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It will not be long before ESG integration is made a global standard through government regulations

ESG integration was once a topic left to the public relations department of the average organization. Now that institutional investors are seeing how responsible integration positively affects a company’s valuation, talks of mandatory government regulation around the world are increasing.

“The pace and scope of regulation as it relates to ESG has risen exponentially since 2005,” says Michael Lewis, a Managing Director who leads the ESG Thematic Research team at Deutsche Asset Management. “Regulation has typically been voluntary, and grouped into four broad themes.”

Those themes, according to Lewis, are:

  • Corporate and investor disclosure such as the EU non-financial reporting directive;
  • Stewardship codes and laws which encourage asset managers to engage with investees;
  • Regulations aimed specifically at asset owners to incorporate sustainability into their investment decision making;
  • Regulations to shift capital to green and sustainable assets.

However, the days of the voluntary regulation practices are coming to a close. Mandated regulation will, before long, be the new global standard in relation to ESG integration.

“Future trends suggest a market moving towards increasing levels of mandatory legislation,” says Lewis. “Good examples of this include the coal divestment bills in California and France’s new energy transition law.

Lewis’s team published their Sustainable Finance Report this past June, where their research shows how ESG integration affects a number of topics like the renewable sector in the U.S., the development of sustainable real estate, the diversification of emerging economies in the microfinance sector and more.

“Since the publication of our Sustainable Finance Report in June 2017, further advancements in the area of ESG are occurring with the final recommendations of the Task Force on Climate-related Financial Disclosure and the EU’s High Level Expert Group on Sustainable Finance [have been made],” says Lewis.

The Task Force on Climate-related Financial Disclosure is responsible for considering the risks for associated with climate change, and deciding what constitutes as effective financial disclosures across organizations.

“One of the task force’s objectives is to ensure that companies provide climate related financial disclosures in their annual financial filings so as to better understand the concentrations of carbon-related assets particularly as it relates to the financial sector,” says Lewis.

To help gather this data, scenario analysis is framed to account for all risk assets associated with climate change. From the data collected, the task force creates recommendations for climate-related financial disclosure.

“Scenario analysis is a key part of the recommendation,” Lewis continues, “and it is likely via Primary Rate Interface signatory status and through EU guidance for implementing the Non-Financial Disclosure Directive that the task force recommendations will eventually become mandatory.”

On the other side, the High Level Expert Group on Sustainable Finance works to bear proposals for ESG integration for sustainable financial regulations, for a more advanced step towards a sustainable and resource-efficient economy with low carbon emissions.

Says Lewis, “These trends demonstrate the increasing forcefulness of regulation driving ESG investing.”

The approaching future of the renewables sector will ultimately be shaped by these trends. Already in the U.S. we have seen how the renewables sector has been impacted by ESG integration.

“The changing composition of the power generation mix, whereby coal’s contribution to U.S. power generation has fallen from 48.2 percent in 2008 to 30.4 percent in 2016,” says Lewis, “and the share of non-hydro renewable has risen from 3.1 percent in 2008 to 8.4 percent in 2016 has occurred in response to the collapse in natural gas prices as well as the increasing competitiveness of renewable energy¹.”

Even though the U.S. has left the Paris Climate agreement, renewable energy sources have been increasingly accounting for all new power generated for more than a decade.

“Indeed since 2005, renewables have accounted for almost 50 percent of new power generating capacity additions in the U.S.,” says Lewis. “In terms of composition, since 2013 solar has been making increasing inroads such that it has accounted for approximately 55 percent of renewable capacity additions, compared to 13 percent in the previous five year period².”

Although the power generating sector in the U.S. has faced setbacks, it is still expanding and its growth has a promising future.

“The transformation of the U.S. power generating sector is occurring at an opportune time given investors search for yield, infrastructure’s perceived inflation hedging properties and infrastructure’s negative correlation relative to more traditional asset classes such as bonds and equities,” says Lewis.

On a global spectrum, the advances in the renewables sector are happening as legislative regulation could spark a sudden change in the value of certain assets. Specifically, asset valuation relating to carbon will be impacted by the regulation focused on climate change.

Says Lewis, “These technological advances in the global renewable sector are taking place at a time when many asset owners are increasingly focused on how government regulation, as it relates to climate change, may prompt an abrupt re-pricing of asset valuations, particularly as it relates to carbon.

“For some asset owners these concerns are leading to increasing efforts to measure and report the carbon footprint of their portfolios. According to the Principles for Responsible Investment investors with AUD10.3 trillion AuM have already pledged to measure and publicly disclose the carbon intensity of their investment portfolios under the Montreal Pledge.”

Relating to climate change on a global scale, investment portfolio management is taking the next level is increasing efforts to decarbonize the world.

“Some investors are going further and under the Portfolio Decarbonization Coalition are reducing the carbon intensity within their portfolios by exploring investment opportunities particularly in the renewable energy sector.”

Moving forward in technology and investment opportunities also means focusing on the development of sustainable real estate, since ESG integration is one of the foremost reasons for investing.

“Real estate is an asset class with amongst the strongest reasons for incorporating sustainability into investment decision-making,” says Lewis. “This reflects the strong link between sustainability and financial performance, developments in the areas of investor requirements, government policies and tenant demand among others.”

The research conducted by Lewis’s Thematic Research team shows how having an ESG real estate strategy can preserve and enhance risk-adjusted returns, and strengthen the investment process.

“Several academic reports have found a positive relationship between green real estate and financial performance,” says Lewis. “In addition, Deutsche Asset Management’s own investment in energy efficiency in our real estate buildings has created more than a 20 percent return.”

As investor requirements for ESG integration continues to grow, government mandated policies would need to expand to match the growth in order to find cost-effective ways to reduce energy consumption.  

“For instance,” says Lewis, “government policies could accelerate low-carbon technology investment in commercial real estate by reforming building energy labels to include operational performance of buildings or by setting deadlines after which inefficient buildings will not be able to be sold or leased.

“Efforts to reduce emissions could also be achieved by investors working with governments to improve urban infrastructure and reducing urban sprawl. Beyond energy efficiency, real estate does contribute to the UN Sustainable Development Goals but it is necessary to develop methods to measure the sector’s positive societal impact in areas such as job creation and efforts to reduce the sector’s wider environmental footprint.”

Moving beyond sustainable real estate, and transitioning into the global microfinance sector, the effect ESG integration has on diversification would allow emerging economies to increase their production and value.

Microfinance describes the provision of banking services to individual, households and small businesses at the base of the income pyramid,” says Lewis. “Recent research by McKinsey Global Institute finds that broadening access to financial services, particularly with digital technologies, could increase the gross domestic product of all emerging economies by 6 percent by 2025³.”

Originally, the microfinance sector began as a way to confront poverty via non-government organization and cooperatives. The last decade has shown us how the microfinance sector has grown to be an important piece of good corporate citizenship.

“For certain pension funds, investing in microfinance is seen as part of their Corporate Social Responsibility strategy,” says Lewis. “For others, financial considerations such as portfolio diversification dominate the motivation to be active in the microfinance sector.”

Investors have not been without their obstacles, however, and one of the largest problems is the small market size.

“One of the obstacles has been market size and the relatively small allocations to the sector from a portfolio perspective, which is typically under 1 percent,” says Lewis. “For some pension funds such a small allocation limits the impact from an overall portfolio diversification perspective.”

He continues. “However, we would expect as the microfinance sector grows and capacity constraints ease that will help to increase the sector’s appeal from a portfolio allocation perspective.”

Data from the Global Impact Investing Network, and other industry surveys, shows how investors expect to see microfinance representing the majority of sustainable and impact investments, where these investments will compose five percent of their total portfolio in the next 10 years.

“In contrast to many asset classes, such as commodities, which had been lauded as possessing strong diversification properties,” says Lewis, “the microfinance sector has shown how its diversification properties have remained intact even during moments of extreme financial market stress such as the 2008-09 global financial crisis.

“The microfinance sector is also benefiting from a more transparent regulatory environment,” says Lewis, “which we expect will also facilitate greater private sector involvement.”

Lewis will be presenting at the ESG Integration Summit on Aug. 29, 2017.

¹ US DoE EIA Electric Power Monthly (April 2017)

² Bloomberg New Energy Finance, US DOE Energy Information Administration

³ McKinsey Global Institute 2016 How digital finance could boost growth in emerging economies September 2016