Top Five ESG Trends to Watch in 2016
By Linda-Eling Lee, Global Head of ESG Research, MSCI
A long-term shift to a low-carbon economy, the emergence of a new generation of investors, and a series of institutional forces are the basis for the environmental, social and governance (ESG) trends that may be top of mind for investors in 2016.
With 2016 now underway, ESG investment trends seem likely to be shaped by the climate agreement reached last November in Paris, the coming of age of millennials, new forms of shareholder engagement and a gap between wages at the top and the bottom of the pay scale.
Here’s our view of how some of those trends may play out.
A More Precise Picture for the Bond Market
Fixed income investors may increasingly use ESG scores to inform their decisions. With rising rates of corporate defaults, a growing number of investors are taking the view that integrating ESG factors in their investment process may help them reduce risk.
A study by Barclays in November 2015 [1] found that investment grade bonds with higher ESG scores outperformed those with low ESG scores between 2007 and 2015, after controlling for systematic exposures such as sector, duration and quality. Further, of the three ESG factors generating a statistically significant return premium during that time, governance demonstrated the largest cumulative outperformance.
Fixed income managers have traditionally lagged their equities counterparts in integrating ESG risk factors. If the credit cycle begins to contract in 2016, investors looking at ESG factors to differentiate credit quality may be better positioned to identify opportunities in a market dominated by downside risk.
Decoupling Clean From Dirty in Power Generation Assets
Investors looking to lower exposure to carbon in their portfolios could drive utility companies to explore ways to decouple clean assets from those that burn fossil fuels.
The agreement reached in Paris by nearly 200 countries to limit the rise of global temperatures to less than 2C (3.6F), has put the onus on companies worldwide to begin to change their practices to reduce their carbon emissions.
For example, while 550 companies in the MSCI ACWI Index are slated to meet their targets to reduce carbon ahead of schedule, we have found that 112 out of 146 of those companies in the energy sector had set no carbon reduction targets, which leaves them potentially vulnerable to costs associated with meeting new emission reduction regulatory standards.
There are few options for investors seeking to invest in the growth of renewables through large, listed utilities. Companies with the largest renewable energy capacity often have significant fossil fuel operations, too.
Some of those companies have begun to experiment with splitting off renewable assets into separate entities. In the U.S., SunEdison and NRG Energy have listed ‘YieldCos’, which aim to capture predictable cash flow from owning and operating their renewables power generation assets. In Europe, the German utilities, E.ON and RWE, have proceeded in different ways to spin off renewable and legacy fossil fuel generation into separate entities.
Unless large utilities do more to separate renewables from legacy carbon-intensive assets, we anticipate that institutional investors may allocate to asset classes that can offer more pure play exposure to low carbon energy assets of the future that the public equities universe may not.
Wealth Management for a New Generation
In the U.S. in particular, the emergence of the millennial generation means that wealth management advisers are navigating a handoff to a younger set of investors for whom ESG matters may be paramount, according to several studies [2].
Millennials also tend to be tech savvy. So-called robo-advisory platforms, which automate many interactions at lower cost and, in some cases, with greater transparency, compared with traditional providers, are slated to handle 5.6% of total U.S. investable assets in 2020, up from a half of one percent last year, according to consultant A.T. Kearney.
Wealth managers may respond by seeking to go beyond traditional descriptors of investment strategies such as cap size, market exposure and historical returns to provide a new dimension of transparency where their clients can see the ESG practices of companies within their portfolios and how those companies comport with their values and philosophies, at the fund level.
We categorized investor preferences along three dimensions: Values (e.g., avoiding businesses involved in tobacco, weapons or human-rights violations), Impact (e.g., capturing measurable social returns) and Long-Term Horizon Investors (e.g., mitigating against water scarcity, energy costs or climate change).
Power in Numbers for Institutional Investors
The coming year may see a notable shift in institutional investors’ role in addressing key corporate governance weaknesses. Some of the largest investors have banded together to produce changes in boardrooms across the market rather than exclusively engaging with individual companies.
A notable example has been the Boardroom Accountability Project, a national campaign spearheaded by the Comptroller of the City of New York that, in collaboration with other major institutional investors, targeted 75 U.S. public companies.
The stated goal of the campaign is to increase shareholder value by asking boards to adopt proxy access.
A potential target for similar sorts of engagement may be refreshment of boards. Two out of three U.S. company boards have at least one director who has served 12 or more years, according to MSCI ESG GovernanceMetrics, which covers approximately 3,000 U.S. companies. Such efforts might also seek to address the lack of gender diversity among these same boards.
Turning the Spotlight on Pay Inequality and Performance
Sixty-two people globally own the same wealth as half of the global population, according to Oxfam.
The debate on income inequality is likely to shift to a focus on the gap in pay between CEOs and the rest of companies’ workers. A year from now, U.S. companies will be required by the Dodd-Frank Act to disclose the ratio between the pay of their CEO and that of a worker at the median of the company’s wage scale, a ratio that has grown to 300-to-1, from 30-to-1 four decades ago, according to the Economic Policy Institute.
The run-up to the release of pay-ratio data seems likely to raise questions not only on how pay gaps within companies contribute to growing wage inequality, but also how pay gaps relate to company performance. An analysis by MSCI in January 2016 found that for 591 companies in the MSCI ACWI Index there was no significant difference in operating profit margins between companies with a high pay gap and those with a low pay gap over the five years that ended in 2014. On average, companies with low pay gaps tended to be more profitable than companies with high pay gaps.
Article by Linda-Eling Lee As Global Head of Research for MSCI’s ESG Research group (www.msci.com/web/msci/esg-ratings), Linda-Eling Lee oversees all ESG-related content and methodology and chairs MSCI’s ESG Ratings Review Committee. She leads one of the largest teams of research analysts in the world who are dedicated to identifying risks and opportunities arising from material ESG issues. Linda received her AB from Harvard, MSt from Oxford, and PhD in Organizational Behaviour from Harvard University. Linda has published research both in management journals such as the Harvard Business Review and MIT’s Sloan Management Review, as well as in top academic peer-reviewed journals such as Management Science and Journal of Organizational Behaviour.
Article Notes:
[1] Desclee, Albert, Lev Dynkin, Anando Maitra, and Simon Polbennikov. ESG Ratings and Performance of Corporate Bonds. Barclays Research, November 2015.
[2] See for example: https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/lu-millennials-wealth-management-trends-challenges-new-clientele-0106205.pdf
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