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Sustainable Investments

Sustainable investments resources

Overview

Sustainable investment includes traditional investment practices and more. In a sustainable investment decision, the financial risks of the investment decision are evaluated via traditional investment practices, like any other investment opportunity. An additional sustainability analysis is performed to examine non-financial environmental, social, and governance (ESG) risks and opportunities that may affect company value.

The investment analysis process rates a company on how it identifies, evaluates, and addresses significant environmental and social risks and opportunities. It also rates the company on the governance structures and practices it uses to manage and mitigate these risks and ensure good governance.

Sustainable investing tools

Institutional investors, investment intermediaries, stock exchanges, and rating organizations identify companies that, in their view, qualify as a sustainable investment. The analytic tools they use to evaluate and measure a company’s ESG status are referred to as ESG screens. The results of the ESG screen are incorporated into the investment, index listing, or rating decision.

A screen might look at how a company evaluates and responds to issues such as:

  • Resource scarcity
  • Energy pricing
  • Waste generation
  • Public health concerns
  • Public opinion trends
  • Demographic shifts
  • Access to skilled labor

There is no uniform ESG screen, no one definition of a sustainable investment. ESG screens also vary by specific industry or sector, since significant sustainability risks, opportunities, and governance concerns vary by industry.

The investment, index, or ranking organization gathers publicly available, relevant ESG data through independent research or using data available on financial data facilities like the Bloomberg terminal. But the specific factors they consider and the weight they give to each factor are most often proprietary. This makes it difficult to evaluate the quality of one sustainable investment versus another.

The world of sustainable investment is developing and growing. The number of Bloomberg terminal customers using ESG data increased 76% in 2014. According to the US SIF Foundation, from 1995 – 2014 there was a 929% increase in requests for ESG data in the U.S. This represents a compound annual growth rate of 13.1 percent.

Institutional investors, portfolio managers, and financial services companies are working to improve, standardize, and refine their ESG screens. As sustainable investment ESG screens evolve, they will hone in on the factors that provide the most decision-useful information for an investment decision. SASB’s development of standards for determining material sustainability issues by industry is a helpful step in this direction as well.

Portfolio composition

Incorporating ESG considerations to make better investment decisions goes only part way toward establishing a sustainable investment strategy. The strategy should include improving an otherwise balanced overall portfolio compositiontoward to favor companies with better combined financial and ESG performance within each asset types and classes.

Resources

ESG considerations

Companies that identify and focus on material environmental, social, and governance (ESG) risks and opportunities outperform. As a result, sustainable investment decisions are guided not only by traditional financial information, but also by information about ESG issues and activities. There are a variety of ESG qualification standards or ESG screens used to evaluate and measure how a company manages ESG issues and how that affects company value. Incorporating consideration of ESG information and being transparent about the chosen process are important elements of sound, sustainable investing decision making and stakeholder relations.

Resources

Shareholder advocacy

Shareholder advocacy for a stronger role by businesses in sustainability has increased in recent years. Institutional investors view sustainability best practices as a path to long-term value and apply pressure for the businesses they invest in to establish and report on sustainability-focused goals, priorities, and practices. This advocacy can take the form of a dialogue between shareholders and the company or shareholders may file a resolution stating the desired action.

Resources

SI vs. SRI vs. II

There are several investment strategies that relate to sustainability. The most common ones are socially responsible investment (SRI) and impact investing. These terms and sustainable investing are often used interchangeably, and although they have similarities, they are not the same.

SRI refers to the application of a filter or screen when making investment decisions to exclude companies with perceived negative social impacts. SRI programs are designed to avoid defined negative impacts and will exclude companies, based on specific, frowned-upon business activities or services. These excluded investments are commonly referred to as sin stocks. Each SRI fund or advisor can have its own subjective definition of what constitutes a socially responsible investment. The definition and lists of sin stocks are expanding, and in some instances will reach beyond social impacts to exclude negative environmental impacts from investments.

Impact investing directs investments to companies that have a positive social or environmental impact. The investment is intended to support positive change and enable measurable progress toward solving or providing positive alternatives to social and environmental problems and negative impacts.

SRI and impact investing are tied to the values and preferences of the person or organization making the investment. In contrast, sustainable investing is driven by the desire to boost financial performance, minimize future risk in a portfolio, and identify growth opportunities using screening tools based on sustainability risk factors. Sustainable investment screening should exclude companies with negative social and environmental impacts and include those with positive impacts, but only if the type of impact affects or has the potential to affect company value.

Why focus on sustainability

Why is the investment community taking such an interest in evaluating the ESG status of target companies? There are several reasons:

  • Market valuation is increasingly based on intangible assets.
  • Standard financial metrics are not adequate for assessing risks associated with intangible assets.
  • Investors need a way to price the nonfinancial risks related to intangible assets when calculating enterprise value and expected returns.
  • Companies that embrace and incorporate sustainability practices into business management and culture create greater value.

In Pitch Decks, you will find graphs from studies showing that companies can use sustainability practices to create value. Investors have drawn from these studies that sustainability is a way of managing non-financial risks. They use information about business sustainability practices gathered through ESG screens to price those risks into valuation.

This is significant because non-financial risk has increased to a point of making valuation difficult without new metrics. As the graph below shows, there has been a dramatic shift in the proportion of intangible and tangible assets that make up corporate value.

While it is easy to measure the financial value of tangible assets, that is not the case with intangibles. Without metrics to measure the risk of an asset being destroyed, appropriated, or abused, the asset is vulnerable to impairment and mismanagement. Sustainability management practices are the foundation of the investment community’s efforts to create metrics, such as ESG screens, to assess this growing area of risk.

Managing and valuing nonfinancial risks

Nonfinancial risks relate to uncertainties. These can range from a black swan event to uncertainty about when a highly probable change will happen. Sustainability is about creating systems and practices that reveal and provide insights and market intelligence about uncertainties all along this spectrum of uncertainty. It is about learning how to manage the most significant uncertainties (nonfinancial risks) for your particular company.

Here are some examples of how sustainability addresses nonfinancial risks.

Sustainability practices help companies develop the ability to:

Environmental

  • identify environmental impacts in the supply chain that could impact costs, reputation, and brand equity;
  • predict scarcity of raw materials on which the company depends;
  • prepare for or avoid increases in environmental regulatory fees and the costs and impacts of new regulation

Social

  • identify and manage business activities that conflict with emerging social norms and expectations;
  • compete for and keep talent in an increasingly mobile and global workforce environment

Governance

  • create and manage effective governance practices and systems that reveal and correct internal vulnerabilities to fraud or corruption;
  • be transparent and accountable to stakeholders;
  • self-regulate and prepare for the costs and impacts of new regulation

Strategy and innovation

  • adapt business models to meet evolving environmental and social conditions;
  • identify and take advantage of business opportunities that emerge from those evolving conditions;
  • foster collaboration, create new partnerships, and engage in coopetition to solve relevant complex problems, open new markets, and develop new products and services

Sustainability management is about developing these capabilities. With good capacity in each area, a company will not avoid uncertainty, but it will manage uncertainty (nonfinancial risks) as effectively as possible. With good management and communication in these areas, investors will be able to price nonfinancial risks. They will be able to lower the perceived cost of these risks as an investment concern, leading to a higher company valuation.