In the last few years, an interesting ingredient has been added to the investment evaluation world – the issue of ESG disclosure and reporting. Much recent discussion of ESG has focused on environmental matters, but governance issues are critical in some sectors, social issues in others. In this note, we build on our last blog and consider how ESG behaviour and disclosure issues affect the world of financial services.
Financial services is not one sector alone, but several different sectors. Virtually all players in financial services are interested in ESG reporting by the companies in which they invest – and most financial services players are big investors, whether on behalf of clients or of their own funds. However, financial services players are affected in different ways by ESG issues and by ESG disclosure/reporting.
Given the events of just over ten years ago, it is governance that attracts most attention in banking. Poor governance in banks (and poor supervision/regulation by governments) nearly brought down the economies of many of the world’s richest nations. The enormous financial power and impact of banks means that investors are alert to signs of poor governance by banks, although interpretation of these signs may be controversial. After all, it was poorly governed initiatives that initially led to very high returns for banks before the collapse!
Property and casualty/general insurers and their reinsurers, while affected by governance issues (for example, are they taking inappropriate risks?), are particularly affected by exposure of the assets that they insure to risks from environmental change and associated regulations and laws. For example, an increasingly unstable climate seems to be increasing exposure to fire and flood claims. Where clients are commercial, disclosure of the risks they are taking becomes much more important. Product liability issues can come to the fore, as in the case of automotive exhausts, particularly as governments introduce more stringent regulations.
For life and pension companies and their reinsurers, while short term issues may be important, it is the longer term (as ever) that is most uncertain. Here, the risks that need monitoring especially closely are environmental and social (especially, as Covid has taught us, but also much broader political governance issues which fall outside the scope of ESG reporting.
In all these sectors, ESG reporting is at an early stage, as discussed in our previous blog, with managers trying to make sense of the outpouring of data stimulated by the requirement for ESG reporting. A good example of this immaturity of approach can be seen on the impact of favourable reports on the share price of water utilities. This demonstrates the herd instinct at its worst. The need for professional integration of ESG measures into company governance was signalled by the OECD five years ago, and many analysts now integrate ESG factors into their work, as recommended by industry bodies.
The recent surge and then fall (though less than the wider market) in ESG-based investments is also evidence of immaturity. ESG reporting is definitely a long-term issue, as is ESG behaviour. Many companies’ reporting of their own ESG performance is based on a rapid assessment, often done under pressure from regulators or investors. The relationship between financial performance and ESG performance is a matter of some controversy, with evidence both ways in terms of whether there is a positive relationship, though most studies indicate a positive relationship, as the Stern Centre study shows.. Even if the evidence is positive, this might be because wise, well-managed companies understand the importance of public demonstrations of ESG performance rather than making big changes in what they actually do. This issue has led to severe criticisms of ESG-focused investing, with some industry players such as Elon Musk calling it a scam.
The implications of the above for different financial services players differ. The investment implications are common to all companies, with the major variation being according to whether the view taken is shorter or longer term. Our recommendation here relates to the importance of using good cross-sector data from multiple sources to identify the ESG performance of companies, and not just using their own or a sector-based evaluation.
However, for each part of the financial services sector, there is a clear need to develop specific policies towards ESG evaluation and reporting, and specific indicators which relate to the different sets of risks and return relating to ESG factors. For example, property and casualty insurers and reinsurers need to develop indicators relating to areas such as climate and associated regulatorily-induced product liability issues, and apply these to their insurance portfolios. Life and pension fund management should be particularly conscious of the risks of following politicised initiatives which may bear no relation to long term returns, and also of the impact of environmental matters on their actuarial calculations.
While environmental issues will be the main focus of ESG reporting discussions, we should not forget that recent history has taught us the importance of taking a much wider view on social, political, economic and governance factors. Many large financial services companies have frameworks of some kind that help them manage these issues, but the need for comprehensive and independent data to feed these frameworks is clear.
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