
RI has boomed in recent years as investors have recognized the opportunity for better risk-adjusted returns, while at the same time, contributing to important social and environmental issues.
Environmental, Social and
Governance (ESG) Issues
Environmental, social and governance (ESG) issues are some of the most important drivers of change in the world today. And these are not just societal issues; they are important economic issues with significant implications for businesses and investors.
Some Examples of Key ESG Issues in Responsible Investing:
There is a broad consensus among governments that the world needs to transition to a low-carbon economy to maintain a safe and stable climate. Responsible investors need to understand how companies are managing their exposure to climate-related risks and opportunities.
There are three broad categories of climate-related financial risks:
- Physical riskRefers to risks generated by extreme weather and climate events such as rising sea levels;
- Transition riskRefers to risks that could result from the process of transition to a low carbon economy
- Liability riskRefers to a risk scenario in which parties who have been negatively affected by climate change could seek compensation from those they hold responsible.
Freshwater resources are at risk from climate change, pollution, and a growing global population which amplifies the needs for power generation and food production.
The World Bank estimates that water scarcity could cost up to 6% of the world’s GDP by 2050.
Water is an important issue for investors because companies, especially those in water-intensive industries such as mining and agriculture, face significant financial risks. These risks include business interruption (directly through local infrastructure or indirectly through suppliers) and the potential market impact of negative media attention if the company is affecting a local community’s water supply or quality.
According to the Canadian Securities Administrators, women hold only 14% of all board seats of publicly-traded companies in Canada. And about 40% of Canadian boards are all-male.
This is a problem not only because it’s ethically problematic, but also because companies with strong representation of women on their boards tend to outperform on a number of financial metrics.
Research has shown that companies with more women on their boards tend to outperform their competitors on a number of financial measures, including return on equity, return on sales, and stock price growth.
Over the past two decades, compensation awarded to top Canadian executives has grown at a much faster rate than wages paid to the average Canadian worker.
A 2018 report from the Canadian Centre for Policy Alternatives found that Canada’s 100 highest paid CEOs earned 209 times more than the average worker. This growth in CEO pay can contribute to rising social inequality, negative media attention and reputational risks for the companies involved. It also raises questions about a company’s overall governance and incentive structures.
To address CEO pay, responsible investors advocate for companies to adopt ‘say on pay’ policies, which allow shareholders to vote on the remuneration of executives.
Free, prior and informed consent (FPIC) of indigenous people should be obtained before the approval of any project affecting their lands or territories and other resources.
The International Labour Organization (ILO) and the United Nations Declaration on the Rights of Indigenous Peoples advance the principle that indigenous groups should be incorporated into the development of new capital projects that affect them.
It is especially important for the extractive sector to obtain and maintain support from local communities, Aboriginal or otherwise. Even if a project has received the necessary regulatory approval, community opposition has the potential to prevent a company’s project from coming to fruition – at great cost to the company.
This is a photograph of the Rana Plaza garment factory in Savar, Bangladesh. In April 2013, the factory suddenly collapsed, resulting in the loss of more than 1,100 lives.
It was a sudden a collapse in the middle of the workday. Obviously this is was a terrible tragedy. But what makes it even worse is that it was totally preventable.
This factory should not have been allowed to operate. But it was operating because companies, including leading global and Canadian brands, were not actively monitoring health and safety in their supply chains. The result was a tragic loss of life, as well as massive reputational, legal and ultimately financial risks for the companies involved and for their shareholders.
RI Market Growth
Responsible investment is growing rapidly in Canada and globally. The latest Canadian RI Trends Report showed that assets in Canada being managed using one or more RI strategies increased from $2.1 trillion as of December 31, 2017, to $3.2 trillion as of December 31st, 2019. This robust growth represents a 48% increase in RI assets over a two-year period. Canadian RI assets now account for 61.8% of total Canadian assets under management, up from 50.6% two years earlier. As for the global market, the latest Global Sustainable Investment Review showed that global responsible investment assets reached US$30.7 trillion at the start of 2018, a 34% increase from 2016.
The latest RIA Investor Opinion Survey shows that the vast majority of Canadian investors are interested in responsible investments. The report found that:
- 77% of investors are somewhat to very interested in RI.
- 82% of investors would like to dedicate a portion of their portfolio to RI.
- 77% agree that companies with good ESG practices are better long-term investments.
How does RI Work?
Using shareholder power to influence corporate behaviour directly. For example, filing shareholder resolutions, voting proxies, and engaging in dialogue with companies to improve their ESG performance.
Investments in ESG themes such as women in leadership, clean technology, alternative energy, cybersecurity, etc.
Explicitly embedding ESG issues into traditional financial analysis. With ESG integration, the portfolio manager combines ESG data together with traditional financial metrics when assessing a company’s value.
Exclusion of certain industries or companies from a portfolio, typically based on ethical or moral criteria. For example, many RI mutual funds exclude tobacco and weapons manufacturers.
Inclusion of certain companies into a portfolio based on positive ESG performance compared to industry peers. For example, there are usually corporate sustainability leaders and laggards in all industries. A positive-screening approach would include the sustainability leaders, while a negative screening approach would exclude the laggards. These approaches are often used concurrently.
According to the Global Impact Investment Network, impact investments are investments made into companies, organizations, and funds with the intention to generate social and environmental impact alongside a financial return. Impact investments target a range of returns from below market to market rate, depending on investors’ strategic goals. Examples include: microfinance, affordable housing, healthcare, education, renewable energy and more. Some impact investments would also be categorized as thematic investments.
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The Benefits of RI
RI can improve risk management
RI can enhance long-term financial performance
RI contributes to positive societal change
Case Study: ESG and Financial Performance