Exploring ESG’s impact on investment returns and financial disclosure of climate-related risks

This article is part two of a three part series on ESG in the insurance industry. Read part one here.

We previously defined ESG as the environmental, social and governance nonfinancial factors that are considered in the investment decision-making process and corporate strategy development. These factors are broad and include a range of financial risks and opportunities.

ESG environmental factors center around making socially responsible investment decisions in companies investing in and supporting environmentally friendly products and services. Greenhouse gases, renewable energy generation and usage, land and material resource use, water management and waste are most considered when investing. Social ESG factors center around human capital, child labor, working conditions and employee relations. Governance factors include decision-making actions and policies impacting the business, diversity of board composition, executive pay, financial statement and disclosure transparency, political lobbying and bribery and corruption.

Investors are increasingly seeking sustainable investment opportunities and analyzing a corporation’s ESG performance. Morgan Stanley’s Institute for Sustainable Investing identified four practical steps to guide the development of a sustainable investment strategy. It’s recommended that the strategy start by identifying and clarifying motivations to incorporate sustainable investing and developing an investment philosophy. Next, identify implementation approaches that reflect the investment philosophy that include screening investments, integration, themes, impact, and engagement. Then, define the investment strategy to apply the approach within the investment portfolio. Finally, design the operational model with the appropriate governance that supports implementation of the strategy.

ESG’s impact on valuation and performance is evidenced in ESG rated investments. According to Morgan Stanley’s Institute for Sustainable Investing, sustainable equity funds and sustainable taxable bond funds outperformed their traditional peer funds in 2020 at the height of the pandemic. Embedding ESG factors into investment decisions improves market sustainability, leads to better societal outcomes and has historically yielded above-market returns.

Corporate valuations and ESG ratings are becoming top of mind for management teams and boards when considering their capital raising and investment strategy. It’s also affecting their response to shareholder activism and their formulations for executive compensation. ESG ratings typically use quantitative data and qualitative analysis, and the resulting scores quantify environmental risks and measures long-term exposure to those risks. Good ESG rating scores, based on a rating agencies’ models, indicate low risks. Ratings should be reviewed relative to the industry and rating agencies’ methodologies. Ratings differ though, as agencies use various methodologies, criteria and factors to assess performance within ESG factors.