Sustainability an essential focus for long-term investors

AMID the turmoil created by the Covid-19 crisis, what stood out was the continued shift towards sustainable or ESG (Environmental, Social and Governance) investing.

Global sustainable funds saw strong capital inflows of around US$117 billion, versus a net outflow of US$30 billion for the broader fund universe over H1 2020. Sustainable funds and indices also outperformed their counterparts in H1 2020. For example, returns on the MSCI World Socially Responsible Investment (SRI) index outperformed the MSCI World index by 411 bps over the same period, even controlling for sector tilts (such as underweight energy, overweight technology).

The pandemic has also highlighted some key ESG-oriented structural shifts. First, it has magnified the vulnerabilities and awareness of rising social inequality, specifically in the areas of access to technology, healthcare, jobs and social safety nets.

Second, safety measures and supply-chain disruptions have triggered a huge push to technology and automation, which could result in an even faster pace of job displacements, especially for lower-skilled workers.

Third, the disruptions to cash flow, production and operating models have raised the need for good governance, corporate resilience and robust capital allocation strategies.

While the "Environmental" aspect, particularly climate change, remains a key focal point, Covid-19 has resulted in "Social" factors having a greater influence on corporate behaviour, economics and financial performance. For example, companies that pay fair wages to their employees saw their share prices clearly outperform, compared to that of companies that ranked poorly on fair pay - thus giving new impetus to "stakeholder capitalism", despite current pressures on companies' profits and investor returns.

THE RISE OF SUSTAINABLE INVESTING

The term ESG was coined in 2005 in a study entitled "Who Cares Wins". This later led to other key initiatives such as Principles for Responsible Investment (PRI) in 2006. Various studies followed, which established the financial relevance of sustainable investing, and illustrated its lower downside risks and volatility, even through the worst of past equity market downturns.

With increasing support from international organisations, government bodies and financial and investment institutions, along with improving reporting standards and data, and growing ESG-related investment vehicles, this has resulted in the sharp rise of sustainable investing, particularly over the last five years.

In 2018, the ESG investing market was worth over US$30 trillion in assets under management (AUM), or about a third of all professionally managed assets around the world - up from 21.5 per cent in 2012. While there are varied estimates of ESG-related AUM, depending on how ESG is defined by asset class, strategy, market and investor coverage, the underlying growth trend is clear.

Investors seeking to integrate ESG into their investment strategies initially faced challenges in data availability and quality, and a paucity of guiding frameworks and disclosure standards for companies. As more players entered the market to provide solutions, the landscape shifted, also creating a different set of challenges for investors. For example:

Regulation (applies to both investors and corporates)

Demand

Supply

Ultimately, more investors are seeking to include ESG factors in their investment choices rather than focusing on financial returns, with allocations to ESG-related mandates likely to continue rising over time. Externalities, such as environmental impact or liabilities, which could arise from structural gaps in business conduct and governance, are also increasingly being priced into company valuations. Issues with data are set to improve in line with education, industry and regulatory developments currently under way. Technology based on machine learning and big data will also unlock valuable insights and ways to apply ESG data to conventional financial information.

Looking ahead, these shifts are likely to further support the continued structural rise of sustainable investing, as investors, businesses and consumers change behaviours to account for future liabilities arising from how they deploy capital today.

GIC'S APPROACH TO SUSTAINABILITY

At Singapore's sovereign wealth fund, ensuring long-term sustainability in our global investments and operations is fundamental to how we fulfil our mandate, which is to preserve and enhance the international purchasing power of the reserves under our management.

We believe that companies with stronger sustainability practices will generate better risk-adjusted investment returns over the long term, and this relationship will only strengthen over time. This is driven by physical factors like climate change, as well as financial market factors, given evolving regulations and investor and consumer preferences. These factors shape the long-term prospects and hence, value of companies.

We also believe in taking a long-term and holistic approach to sustainability in our investment and corporate processes. We recognise that for any investment, there are trade-offs and conflicts between different sustainability goals; there may be inherent conflict between environmental-sustainability goals and social-sustainability goals in the short term, especially for some emerging market countries. Hence, we favour engagement over divestment, and achieve this by directly involving management on discussions on how to operate more sustainably. Such an approach, unlike divestment, will lead to more beneficial outcomes for stakeholders over the long term.

Our approach to sustainability is led by GIC's Sustainability Committee, which shapes and implements our sustainability framework, supports and promotes sound investment stewardship, and drives GIC's response to emerging ESG risks and opportunities.

PUTTING SUSTAINABILITY INTO PRACTICE

We apply an O-D-E framework to integrate sustainability across our investment and corporate processes.

"O" refers to going on the Offensive when it comes to investment opportunities; "D" refers to Defensive risk management; "E" is how we improve our operations and processes to achieve Enterprise Excellence.

CONCLUSION

Sustainability is one of the most significant trends in the financial markets, given its material impact on a company's risk profile, cost of capital and long-term performance. Investors face a real risk of underperforming if they do not effectively integrate ESG considerations into their investments.

Given our mandate, sustainability remains a key priority and an essential part of GIC's investment strategy, risk management, corporate culture and process. By integrating sustainability factors into our management and investment processes, we build resilience and diversification in our portfolio to achieve better long-term returns.

In addition, we strive to create positive outcomes for our portfolio and the communities we invest in, by helping companies move toward a more long-term stakeholder-centric model of corporate behaviour.

This will reinforce GIC's role as a long-term investor and a responsible steward of our country's reserves.