February 23, 2016 1:00 pm JST
Fiona Reynolds

Socially responsible assets bring long-term gains

In the face of financial turmoil, the subject of corporate social responsibility might seem "off-topic." With equity markets reeling and investor psychology mired in panic, investing along environmental, social and corporate governance (ESG) lines can sound like an extravagance.

     The truth is that it isn't. The issue of long-term sustainability and the application of ESG are central to the emergence of a more stable global financial system. The last global financial crisis was not simply a phenomenon caused by financial markets excess. It occurred in the context of a global environmental crisis, declining worker productivity, a dramatic rise in food and water insecurity, volatile energy prices and a shift in the geopolitics of energy security.

     Focusing on sustainability and ESG can provide the economic lift that central bank policy tools such as quantitative easing and low interest rates have failed to generate. In Asia, this drive is focused on the region's vast infrastructure needs, which are estimated to be $8.22 trillion by 2020, according to Singapore's Institute of Southeast Asian Studies.

     Regional governments increasingly understand that the decline in productivity since the financial crisis has crimped growth. Economic growth in the Asia Pacific region averaged 9.5% annually between 2005 and 2007, but last year it fell to 3.2%, according to the Pacific Economic Cooperation Council, a body that represents businesses and academics. The impact of a slowing China suggests that even 3.2% would be hard to meet in 2016.

     Requiring compliance with ESG standards could be a key policy measure to restore Asia's productivity, reduce the region's high levels of household debt and push up economic growth. This would involve returning a greater share of profits to workers via wage rises and stock ownership.

     Anchoring the ESG drive globally is the Principles for Responsible Investment, a United Nations-supported initiative established in 2006 with the aim of fostering the growth of ESG investing. In particular, PRI wants to redress the imbalance between the East and West in embracing an ESG culture.

     There are 1,476 global signatories to the PRI controlling $59 trillion of assets, an increase of 1,500% from the $4 trillion behind the initiative when it was launched a decade ago by then UN Secretary General Kofi Annan at the New York Stock Exchange.

     Signatories agree to adhere to the PRI's six principles which commit them to factoring in ESG considerations when making investment decisions. Just 5% of those signatories are based in Asia.

     This will change as ESG awareness spreads. The big asset managers, pension funds, insurance companies and private banks will be asking questions about ESG capabilities before committing to investing.

Outperformance

There has long been skepticism about the material impact of complying with ESG standards. Will capital returns be compromised? Does ESG compliance offer a real input into risk mitigation? The answer to these is that taking a holistic approach to corporate management and risk assessment not only improves performance, but also enhances returns for investors in the long term.

     A recent study conducted by the University of Hamburg and Deutsche Asset & Wealth Management, the largest of its kind to analyze the relationship between ESG adherence and corporate financial performance, concluded that companies that prioritize ESG have superior long-term financial returns.

     Indeed, the MSCI Emerging Markets ESG Index of 355 companies that comply with ESG standards rose over 7% to the end of March last year on an annualized basis, versus a gain of just 0.8% for the benchmark MSCI Emerging Markets Index.

     A 2009 Harvard Business School study compared the performance of 90 companies in the U.S. which had embraced ESG principles versus their peers that had ignored them. Over a 16-year period beginning in 1993, the former group outperformed by almost 5% per annum in terms of stock price and return on assets.

     Such long-term outperformance is particularly important for pension fund and life insurance managers who are matching long-term liabilities with assets.

     As decades of supercharged economic growth give way to a more modest pace, so the mindset of corporate management is shifting. Asian companies are now more likely to be mindful of their carbon footprints, to have a more open management style and to pay heed to minority shareholders. As global investors increasingly demand a fairer workplace, the hope is that Asian companies will hand on a bigger share of profits to employees.

     Asia has made strides: the stock exchanges in Malaysia and Hong Kong are demanding more disclosure on sustainability before public listings. Bursa Malaysia has been a regional leader in this regard and companies seeking a listing on the bourse have made more inroads in ESG compliance than some asset managers.

     Malaysia introduced the FTSE4Good Bursa Malaysia Index in late 2014 to track the performance of companies that adhere to ESG practice. Such companies must adhere to criteria that measure their efforts to conserve the environment, the impact of their activities on the community and their commitment to strong corporate governance and responsible decision-making.

     Last December, the stock exchange of Hong Kong also strengthened the ESG criteria in its listing rules. Japan has been the most mindful in the region about ESG. There have long been stewardship codes in the country and the Abenomics program has placed sustainability at the top of the agenda, all the more so in the aftermath of the Fukushima nuclear disaster.

     As ESG considerations become mainstream for companies looking at long-term strategies; asset managers undertaking diligence, risk assessment and liability matching; and governments seeking to comply with the December Paris climate agreement, the dynamic for change is powerful and irreversible.

Fiona Reynolds is managing director of Principles for Responsible Investment, a UN-backed international investor network. She has more than 20 years' experience in the pension sector.

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