Sustainable Development and ESG Investing – A Historical Overview
The concept of sustainable development has evolved over the course of time. Fundamental discussions begun in 1968 at the United Nations Education Scientific Cultural Organisation (UNESCO) conference on the biosphere. Ultimately, the UNESCO conference catalysed the discourse regarding the views on sustainable development. Subsequently, at the first United Nation World Conference on Environment in 1972, the economist, Ignacy Sachs closed with a statement introducing his views on economic development by stating that, “growth should not become a primary goal but remain an instrument for solidarity among the previous generations and those to come.'
It must also be mentioned that during the 1970’s decade, there were some defining industrial environmental catastrophes that pushed international institutions to conceptualize further the notion of preserving the planet for future generations. The major industrial disasters during this period include the wreckage of the Amoco Cadiz in 1978; emission of dioxin in Seveso, Italy in 1979; a nuclear incident at Three Mile Island in the United States in 1979; the explosion of the Union Carbide pesticide plant in Bhopal, India in 1984; and in 1986 at the Chernobyl nuclear power plant in Ukraine.
During the mid-1980’s, a growing awareness on the term sustainable development is heightened with the release of the 1987 report titled 'Our Common Future”, better known as the Brundtland Report on Sustainable Development by the World Commission on Environment and Nations Development. The report comprises of a comprehensive list of the problems which threaten the ecological balance of the planet: deforestation, soil degradation, greenhouse gas effect, and the expansion of the ozone hole.
The solution then proposed by the Commission was sustainable development which was defined as the “development that meets presents needs without compromising the ability of future generation to meet theirs”. The report further defines key concepts inherent in sustainable development with one of them being 'Need', which states that a large proportion of people in the world live in poverty and most of these people are found in developing countries.
Therefore, in order for countries to eradicate poverty completely, their needs to be economically developed will result in an increase in income and resources to cater for everyone. The second concept defined in the report is that of 'Limitation' which states that the concept of sustainable development implies the need for limits. This is not absolute limits but limitations imposed by the present state of technology and social organization on environmental resources and the ability of the planet to absorb the effects of human activity. To summarise, the 1987 Brundtland report described sustainable development as aiming to promote a state of harmony between human beings and nature.
During the 1992 Rio Earth Summit, 17,000 NGOs attended a parallel NGO forum that provided recommendations on the issue of climate change to the Earth Summit. The summit subsequently influenced the establishment of the Convention on Biological Diversity, and the United Nations Framework Convention on Climate Change (UNFCCC). This resulted in a common agenda for the 21st century which was created, known as Agenda 21. The agenda proposed addressing environmental issues by combating poverty, conserving, and managing natural resources, preventing deforestation, promoting sustainable agriculture, addressing production and consumption patterns, and protecting the atmospheres and oceans.
The issues can be viewed from 4 dimensions: Economy, Environment, Society and Ethics. At the same time, private corporations started feeling the pressure from NGOs and anti-globalization movements and they identified the concept of sustainable development as a way to respond to criticism. From 1999, corporations became involved in the UN’s 'Global Compact', which is a code of conduct launched by the United Nations. The Global Compact encourages companies to align their strategies and operations with universal principles on human rights, labour, environment and anti-corruption, and take actions that advance societal goals.
The shift to SDGs
Between 2000 and 2015 was the era of the UN Millennium Development Goals which then shifted in 2016 to the Sustainable Development Goals (SDGs). The SDGs are a framework/blueprint agreed upon by UN member states which describes a set of goals to achieve development that is sustainable at a global level. It consists of 17 goals, and 169 targets to achieve sustainable development. These goals are part of the UN’s Agenda 2030 which are to be achieved over a 15-year period between 2016 and 2030.
Currently the goals require funding/investment of $3,9 trillion per annum and there is an estimated $2,5 trillion investment gap which is an opportunity for private investors to contribute to the achievement of the SDGs. Institutional investors are fiduciary institutions, and hence, their operations are subject to the legal standard of loyalty and care imposed on those who are responsible for managing people’s money. The duty of loyalty, is often referred to as “the exclusive benefit of the beneficiaries of the institutions”.
The duty of care requires the fiduciary to act as a prudent person in the exercise of his/her obligation. That is, to take action that, after due consideration, a prudent person would take in a similar situation. However, this traditional understanding of fiduciary duty particularly in common law countries presented an obstacle on the mainstreaming of responsible investment. This led to the UNEP-FI commissioning a law firm called Freshfields to investigate this conflict where it was conceded that due to the size of assets and significant power institutional investors wield, it is therefore a requirement that they act on behalf of beneficiaries taking into consideration ESG risks to better predict financial performance. Hawley and Williams (2006) further stated that institutional investors are universal owners due to their ownership of the economy through their diverse investment in all sectors. Therefore, the investment in SDGs is aligned to the fiduciary duties of institutional investors by ensuring sustainable financial returns for the beneficiaries whilst contributing to issues of sustainability as outlined in the SDGs.
The ESG rating system
People of faith have historically influenced investing based on qualitative criteria for thousands of years. Religious or faith-based investors have consciously avoided investing in stocks that they labelled 'sin stocks,' which included a range of industries such as the alcohol, gambling, tobacco, and war-related materials industries (Zhang, 2008). These decisions emanated not from a desire to maximize economic profitability alone, per the neo-classical economic school of thought, but instead were based on a desire to conform to a set of values that transcended personal economic gain.
This framework provided an experiential foundation for exploring ways to value other environmental, social, and governance objectives in investing. In today’s modern day, there have been models created and used as a foundation to the qualitative measurement of sustainability practices within corporations, as well as the development of quantitative metrics which were useful in portfolio construction. These models have resulted in an ESG rating system. The ESG rating system, provided an opportunity for companies and private investors alike to integrate environmental, social, and governance preferences into their investment policy, which provided increased insight into previously unrecognized risks within those investments.
Eugene Fama and Kenneth French published their ground-breaking study 'The Cross-Section of Expected Stock Returns', which developed the first asset pricing model to weigh a collection of specifically identified risks and attempt to predict the return distribution of an asset. A large part of Fama and French’s conclusion was that cross-sectional data on the risks they identified as material to returns truly allowed investors to more accurately predict asset returns. This same cross-sectional data was developed for the ESG space. The development of this cross-sectional global data was supported in large part by European legislation that required businesses to disclose environmental and social practices.
This legislation is best displayed by the 2002 High Level Group of Company Law Experts Report, which was one of the first to implement government policy changes because of the rising interest in responsible investing. This report specifically focused on improving corporate disclosure requirements, shareholders’ rights and proxy voting, board regulations, and the broader responsibilities of institutional investors. Perhaps the most significant report to date within the sphere of responsible investing is the 2004 Environmental Programme Finance Initiative Report, published by the United Nations, which first coined the phrase 'Environmental, Social, Corporate Governance analysis' to describe the categories of analysis in socially responsible investing.
This phrase was later shortened to ESG investing (Gilbert, 2010). The United Nations further established the Principles for Responsible Investment, which was released in 2006 (United Nations, 2006). These principles have served the purpose of setting standards by which companies can set their policies. Soon after, Deutsche Asset Management established the first thematic mutual fund, which focused on climate change, thematic portfolio construction quickly developed into a common investment strategy known as impact investing (Gilbert, 2010). Green Investing became a common impact-investing model, wherein portfolios were constructed with the goal of reducing environmental risk. This was especially made visible by the 2015 conference of parties at the United Nations Climate Change Conference (also referred to as COP21) where multiple countries made public commitments to reduce greenhouse gas emissions through greenhouse gas reduction goals.
The concepts of Sustainable development and ESG investing throughout the centuries have been founded fundamentally on the relationship between financial return and social, environmental, and governance-based convictions.
NEO KOOTSHOLETSE is Transactional Banker at RMB