RESPONSIBLE INVESTMENT BASED ON ESG COMPONENTS

RESPONSIBLE INVESTMENT BASED ON ESG COMPONENTS

Elena Vladimirovna Zhukova

The applicant of The Basic Department of the FAS of Russia, Plekhanov Russian University of Economics,

Russia, Moscow

ABSTRACT

The sustainable development goals that laid down in the national projects of the Russian Federation imply the formation of new strategic guidelines in the economy. A significant role in this process is played by the so-called ESG factors (environmental, social, and managerial), which cannot be taken into account in the company's activities without the concepts of sustainable and responsible investment, which directly addresses financial issues in the light of global risks of climate degradation, ecology, and corporate governance. Revealing the essence, role and place of strategic management based on ESG factors, the authors justify the necessity and possibility of shifting the emphasis of the financial investment market towards responsible investment. The article considers its main elements, the theory of the relationship of ESG factors with the financial performance of firms, driving the interests of investors, provides approaches to investment that contribute to sustainable development in variable ways, and also considers examples of the methodology for assessing sustainable assets.

Keywords: sustainable development; ESG-factors; ESG-risks; responsible investment; strategy.

1. Introduction

Sustainable development plays an important role in shaping the future of the financial industry. Indeed, assets managed with ESG factors in mind are growing exponentially, and most financial market participants recognize that the transition to sustainable development can no longer be ignored.

Sustainable investment has become an important trend in the financial sector. On the other hand, it is crucial to recognize that progress in this area may vary significantly across geographical regions and jurisdictions. While some developed countries, such as Switzerland, are on track to fully implement sustainable finance, others are still lagging behind. As for emerging markets, China is one of the most active countries in Asia in the field of "green" finance. As of September 2019, China had the second-largest green bond market in the world, just behind the United States, [5] while none of the other emerging economies came close to this level.

The survey of asset managers on the inclusion of investments related to sustainable finance in their investment portfolio also shows the significance of the risks associated with climate change and the transition to a sustainable economy. Therefore, in order to fulfill our obligations to our customers, it is necessary to maintain long-term business relationships in this sector and minimize the impact of climate risks. In addition, green finance is actively developing, especially through green bonds, as investors take advantage of opportunities arising from the low-carbon transition, such as financing new green technologies.

There are many ESG factors that can be included in investment decisions. Environmental factors include issues such as climate change, resource depletion, waste, and pollution; social factors include working conditions, local unions, and employee relations; governance factors include executive pay, diversity of functions, and governance structure, as well as issues of bribery and corruption.

Ensuring sustainable development, including a low-carbon global economy, involves changing the behavior of institutional investors towards the introduction of responsible investment practices. Investors should identify and assess the risks and opportunities associated with sustainable development in order to build sustainable portfolios and contribute to their long-term value creation. Recently, significant political commitments have been made to move in this direction, in particular the Paris Agreement on Climate Change [1] and the UN Sustainable Development Goals [2].

There are other investment strategies that have similarities to responsible investments, but remain different-usually because they prioritize ESG factors over net financial returns. These strategies include socially responsible investment, effective investment, and sustainable development investment.

For this reason, the interaction of investors with companies (their management) – the channel through which responsible investments can support sustainable development-is vital. ESG factor management refers to the activities carried out by institutional shareholders (usually asset managers) to monitor, participate in, and intervene in matters that may affect the long-term value of the investee companies.

2. Discussion

The priority of ESG factors is currently the environmental component, from the point of view of which all strategic decisions in business are considered. The pro-environmental mood of voters provides a lot of political capital for politicians to "toughen up" environmental issues. This may well materialize in the development and adoption of more regulations that will punish polluters and reward clean industries and companies. New environmental regulations could include anything from carbon taxes, mandatory offsets or bans on fossil fuels, to subsidies for green buildings and tax breaks for companies providing green solutions. In addition, public investors, such as pension funds and sovereign wealth funds, are expected to be required to apply strict ESG criteria and take ESG considerations into account when allocating capital.

Many of these new rules will be financially significant and will affect stock market valuations accordingly. When financial markets assess this increased political risk, investments with a good ESG reputation will look even more attractive, while the risk and return profile of polluting companies will deteriorate. The timing of these new rules will also be important. Most institutional investors expect only a delayed (and, as a result, more decisive and disruptive) policy response, based on a recent survey conducted by the UN Principles for Responsible Investment (PRI) [18].

There are currently two main theories that predict the relationship between ESG and financial performance: stakeholder theory and compromise theory. These theories offer opposite predictions, and each is supported by an empirical view of the company based on resources, and management theory is relevant to stakeholder theory and offers similar predictions. Agent theory offers predictions similar to those of compromise theory. The existing views on this issue are presented below.

Presented in Freeman's work [11], stakeholder theory asserts that a firm has an ethical obligation to maximize the values of all shareholders (customers, debtors, employees, and regulators). Some researchers note that the stakeholder management approach leads to more efficient contracting [15]. Firms participating in ESG activities indirectly express their willingness to comply with the requirements of stakeholders and avoid some of the costs associated with strict compliance with formal contractual agreements. Examples of such additional costs are union deductions and increased government regulation. Stakeholder theory states that ESG activities should be a source of opportunity, competitive advantage, and corporate innovation, not a cost, charitable act, or even a constraint [16].

The resource-based view indicates that ESG activities can be considered as strategic investments. These investments can help the firm gain a competitive advantage by acquiring additional skills that would be difficult to replicate [20]. Thus, the improvement of corporate social indicators (ESG) should lead to an increase in financial indicators [19].

Management theory recognizes managers as managers of a firm who seek to maximize the long-term value of the firm in order to meet the competing interests of all stakeholders. Managers participate in ESG events to strengthen relationships between different stakeholders, such as employees, customers, suppliers, and communities, and to promote an enabling business environment [4, 14]. Therefore, an increase in ESG activity should increase the value of the firm.

The compromise view of ESG activity considers this set of factors as a potentially inefficient use of resources. The funds diverted to ESG activities could be used more efficiently by the firm. According to this view, managers should maximize the value of the firm and refrain from socially responsible initiatives to make the world a better place [12]. ESG is seen as an irrational aspiration. Devinney points out [6] that a firm can be made more "virtuous", but this virtue invariably comes at a price. Aupperle et al. it is noted [3] that socially conscious firms incur higher direct costs and receive lower profits than socially unaware firms.

The global scale of the climate change problem is likely to lead to significant instability in the global economy [22]. Financial losses from climate change are not limited to one sector of the economy – this will negatively affect economic growth and infrastructure [10], so all sectors of the economy will suffer. Based on this, climate change has been called an "irreversible risk" [23].

Neglect of social and environmental factors poses serious challenges to sustainable prosperity and stability. Implementing policies that promote responsible investment practices can help address these challenges and enable the financial sector to support sustainable and inclusive growth [7]. This means that the focus should shift to promoting good governance, greater transparency and accountability, and equalizing incentives between capital users (companies), capital providers (depositors and beneficiaries), and the investment chain that connects them. Ultimately, this approach will make the investment system more transparent and promote the long-term interests of investors and society [21].

The expansion of sustainable finance is an opportunity to increase the stability of the financial system and contribute to the growth of the economy as a whole. Therefore, it is necessary to mitigate the risks that prevent the ESG principles from being fully taken for granted when making investment decisions.

The adoption of the ESG investment criteria aims to create a form of financing that contributes to the achievement of sustainable development goals, usually aimed at promoting sustainable and inclusive growth. At the same time, the extent to which green finance contributes to achieving such goals seems vague, since instruments such as green bonds do not necessarily solve further social goals by themselves.

The growth in the scale and volume of sustainable investment is now mainly driven by endogenous elements, primarily the perception of climate risks and opportunities, which is a sign that the market is becoming mature. However, there are still tensions that prevent sustainable investment from leaving its niche and entering the mode of conventional financing. This determines its contribution to achieving ambitious climate change mitigation and sustainable development goals, such as those set by the United Nations in the 2030 Agenda.

A responsible approach to investment can contribute to sustainable development in two ways. The integration of ESG factors into the investment decision-making process can lead to a reallocation of capital in favor of companies that perform effectively according to the ESG criteria, and from companies that perform less efficiently. The extent to which this happens will depend on the degree of ESG integration and whether the investor is clearly trying to make a positive impact.

Responsible investment strategies have evolved rapidly in recent years, as forward-thinking investors understand the need for a more inclusive approach to investment. Despite this growth, total assets under "responsible management" account for a relatively small share of the overall European fund management industry. For example, responsible investments defined by the Principles of Responsible Investment (PRI) [17] cover only 11% of the entire EU fund management industry. Other investment strategies that explicitly attempt to have a positive social and / or environmental impact, rather than simply integrating ESG factors into the investment decision-making process, are even smaller [8].

Deutsche Bank analysts have made a forecast for the next 17 years of investment in sustainable development (Figure 1).

Figure 1. Global Sustainable Investment Assets, US $ trillion

Source: [9].

Figure 2 shows that $ 30 trillion is currently under management. Based on this forecast, ESG assets will reach $ 160,30 trillion by 2036, which is 433 percent more than in 2018. This would mean almost 100 percent integration of ESG into fund management. This forecast confirms that the growth of sustainable investment will accelerate further in the coming years and will be fully integrated into asset management.

The UN Sustainable Development Goals (SDGs) require investments of $ 5-7 trillion per year until 2030. Since this amount goes far beyond the government budget, a significant portion of the funding must come from private sources. This is where sustainable investment will play an important role. Mobilizing financial flows for projects in line with the SDGs is high on the political agenda. This is also evidenced by the historic agreement of the UN Member States on this topic, called the Addis Ababa Action Agenda. It includes "more than 100 concrete measures to finance sustainable development, transform the global economy, and achieve the Sustainable Development Goals" [24]. In the long term, this policy support should translate into new rules that favor sustainable investment and innovative mixed financial solutions for projects that are acceptable for risk reduction. This will create investment opportunities that are aligned with the SDGs.

Increased awareness and transparency about environmental and social impacts will contribute to the accelerating trend of new ESG regulations. In recent years, policy makers have become more aware of the scale and socio-economic significance of environmental and social impacts. Governments are increasingly using a range of tools and methodologies to reliably measure so-called "externalities". The International Institute for Sustainable Development (IISD) has also developed its own Sustainable Asset Assessment Methodology (SAVi) to assess the environmental, social and economic impacts and risks of infrastructure projects.

Sustainable Asset Valuation (SAVi) is a valuation methodology that helps governments and investors channel capital into building sustainable infrastructure. Based on this methodology, the environmental, social, managerial, and economic externalities of infrastructure projects are determined. SAVi combines the results of systems thinking and system dynamics modeling with project finance modeling. Assessing external factors allows governments and investors to assess the second-order benefits and trade-offs of infrastructure investment.

SAVi also demonstrates what the financial consequences will be if external factors today turn into direct project risks tomorrow. Such valuations provide investors with invaluable information for making asset allocation decisions.

Based on the significant demand for the SAVi methodology, including from governments, it can be concluded that there is a great interest on the part of governments in taking into account the external effects of infrastructure projects and businesses. Policy makers are asking what to do with companies that make a profit by externalizing their costs, that is, they have a negative impact on the environment and the social sphere, which is ultimately paid for by society as a whole.

The assessment of these external factors will serve as the basis for new environmental regulations. For example, the social costs of carbon emissions will be taken into account when determining the amount of the carbon tax.

3. Conclusion

All of this underscores that institutional investors with a significant amount of assets under management are moving confidently to sustainable ways of investing. This transition is expected to accelerate further in the coming years. According to Société Générale, "the move to ESG-compliant portfolios and indices may represent one of the biggest shifts in assets since the advent of the euro" [13]. Public markets and asset valuations will begin to reflect this capital shift. For companies with large negative environmental footprints, this will lead to higher capital costs, lower stock prices, and the possibility that some of their assets will be stranded.

The growing institutional demand for sustainable investment can largely be attributed to the increased interest in value-based investments on the part of their participants, but this alone is not enough to ensure the necessary development. Rather, the new ESG regulation and the ability to reliably assess ESG risks will be the main factors driving institutional adoption, and are thus important components that can help turn this increased interest into institutional action.

To expand the process of sustainable investment, financial professionals must have the necessary skills and understanding of how to integrate ESG initiatives into investment decisions when advising clients. Any financial institution that wants to provide services in this area must undergo mandatory ESG training for the relevant staff. This would allow front office staff (such as investment consultants) to educate their clients and raise awareness about this new way of investing by talking about it at relevant events. ESG training will also be essential for mid-level and back-office staff responsible for disclosure, reporting, and risk management related to sustainable development.

Responsible investing requires investors to take a different investment approach than usual: an approach that includes qualitative assessments and active ownership in addition to the traditional quantitative analysis of financial risk/return. In other words, environmental, social and managerial factors (ESG) should be included to assess the long-term potential of companies.

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