If you had been in or around London in late April, or witnessed some UK news coverage at the time, you will be well-aware of the Extinction Rebellion-led climate change demonstrations which took place. These coincided not only with the hottest Easter weekend on record but also with a UK visit for Greta Thunberg, the 16-year-old Swedish activist, who met numerous UK Members of Parliament to further highlight the threat of climate change.

The resulting media coverage was very illustrative of just where the debate about the topic currently sits in the public sphere. At times it was quite disheartening to hear the rhetoric from many climate change deniers. But it was also less than encouraging to recognise how many people are not fully aware of the efforts that are taking place in both public policy and corporate circles to meet the challenges of global warming.

The role of capital

The investment business is rapidly adapting non-financial goals to complement the focus on investment returns, to meet broad social ambitions. This is not solely around climate change but also around a wider set of environmental, social and governance (ESG) issues.

While there is far from a standard approach to the incorporation of ESG into how asset managers conduct their businesses, there is a fundamental principle that is common – the allocation of capital in a modern economy is discretionary. That is, capital will be allocated where investors think they can get the best return, where there is the lowest risk and, increasingly, where society wants to see changes in non-financial performance.

Non-financial performance indicators might be the volume of CO2 emissions a company’s activities generate, the number of females in key management positions, how a firm is contributing to achieving the United Nations (UN) Sustainable Development Goals and/or increased transparency in corporate governance.

Businesses have an incentive to minimise their cost of capital, so should adjust their behaviour over time to boost returns, reduce risk and improve their overall ESG footprint. I believe those that do will be at a competitive advantage, in that the cost of capital will be lower. This should benefit shareholders and in addition, reduce the risk to creditors.

Risk management

 Like credit ratings, ESG can be viewed in many ways as a risk management tool. If a company’s business model puts it at risk of regulatory or legal action because of poor environmental controls, then there could be a significant credit impairment.

Having some way of monitoring the risk profile of a company over and above traditional credit metrics is clearly a benefit to bond investors.

As the investment industry creates more sophisticated ways of measuring ESG and the risk profiles of individual issuers, sectors and countries, there is an inevitability of there being a stronger link between ESG scores, performance and risk.

I believe the way traditional credit ratings and ESG have evolved reflects the risks of the value of a bond being impaired due to its credit profile very well. For example, investors could likely demand a higher yield on poorer quality ESG-rated issuers to compensate for the risk that the issuer’s business model is not sustainable.

The higher cost of capital will either lead to the business model not being sustainable or to a change in the model to deliver higher ESG standards. The legislative and regulatory environment will help promote change, but investors have a very important role to play. Hence the rapid evolution of ESG overlays, dedicated sustainable funds and impact investing.

From an active management perspective, I see analysis of ESG becoming core to the investment process. Fund managers can make the right investment choices, not only to benefit from evolving trends, for example in clean economy activities, but also to minimise downside risks by reducing exposure to issuers with lower standards.

Keeping active

There are various levels of active management when it comes to ESG. At one level, there are policies based on exclusion where asset managers and owners choose not to invest in companies – and countries – where activities are not seen to be in the social interest, for example firms involved in the manufacturing of certain weapons and so on.

But as well as excluding investment in certain activities, there is now increased emphasis on impact investing where capital is deployed to target specific outcomes – reducing emissions, achieving the UN’s development goals and supporting micro-finance projects. Such strategies tend to be more targeted and have been particularly associated with private equity.

For the mainstream, the challenge is to incorporate ESG into the investment process whilst retaining the key focus on financial returns and performance. I firmly believe that the two are not mutually exclusive. On the contrary, I believe forcing companies into better behaviour should lead to better long-term financial performance.

After all, large owners of capital, such as pension funds and insurance companies, can have a profound influence on corporate behaviour and government policy through the power of their investment policies.

For investors, having a higher quality ESG exposure should result in better returns over the long-term. And if asset owners have ESG ambitions for their portfolios, I believe it is better to employ active managers to achieve ESG goals. In my view, index investing is not an efficient way of allocating capital in an economy and it is certainly not an efficient way of allocating capital to achieve a better outcome for non-financial goals.

Greater governance

In fixed income the focus is on credit. Assessing the governance of companies has always been a core part of credit analysis when it comes to having faith in corporate managers’ abilities and willingness to manage their balance sheets effectively, look after the interests of both creditors and shareholders, and be focused on their credit ratings.

Expanding the scope of governance to understand a company’s ESG footprint and how it is managing it is a natural extension of traditional credit work. This, however, needs work and resources and asset managers are increasingly tasking their credit analysts with a broader remit, alongside responsible investment specialists, to engage with companies on these issues.

Today it is inconceivable that events such as the Volkswagen emissions testing scandal would not result in significant corporate management change, partly because of the focus on these events by responsible investment policies. ESG policies play a huge role in affecting these changes which hopefully result in “better-run” companies and a stronger ESG profile.

Achieving a credit portfolio which targets an improving ESG exposure over time requires an ability to monitor the ESG profile of individual companies through data that measure a broad range of factors. It also requires the ability to make sense of the data, understand what drives companies to improve their performance and still make relative value decisions that take into account both ESG scores and traditional credit metrics.

ESG’s edge

ESG is becoming core to active management in many parts of the financial industry. ESG analysis gives an additional edge to security selection and helps meets the non-financial requirements for investors. In a world of low rates and stable fundamentals in credit markets, ESG analysis can make the difference in choosing to invest in the bonds of one company relative to another with the same traditional credit profile.

Even if this does not show up in relative performance in the short term, it is increasingly obvious that investors would rather have exposure to those companies with better ESG profiles, even if there are no discernible differences in short-term relative value or return potential to those with lower profiles.

Indeed, an asset manager’s ESG credentials are a core requirement in any pitch for new business or to get funds listed on a platform. This also means product development is driven by ESG requirements with specific sustainable funds, green bonds and impact products becoming more and more prevalent amongst the offerings of investment managers.

Markets are vehicles for social change

The financial world is playing its part by putting ESG at the core of investing. Equity markets provide the vehicle for investing in companies, which are trying to develop new forms of energy, that are challenging traditional corporate agricultural methods and that are making advances in healthcare because of new technology with the benefit of reducing the burden on public health systems.

Debt markets can provide the ability to shift capital to influence corporate behaviour – and even sovereign behaviour in some cases. But there is much more to do if society wants to meet its climate and environmental ambitions.

At times this may mean making decisions that could impact on financial returns in the short term. But if it means meeting the two-degree target for global warming, the longer-term benefits will make that worthwhile.

Finally, there is an increasing focus on how developing countries can be encouraged to be “greener”. China is a massive challenge in this respect given its reliance on coal as a major energy source. But at the same time, China has a rapidly-growing green bond market, giving investors the opportunity to help fund projects which should potentially deliver more energy efficient factories, transport systems and buildings.

Ultimately, responsible investing is about influencing change for the better. That ambition can go hand in hand with prosperity. As the asset management industry rapidly gets to grips with putting responsible investing at its core, the message that it is a good thing should come through loud and clear.