ESG Outlook:Key Trends Fueling Momentum

March 2019 Notes from the ESG Desk

Milestones in 2018We saw significant momentum in the ESG space during 2018. Asset managers launched new or repurposed strategies ranging from those designed to integrate environmental, social and governance issues more broadly into the investment process to screening strategies that exclude so-called “vice” industries (e.g., firearms, coal mining) and overweight “good” industries (e.g., renewable energy, clean tech) in client portfolios. We also noted a variety of new investment vehicles, such as ETFs and impact-related thematic products.

Globally, asset owners have increased their focus on allocating capital toward ESG-related investments. Growing concern for stranded fossil fuel assets and water stress generated particular interest in investment solutions that address climate change risks.

Issuers have also started placing more emphasis on ESG disclosure. They have stepped up organizational transparency around ESG-related risk management practices and business ethics controls to address growing investor concerns, especially after a series of scandals resulted in adverse impacts on market valuations and credit spreads.

What’s Driving ESG Investing?We believe four key trends demonstrate why implementing ESG principles into an investment program is so important. Successfully navigating these issues may contribute toward mitigating downside ESG-related risk, increasing upside potential and helping managers adapt to a shift in global investment mentality.

New Business Risks

Risks originating from extra-financial issues and events may have significant economic impacts on companies. For example, the Paris Agreement’s long-term goal of keeping the increase in global average temperature below 2 degrees Celsius (C) above pre-industrial levels and to limit the temperature increase to 1.5 degrees C has led to tougher environmental regulations particularly in Europe and China. For the conventional fossil fuel industry, these developments present potential risks such as increased compliance costs, customer defections and stranded assets.

The effects of rising sea levels are another latent climate change-related risk. As oceans continue to encroach various coastal metropolitan areas around the world, their rising waters have the potential to drive down real estate asset valuations and create material operational disruptions for companies.

The environmental and human health impacts of industrial disasters, including the recent Brumadinho dam collapse, Deepwater Horizon oil spill and Fukushima nuclear power plant meltdown, resulted in serious reputational damage and material liability costs to the implicated companies.

Concerns about cybersecurity and product safety are also increasing pressure on companies to not only serve but protect their customers.

Managing these evolving risks depends on the underlying strength of companies’ corporate governance. As a consequence, issues such as links between sustainability targets/initiatives and executive compensation, board independence and business ethics may likely become more important.

“Growing concern for stranded fossil fuel assets and water stress generated particular interest in investment solutions that address climate change risks.”

FOR INSTITUTIONAL USE ONLY/NOT FOR PUBLIC USE 1

Guillaume Mascotto

Vice President

Head of ESG and Investment Stewardship

Technological Advances

Technological innovation is changing the way consumers demand and utilize goods and services. Smart grids, demand-side management and electric vehicles exemplify how the deployment and use of energy is changing. E-commerce has evolved to include integrated “click and mortar” solutions. Robotics and industrial automation are redefining traditional manufacturing business models.

As a result, most sectors of the economy are seeing paradigm shifts in the way business is conducted, thereby presenting risks to those companies lacking the appropriate strategic direction for adapting to technological change.

Social Media

The ubiquity of social media has sensitized people to global issues in real time–from gender and income equality to business ethics to environmental protection. In turn, investors, especially in developed markets, are paying closer attention to company behavior and social license to operate, as well as compliance oversight and organizational transparency.

Millennial ImpactGenerally possessing a greater global perspective than previous generations, many millennials believe that climate change andaccess to affordable health care and education are issues with potentially serious repercussions for their future. Many of them are demonstrating a desire to align their worldview and values with their investment activities, which we think will become increasingly important as wealth gradually transfers from baby boomers to their generation.

What’s Stoking ESG Momentum in 2019?We expect momentum in the ESG space over the next year to be influenced by these key drivers:

§ Cybersecurity and Data Privacy. Investors and consumers are concerned about online activities and attendant risks to their personal data. While many people have embraced the digital revolution, they are not all willing to do so at the expenseof their privacy. This development has shifted the onus on companies from a “know your customer ” to a “protect your customer” data relationship. Accordingly, we expect companies and governments to pay closer attention to cybersecurity risk management and compliance as evidenced by the European Union’s General Data Protection Regulation, a new law governing data protection and privacy.

§ Corporate Misconduct. We believe consumers and investors may be increasingly quick to seek punishment for misconduct or unethical behavior by companies and management. As recent transgressions have demonstrated—for example, the creation of fake customer bank accounts and the falsifying of vehicle emissions data—tolerance of corporate wrongdoing continues to wane. We think company behavior, compliance oversight and organizational transparency are increasingly becoming part of the overall investment quality equation.

§ Corporate Impact. There is growing demand for movement beyond corporate citizenship toward measurable corporate impact. We expect investors to increase their focus on investment solutions that can both address their concerns about global issues and provide financial security. Inclusion of the U.N. Sustainable Development Goals in investment decision-making is one way of attaining both aims. These 17 goals address a host of environmental and social issues central to ESG-focused investors, including eliminating poverty, achieving gender equality and managing climate change.

§ Investor Demand for Solutions-Based Innovation. We also predict that investor demand for solutions-based technological and scientific innovation will increase. In the current economic model, we are locked into an existing development path that supports fossil fuel-based technologies and potentially constrains technological innovation toward “greener” solutions. This should drive interest in investment products that address specific themes, including technological solutions, energy transition, health care and life sciences, and a circular economy designed to better utilize existing resources.

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