2 The ESG Market and Engagement

[Introduction]
ESG concerns long-term investment sustainability and is directly related to the long-term performance, and
valuation of a business. In a rapidly changing world, investors must be alert to, and respond to, any evolving
risks and opportunities, and it is these that ESG investing seeks to address.

To achieve the desired long-term investment sustainability, many investors wish to use their share
ownership to engage with investee firms in order to exercise their voting power to influence corporate
behavior. This is not just for philanthropic reasons, however; there is growing evidence that engagement on
environmental, social and governance (ESG) issues can enhance long-term shareholder value.

In this concept we examine the size and growth of the ESG market, and the key drivers behind the ever-
increasing interest in ESG investing. In doing so, we look at how we can assess the impact that ESG investing
has on industry and company performance, and review the challenges of undertaking ESG analysis across
different geographical regions and cultures. We also define and describe exclusion-based, integration-
based, engagement-based and impact-based ESG investing and examine the importance of stewardship and
engagement to the investment community.
[ESG initial development]
Given concerns regarding global warming, depleting natural resources and inequality of wealth, allied to a
series of major corporate scandals perpetrated by directors, there is a widespread acknowledgement that
the long-term success of a business will be heavily influenced by environmental, social and governance
factors.

Businesses must be alert to the risks and opportunities that these factors bring and, where this is not the
case, investors should raise their concerns with the business through engagement.

Externalized costs, i.e. costs resulting from business activities that are faced by society in general, rather
than the business itself, are increasingly being internalized through legislative or regulatory developments,
or through reputational damage from the failure to meet consumer expectations. Businesses must
recognize that this trend will continue and begin to take responsibility for such factors.

As a consequence, companies are facing increasing demands for ESG disclosures, with those failing to do so
losing investor confidence, suffering a falling share price and rising cost of capital.

Arguably, the 2006 launch of the Principles for Responsible Investment (PRI), with its six voluntary and
aspirational investment principles, kick-started the rise of ESG, with the number of signatories to the PRI
and the scale of assets under management rising dramatically since that date.

In terms of global assets under management, the ESG market has grown at roughly 30% annually. Since
2006, however, this growth rate has not been achieved globally, with Europe being early adopters.
The six PRI Principles
1. We will incorporate ESG issues into investment analysis and decision-making processes
2. We will be active owners and incorporate ESG issues into our ownership policies and practices
3. We will seek appropriate disclosure on ESG issues by the entities in which we invest
4. We will promote acceptance and implementation of the Principles within the investment industry
5. We will work together to enhance our effectiveness in implementing the Principles
6. We will each report on our activities and progress towards implementing the Principles

Growth in responsible investment

1. Materiality
Increasing recognition in the financial community that ESG factors play a material role in determining
risk and return, resulting from:
• Pressure from competitors seeking to differentiate themselves by offering responsible investment
services as a competitive advantage
• Value-destroying reputational risk from issues such as climate change, pollution, working
conditions, employee diversity, corruption, and aggressive tax strategies, in a world of globalization
and social media

2. Growth demand
Growing demands from beneficiaries and investors for greater transparency about how and where their
money is being invested, due to:
• Understanding that incorporating ESG factors is part of investors’ fiduciary duty to their clients and
beneficiaries
• Concern about the impact of short-termism on company performance, investment returns, and
market behavior
• Beneficiaries becoming increasingly active and demanding transparency about where and how their
money is being invested

3. Regulation
Higher levels of regulatory guidance that incorporating ESG factors is part of an investor's fiduciary duty
to their clients and beneficiaries. This also includes the legal requirement of protecting their long-term
interests and those of the wider financial system.

4. Academic evidence
Studies the notion that incorporating ESG does not adversely impact on long-term profitability.
Geographical update
The 2018 Global Sustainable Investment Review (GSIR) highlights that some regions were slow adopters of
the PRI Principles but are now catching up fast, with the growth of sustainable investment assets by region
in local currency for the period 2014–2018 being as follows:
Growth per Compound
Period Annual
Growth Rate
Growth Growth
2014 2016 2018 (CAGR)
2014 – 2016 2016 – 2018
2014 – 2018
Europe €9,885 €11,045 €12,306 12% 11% 6%
United States $6,572 $8,723 $11,995 33% 38% 16%
Canada (in CAD) $1,011 $1,505 $2,132 49% 42% 21%

Australia/New
$203 $707 $1,033 248% 46% 50%
Zealand (in AUD)

Japan ¥840 ¥57,056 ¥231,952 6692% 307% 308%

As we can see, from 2016 to 2018, the fastest growing region was Japan, followed by Australia/New
Zealand and Canada.

Sustainable investment strategies

The GSIR also highlights the investment strategies that are primarily used by region in 2018. As we can see,
negative screening is clearly the largest sustainable investment strategy globally, and in Europe. However,
the strategy of ESG integration is growing very rapidly and is likely to overtake negative screening as the
primary approach in the near future.
- Impact/community investing: Targeted investments aimed at solving social or environmental
problems, and including community investing, where capital is specifically directed to traditionally
underserved individuals or communities, as well as financing that is provided to businesses with a clear
social or environmental purpose.
- Sustainability themed investing: Investment in themes or assets specifically related to sustainability
(for example clean energy, green technology or sustainable agriculture).
- Positive/best in class screening: Investment in sectors, companies or projects selected for positive ESG
performance relative to industry peers.
- Norms-based screening: Screening of investments against minimum standards of business practice
based on international norms, such as those issued by the OECD, ILO, UN and UNICEF
- Corporate engagement and shareholder action: The use of shareholder power to influence corporate
behavior, including through direct corporate engagement (i.e. communicating with senior management
and/or boards of companies), filing or co-filing shareholder proposals, and proxy voting that is guided
by comprehensive ESG guidelines.
- ESG integration: The systematic and explicit inclusion by investment managers of environmental, social
and governance factors into financial analysis.
- Negative/exclusionary screening: The exclusion from a fund or portfolio of certain sectors, companies
or practices based on specific ESG criteria.
[ESG studies]
There is increasing evidence to show that ESG integration positively enhances performance, improves
client engagement and stewardship, and reduces reputational risk.

The search for a relation between environmental, social, and governance criteria and corporate
financial performance can be traced back to the beginning of the 1970s, and many scholars and
investors have published studies in this area.

In 2015, Gunnar Friede, Timo Busch and Alexander Bassen published the largest study to date in the
Journal of Sustainable Finance and Investment which combined the findings of about 2,200 individual
studies.

What this study revealed is that 62.6 percent of the time, positive ESG effects had a positive impact on
investment performance, with a negative impact being experienced just 8 percent of the time.

The study also showed that these positives and negatives varied by asset class.

With respect to equities, ESG factors demonstrated a positive impact of 52.2 percent of the time and a
negative impact just 4.4 percent of the time.

For bonds, the difference was more pronounced, being positive 63.9 percent of the time and negative
0 percent of the time, and for real estate, the figures were 71.4 percent and 0 percent respectively.

Given the sample sizes involved, this represents very strong empirical evidence that there is a positive
correlation between ESG and the financial performance of the major asset classes.

The study also showed that these positives and negatives varied by ESG class.

Environmental factors were observed to have a positive influence 58.7 percent of the time, being
negative only 4.3 percent of the time. For social factors, the corresponding figures were 55.1 percent
and 5.1 percent, and for governance factors they were 62.3 percent and 9.2 percent.

Thus, we can see that the governance is the most influential factor impacting on corporate financial
performance and social factors are the least influential, however, all three factors are distinctly
important.

Finally, the report revealed differing regional impacts.

North America registered a 51.5 percent positive impact and a 5.3 percent negative. The
corresponding figures for developed markets in Europe were 46.7 percent and 8.9 percent and in
developed Asia they were 38.5 percent and 7.7 percent, the totals for all developed markets being
49.8 percent and 6.2 percent. In contrast, the figures for emerging markets were 70.8 percent and 4.2
percent, ESG appearing to have a far greater impact in these markets.

The study concluded that the findings are far from consistent across regions, making regional
comparisons somewhat difficult, a suggestion being that the cross-country relationship is particularly
affected by a high humane orientation in certain regions.

ESG factors have a statistically significant impact in overall terms for each of the major asset classes,
for each ESG category, environmental, social or governance, and in each geographical region, the
impact appearing to be more pronounced in less developed regions.
[Stewardship and Engagement]
Next, let's explore stewardship and engagement. There are a total of 4 sections to review.
- Stewardship:
Within an investment context, a steward is an individual who accepts and is entrusted with the
responsibility for holding or managing assets on behalf of another/others, e.g.:
◼ Trustee holding entrusted assets on behalf of beneficiaries
◼ Directors managing business assets on behalf of the business owners (the shareholders)
For fund managers managing portfolios of assets on behalf of clients, stewardship is an ethical concept
that implies careful and responsible management of any entrusted assets and should be conducted in
the best interests of the asset owner(s).

- Engagement:
ESG engagement is the constructive dialogue between the shareholders of a business and its managers
(stewards), to discuss the issues that are of concern to the shareholders and how they would like
management to manage ESG risks or take advantage of corresponding opportunities.
As a minimum, engagement can be achieved through shareholders exercising their voting rights at
annual general meetings (AGMs) or other general meetings, although more frequent and more active
engagement is becoming increasingly common.

- Engagement benefits: There is a growing body of evidence that positive engagement enhances
corporate value, and that any failure on the part of management to actively engage with their investors
has adverse business consequences in terms of lower share prices and a higher cost of capital. Most
studies in this area conclude that:
◼ Successful engagement activity is followed by positive abnormal financial returns, most
commonly through a reduction in downside risk
◼ The effect is stronger the more successful the engagement is
◼ The effect is strongest in relation to governance
Engagement clearly helps investee companies to understand investor expectations, allowing them to
both respond accordingly and to provide any ESG information required.

- Stewardship code and principles:

The first formal governance code was developed in the UK and has been adopted as a model by many
countries, including Denmark, Hong Kong, Japan, Malaysia, Singapore, South Africa, South Korea,
Taiwan and Thailand. In addition, investor associations have developed their own best practices that
reflect a similar set of principles in a number of other markets, including: Australia, Brazil, Canada, the
EU, Italy, the Netherlands, Norway, Switzerland and the USA. Furthermore, it is likely that the EU
Shareholder Rights Directive II will require investors to make a public commitment to stewardship, and
to engage effectively will lead to the development of further such codes across Europe. The aim of
these Codes is to require institutional investors, fund managers or service providers to actively engage
in corporate governance in the interests of their investors, and registered fund managers are commonly
required to state whether and how they address their domestic Code’s principles.
 The Code sets out best practice guidelines on the following areas
- Board leadership: The company should be led by an effective and entrepreneurial board whose role is
to promote the long-term sustainable success of the company, generating value for shareholders and
contributing to the wider society,
- Segregation of duties: No director should have absolute control, which is achieved in public companies
by requiring the chair (who leads the board) and the CEO (who is in charge of the operations) to be
separate individuals.
- Board composition: The board should include an appropriate combination of executive and non-
executive (especially independent non-executive) directors, such that no individual or group of
individuals dominates the board’s decision-making. The board should also have a combination of skills,
experience and knowledge, achieved through diversity.
- Audit risk: Every public company should have an audit committee who meet at least twice a year to
review adherence to reporting standards.
- Executive remuneration: Policies and practices should be designed to support strategy and promote
long-term sustainable success. Executive remuneration should be aligned to company’s purpose and
values and be clearly linked to the successful delivery of the company’s long-term strategy.

Requirements for an effective engagement process

Step 1 - Context and focus: Engagement is undertaken in the context of long-term ownership, with a focus
on long-term value creation and preservation to align with investor objectives.
Step 2 – Framing: Engagement is framed by a close understanding of what the business does, how it does it
and what long-term opportunities it has.
Step 3 - Clear objective: Engagement is based on clear objectives that are focused on effecting a positive
change.
Step 4 - Long-term: Engagement recognizes that change should be achieved at an appropriate pace and not
achieved in an overly hasty manner.
Step 5 - Open and consistent: Engagement requires a consistent, open, direct and honest dialogue between
the company and its investors.
Step 6 - Conduct and support: Engagement must be conducted in a professional manner and with sufficient
shareholder support to ensure company understanding.
Step 7 – Efficient: Engagement must be conducted efficiently to ensure it achieves the broadest possible
coverage.
Step 8 – Reflection: Engagement must allow for reflection, allowing lessons to be learned, thereby
improving future engagement activity.
Summary (mandatory): Effective engagement must aim to achieve clear long-term beneficial change,
through an open exchange that achieves the broadest possible coverage.
Engagement approaches
Engagement approaches typically vary with management style, although this is not a hard and fast
distinction. The primary contact for any engagement will typically be dictated by the issue at hand,
although escalation measures should be anticipated in order to advance an engagement that has stalled.
Also, escalation may be conducted collectively.

1. Active or company-based engagement: Active investment management is often undertaken through a

company-focused, bottom-up analysis, hence a company-focused, bottom-up engagement fits most
naturally with this investment approach.

Active investors start by examining the company and its business issues and develop a specific engagement
approach covering a range of issues. The companies targeted for engagement may be underperformers or
may be selected based on financial or ESG metrics.

Initial engagement typically seeks a direct discussion with the board or senior management of the target
company.

2. Passive or issue-based engagement: Passive investment is most commonly undertaken through a top-
down analysis; hence a top-down engagement approach tends to be more common.

Passive investors typically start with an issue that they have identified in their entire portfolio, perhaps
through screening or other research, on which they seek to engage with all investee companies for whom
that issue is relevant.

As they may seek to engage with many companies simultaneously, the process is typically initiated through
a letter written to all relevant companies, which is then followed up by a request for dialogue. These issue-
based approaches often include examples of what is considered best practice in the particular area of
concern, allowing the investee company to better prepare for any engagement.

3. Making it real: The engagement’s clear objective will dictate the primary point of contact, for example
the primary contacts for the following issues will typically be:
• Business strategy or operations: the CEO or CFO, with escalation if required to the non-executive
directors
• Governance: the chair, with escalation to a senior director
• Voting issues: the company secretary, with escalation to the relevant board committee
• ESG operational issues: the sustainability team or the investor relations department, with escalation
to the senior management or the board
To be constructive, it is best for any initial dialogue to take place privately to avoid media attention,
typically either at the company’s head office or the offices of the investment institution.
4. Collective engagement: Collective engagement is an alternative engagement model that is often very
powerful. Whilst a single investment institution may have limited influence, several acting collectively may
carry great weight.

Collective engagement is also very efficient for both investors and investees, as it is achieved by a common
stewardship team in a common engagement meeting.

Difficulties may arise in coordination and consistency where issues are expanded or escalated, and there
may be some regulatory concerns. Nevertheless, there are a number of organizations who support their
members with this governance work, such as the ICGN or GAAP.

5. Escalation: Where an engagement has stalled, it may be necessary to escalate the matter. The original
Stewardship Code suggested the following escalation approaches (no such list being included in the 2020
version):
• Holding additional meetings with management specifically to discuss concerns
• Expressing concerns through the company’s advisers
• Meeting with the chair or other board members
• Intervening jointly with other institutions on particular issues
• Making a public statement in advance of general meetings
• Submitting resolutions and speaking at general meetings
• Requesting a general meeting, in some cases proposing to change board membership
This is not, however, a comprehensive list and other approaches may also be adopted such as:
• Private or public letters to the board
• Collective engagement with other stakeholders to build support
• Arbitration or legal redress where relevant
The ultimate sanction being to add the company to an exclusion list.

Engagement barriers
There are many barriers to effective engagement which investors and companies must try to avoid,
including:
Investor barriers
• Lack of clarity regarding the engagement objectives
• Lack of consistency (particularly for collective engagements), continuity or progress monitoring
• Lack of influence
• Inability to demonstrate materiality, resulting in a failure to achieve investee buy-in
• Poor preparation or subject knowledge
• Lack of knowledge regarding the company and its ESG policy
• Language barriers and cultural differences for overseas investors
Company barriers
• Company bureaucracy
• Refusal to engage, perhaps due to investor size
• Lack of resources
[recap]
The aim of ESG is to achieve long-term investment sustainability and is directly related to the long-term
performance and valuation of a business.

There is strong empirical evidence to show that ESG and corporate financial performance are strongly and
positively related which has contributed to the global growth of ESG investing, with annualized growth in
AUM of around 30% since 2006, although regional rates have varied. The primary growth drivers appear to
be materiality, market demand, and regulation, underpinned by growing academic evidence on the
beneficial effects of ESG.

The current dominant ESG strategy is negative screening, although it is expected that ESG integration may
shortly become dominant. Engagement and shareholder action are also key approaches, and many
investors wish to use their share ownership to engage with investee firms in order to exercise their voting
power to influence corporate behavior.

Typically, engagement is encouraged by the relevant domestic Stewardship Code, which may be undertaken
by individual investors or institutions, although it may be more effectively conducted on a collective basis.
It may be undertaken on an issue-based top-down basis, as normally used by passive managers who wish
to engage with many companies on a single issue. Alternatively, it may be undertaken on a company-based
bottom-up basis, that is more normally adopted by active managers who wish to address a number of
issues with a single company.

Irrespective of how it is achieved, engagement objectives mustF be clearly specified and communicated, as
any failure in this respect may represent a barrier to acceptance. The primary business contact point will
typically be determined by the issue at hand, although escalation measures should be anticipated in order
to advance an engagement that has stalled.

Correctly undertaken, however, engagement, and ESG investing in general, may be anticipated to provide
positive business benefits, especially in the context of minimizing downside risk.

The four key areas of the Stewardship Code are: Purpose and Governance; Investment approach;
Engagement; Exercising rights and responsibilities.