Many mainstream investors have begun to use environmental, social, and governance criteria (ESG) to inform their investment decisions. According to Thomson Reuters' 2008 survey of 25 global buy-side investors, 84 percent claimed to evaluate ESG criteria. And in a 2009 Responsible-Investor.com survey of 75 respondents representing more than US$28 trillion in assets under management, 60 percent said they use an ESG strategy for at least a portion of their assets, and 73 percent believe that asset owner interest has grown since 2008 as a result of stakeholder, political, and regulatory pressure, as well as risk management.

When traditional financial metrics are no longer sufficient to predict long-term sustainable performance and share price, businesses today face greater scrutiny from a variety of stakeholders on practices related to ESG issues.

One of the primary stakeholder groups leading this trend are mainstream investors, who are beginning to use ESG performance as a proxy for a company's strong management, and a demonstration of the business' ability to identify risks and plan for long-term, strategic growth.

This development, which BSR describes in its new report "ESG in the Mainstream: The Role for Companies and Investors in Environmental, Social, and Governance Integration," is what is known as "ESG integration," which refers to the incorporation of ESG criteria into investment analysis based on the belief that ESG issues are a driver of financial returns.

There are several indicators of this trend:

  • The number of signatories to the UN Principles for Responsible Investment (UN PRI) has soared to 500, representing US$18 trillion of assets.
  • The investment community is using a broader set of metrics for assessing management quality and risk.
  • Demand from institutional investors—especially pension and public funds—is on the rise.
  • Some investment firms view ESG integration as a way to create competitive advantage and differentiate their firms.
  • Finally, the availability of ESG data has greatly improved through enhanced company reporting and research; there also has been a steady rise in legislation and regulation related to ESG performance and disclosure.

The increase in ESG integration has significant implications—and not just for the financial services industry. What follows are several important developments that all public companies should consider when thinking about how to manage ESG issues and communicate to investors.

  • Integration is still somewhat limited to specific investor types or niche products. The majority of the growth in integration is being driven by global pension funds, especially in Europe. This is due both to the incorporation of ESG factors into their fiduciary duty, and the longer time horizon of institutional investors.

    Furthermore, very few large-scale mainstream investors, with the notable exceptions of Robeco Investment Management and the Dutch pension fund APG, have integrated ESG criteria across their full portfolios. Rather, many mainstream investors are designing specialized products to meet the demands of a specific client base. These niche products—opportunities for investors to gain familiarity with ESG issues, to test the value of integration, and to become acquainted with the marketplace for ESG investment. However, they also reveal that ESG integration is still viewed as only one type of investment strategy as opposed to a fundamental component of valuation that should be a part of all investment strategies.

  • Investors focus on material issues. Rather than using all ESG factors with available data, mainstream investors are applying the concept of materiality to evaluate which of these issues are likely to significantly influence companies' products, clients, and market share. The investors then integrate performance indicators only for those particular issues and for those particular companies or sectors. While still important in the broader sustainability context, not every ESG issue will impact financial performance. It is critical that company leaders—including senior management and investor relations representatives—understand their own material issues and communicate this through annual reporting and other interactions with investors.
  • Companies are not proactively communicating to investors on ESG issues. The general consensus, both among investor relations officers (IROs) and investors, is that IROs are not communicating with investors on ESG performance.

    Many companies explain that a lack of questions from investors has diminished any potential motivation for integrating ESG into their communications. Consequently, IROs generally have been reactive rather than proactive in providing investors with data about ESG issues. Thus, investors either bypass IROs or rely on publicly reported data or third-party research providers. Improved communication with IROs, and more access to senior management, will enable a deeper understanding among investors of how the company manages its most material issues.

In some cases, mainstream investors are integrating ESG concepts, but they're using different terminology to describe the criteria. Many traditional financial indicators are impacted by or related to ESG—such as costs of input, political risk, and more. For example, rather than asking about sustainable supply chain management, an investor will focus on the costs of inputs. Similarly, climate issues are often discussed in terms of risks/opportunities under potential cap-and-trade legislation.

Companies must be able to demonstrate the link to ESG performance when responding to such analyst questions, and as ESG issues continue to become more material, companies may receive an increasing number of ESG-related questions, even if the questions are posed in different terms.

How ESG Integration Could Impact Your Company

These trends have important implications for public companies, as well as for the investor community. To respond to and promote ESG integration, BSR recommends that companies ensure that their senior management and investor relations teams develop familiarity with the ESG issues most material for their business and create a proactive strategy for communicating with investors on ESG performance. The investment community also should help advance integration by requesting ESG data from IROs and management and by embedding the integration approach into their own firms.

While integration of ESG into mainstream investments is still in the early stages, increased communications between investors and companies on these issues can address many of the persistent challenges and work to improve ESG integration. When investors begin analyzing ESG performance the same way they assess a company's management team or external market risks, then companies will be rewarded or penalized for how they manage ESG issues as part of improving overall business performance and long-term, sustainable growth.

While this is not yet a typical investment approach, there is exciting momentum in this direction. BSR looks forward to continuing this dialogue with investors, public companies, research and data providers, and other experts in an effort to help shape the future of investments.