As environmental, social and governance factors become a priority for governments and consumers alike, ensuring ESG factors are incorporated into security selection processes is crucial—not only to meet the expectations of savers, but also to achieve sustainable long-term returns.
A major reason why ESG factors are increasing in importance for investors is climate change. The 2016 Paris Agreement has led to increased public spending on clouise targets, and growing shareholder pressure on companies to reduce their economic impact.
REDUCTION IN CARBON EMISSIONS NEEDED TO BE COMPATIBLE WITH PARIS AGREEMENT BY 2030
Source: Climate Action Global Tracker Proxy Preview, J.P. Morgan Asset Management. Data as of 29 August 2019.
Earlier this year, for example, European Union policymakers set out screening criteria for 67 economic activities that substantially contribute to climate change or its mitigation. Asset managers will be expected to disclose information on how products marketed as “environmentally sustainable” relate to these 67 activities.
In the US, meanwhile, companies are coming under growing pressure from shareholders to implement climate-related policies, even as the current US administration has pulled out of the Paris Agreement.
In addition to climate change, social factors have also become a major focus in many developed markets following years of lacklustre wage growth—particularly in low- and middle-income households. Governments are now attempting to alleviate the situation with the implementation of various social policies, such as living wages and on-the-job training.
All of these developments are making it crucial for investors to consider the impact of ESG-related factors when valuing securities. There are several ways to achieve this. One way is through ESG integration, which means investors consider ESG factors when making their investment decisions in the same way they would consider other traditional variables that might affect a company’s outlook.
Dedicated ESG strategies, on the other hand, have investment processes that are more rules-based. The basic approach is provided by exclusion strategies, which simply apply investment restrictions on certain industries, such as weapons, tobacco, thermal coal extraction, unconventional oil and gas extraction, alcohol and adult entertainment.
Positive tilt strategies also exclude certain industries, but then award a larger allocation to the most sustainable companies, while best-in-class strategies seek to select the most sustainable companies within their industry sectors (minus exclusions)—thereby maintaining greater sector diversification.
Finally, thematic and impact strategies are built according to specific forward-looking sustainability goals.
With investors increasingly scrutinising and comparing securities according to ESG criteria, company managements are responding by providing greater disclosure on ESG issues, while the influence and importance of ESG rating agencies is also growing.
However, ESG scores can vary significantly and ratings are often biased towards countries, industries or companies that have better disclosure. Therefore, some asset management firms have built their own proprietary tools to produce in-house scoring systems that can account for these limitations.
Whatever approach investors choose to take, it’s clear that with governments increasingly acting on environmental and social issues and savers now wanting to be a force for change, ESG factors are only going to become more important. At a minimum, understanding how consumer preferences and government policies are changing will be necessary to mitigate risk.
To learn more about how J.P. Morgan Asset Management believe that ESG considerations can play a critical role in a long-term investment strategy please visit www.jpmorgan.com/esg
Karen Ward, Chief Market Strategist for EMEA
Jennifer Wu, Global Head of Sustainable Investing