Environmental, social and governance (ESG) criteria describe areas that characterise a sustainable, responsible or ethical investment. They are an increasingly popular and important way for socially- conscious investors to evaluate a company’s operations when screening for potential investments.

By compiling ESG-related information about an organisation, we gain insight into the quality of management, as well as the environmental and social impact of financed activities, helping both the organisation and investors to better forecast the performance of the organisation, the risks they may be exposed to and the opportunities they may have.

Listed companies should strive to offer investments with long-term value, looking beyond governance risks, taking into consideration the impact of a company’s potential environmental and social risk. This can include a company’s employment practices, their talent management, product safety and data security. It also ‘analyses’ board diversity and business ethics.  By reporting on ESG factors, companies will increase their accountability and clarity to all their stakeholders. That said, thus far, there has not been a consensus by stakeholders on how to manage ESG risks and how to communicate these.

Environmental and social considerations are not routinely factored into the investment decision-making process, as the risks would become more apparent further down the line. Recognising and including sustainability factors in the investment decision-making process can increase the resilience of the economy and the stability of the financial system, as well as impact the risk return of the financial product. However, a financial adviser must provide the information necessary to the end investor.

Investors want information regarding how companies are managing ESG-related opportunities and risks and how they integrate them into their management decisions. Having ESG information will allow asset managers to better forecast performance, risks and opportunities, as they will have a more comprehensive view of that company. 

Regulation

The new EU regulation titled ‘Sustainability-related disclosures in the financial services’ details how financial institutions should integrate ESG information when advising clients, as part of their best interest and compliance policies.  MiFID II regulations, the legislative framework instituted by the European Union (EU) to regulate the European financial markets, have been amended to integrate ESG considerations and preferences in investment advice and portfolio management.  

This regulation accompanies the EU’s Action Plan for financing sustainable growth, which seeks to incorporate sustainability into the suitability assessment of financial instruments and the integration of sustainability risks by the financial market participants’ investment decision-making process. This will affect asset managers, investment funds and financial services firms, who will have to satisfy both the local regulator and the investor with regards to the way they invest and report, as well as the products they offer to reflect the change or move towards more sustainable and ESG-conscious investments. Given the unique standpoint of asset managers, the implementation of these regulations may provide them with a possible competitive advantage if they are ready to take on the change.

Lastly, the Taxonomy Regulation will provide the legal framework for an EU classification system that highlights to what degree economic activities can be considered sustainable, by providing both businesses and investors a clear picture of how a company operates in terms of their sustainability, ensuring they are making informed decisions about investments. Current classification systems make comparisons difficult due to non-standardised reporting, with sustainability disclosures being unclear as they were not properly developed or regulated.

This reporting will also facilitate the assessment of the long-term value of the company for consumers and investors, as well as other stakeholders by considering all aspects of a company, having information on financial and non-financial performance, including development, position and impact of their activity, as well as transparency of their business model.

In turn, companies will be encouraged to develop a responsible business model with a transparent approach to their sustainability policy as well as being more proactive towards achieving sustainability goals. The regulation also requires that companies disclose the adverse impact of ESG matters, such as company activity that may cause excessive pollution to the area or disruption of the local habitat to ensure that investors are aware of the sustainability of their investments. 

These regulations will enable investors to make more informed choices, so that their assets will be used more responsibly and support sustainability

Through these regulations, financial market participants will have to specify how they will integrate sustainability risks in their policies, disclose why they do not take into account sustainably negative impacts and clearly define when they will take these into account. This could include information about their carbon emissions, diversity on their board and remuneration policies concerning equal pay for equal work, among others. 

By including ESG reporting from the outset, smaller companies will gain an upper hand, future proofing and ensuring longevity of the company. Incorporating sustainability, in all its facets, is a sound business decision, putting the company at an advantage when in need of understanding future regulation as well as attracting responsible investors.

Bond issuers: implications on the capital markets industry 

Companies listed on a stock exchange (whether local or otherwise), need to keep in mind that they would be subject to more scrutiny than an unlisted entity would. Any action or stance a listed company takes on ESG reporting would be amplified due to the larger pool of potential investors. Hence, a listed company would benefit from an increased focus on ESG scorings, as this would not only benefit its reputation and overall likeability on the market but it might also help incentivise non-listed companies to follow in the same footsteps. While the onus of having positive ESG scorings lies on the company, financial advisers can also do their part in advising towards positive ESG practices.

 The increased interest in ESG reporting and the interest in assisting in the achievement of the UN’s 17 Sustainable Development Goals (SDGs) are both viewed as being inherently positive for a company’s image.  For a listed company, an increased positive image could be the driver for an individual to be inclined to invest in that company’s security as opposed to another. Similarly, this improved reputation and increased pool of investors could be seen favourably with regards to an increased share price of a listed company.

Notwithstanding the boost in reputation and likeability of the company, ESG reporting may also strengthen internal reporting systems and business models. The process itself can assist in the identification and management of risk, as well as the identification of possible future challenges or future opportunities for the company. Companies should get a jump-start on this to be at the forefront, giving them an edge over competitors. The implications of the new regulations would include compliance to design of the product and the delivery and sale of services.

 As the social and economic impacts of COVID-19 are coming to light, investors are taking a different, more disciplined approach to their investment decisions, becoming more aware of the fact that the mismanagement of ESG factors could have financial repercussions for a company. Reorienting private capital to more sustainable investments requires a comprehensive rethinking of how our financial system works.

This is necessary if the EU is to develop more sustainable economic growth, ensure the stability of the financial system and foster more transparency and long-termism in the economy. 

ESG is a matter of growing importance, the EU’s work on these regulations stresses their importance, encouraging transparency and clarity for all. We need to encourage capital to flow towards sustainable investment and resilient development, not only environmental but also socially sustainable investments.

The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018. For more information, visit https://cc.com.mt/. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.