Maggie Williams examines claims that this could be the year responsible investing comes of age

As the world speculates on the immediate effect that a Trump administration and a UK-less EU will have on markets, a report from MSCI argues that long-term investment outlooks based on physical, not regulatory, risk will deliver greater value.

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Water shortage

According to MSCI’s 2017 ESG Trends to Watch, the policy shifts of 2017 are a sideshow in comparison to the challenges posed by long-term physical trends, such as water shortages. There will, the report says, be “a temptation to react and over-react to spasms in the Twittersphere. But it’s the slow-burning risks that can matter most”.

Taking a long-term view, and thinking “like an owner, rather than a trader” is the report’s overarching recommendation.

There is now an abundance of research and tools

“Getting into that mindset may be easier than you think,” says Matt Moscardi, co-author of the report at MSCI. “ESG data shows long-term trends, but traditional factor data also points in the same direction. Dividend growth and dividend yield have the closest correlation. There is now an abundance of research and tools for large asset managers to view their portfolios for the long term.”

The report warns of the dangers of the “value leakage that a misalignment of incentives, a lack of accountability or exposure to long-term risks such as climate change can produce”. Instead, it favours strategies that “emphasise vigilance and influence”.

Developments in Asia

The same think-like-an-owner rules apply across all geographies and MSCI’s report identifies improvements in stewardship in Asia as a specific trend for 2017. Six of the 14 countries that have created stewardship codes since 2014 have been in the region.

Asset owners can learn from European mistakes

“Stewardship in Asia is a mixed bag,” cautions Moscardi. Although countries in the region are, he says, “still figuring it out” when it comes to stewardship, there will be rapid progress - not least because the region can draw on the experiences of Europe and North America. “Asset owners can learn from European mistakes, where owners didn’t always gear to the long term.”

There are good examples of changing mind-sets in Japan, Hong Kong and Malaysia among others. However, resolving the challenges of short-term versus long-term investment, and different social and environmental factors within each market in Asia, mean 2017 will be a year of “ferment and discovery” in the region.

ESG grows up

The practicalities of how and where ESG factors are taken into consideration could also become more relevant this year, as they are applied to a wider range of asset classes and strategies. “2017 may be the year that ESG grows up,” claims the report.

ESG signals are nuanced and selective application could be preferable to a blanket approach

Analysis from Cambridge Associates shows that ESG makes more of a contribution to performance in emerging markets-based companies than in developed markets; Barclays has found that governance factors can link to credit as well as to equity performance. “Both reports show that ESG signals are nuanced and selective application could be preferable to a blanket approach,” says MSCI.

Consistency in reporting ESG factors is another area that has required further development. Research by PwC has shown that 92% of investors say companies do not disclose ESG data in a comparable format. However, the UN’s Sustainable Development Goals (SDG) framework is becoming a common point of reference – to the surprise of analysts. “The SDG is aspirational, it’s not a framework for disclosure,” says Moscardi. “But elements of it may be incorporated into reporting. It’s a win-win. Companies can talk about good stuff they are doing, and that is hard to come by. It’s a useful lexicon for outcomes that are not on balance sheets, but can make a long-term investment case.”

Assessing physical risk

One of the report’s clearest messages is that, whatever happens politically this year, “the planet does not care about policy”. Physical risks, such as the water shortages affecting the Middle East and the US among others, are a long-term concern regardless of who is sitting in the White House.

2017 could be the year that investors protect their portfolios against climate risk

Taking account of physical risks might be new thinking for asset managers, but the report argues the insurance sector has worked on this basis for years: “2017 could be the year that investors protect their portfolios against climate risk like insurers price physical risk in premiums - the question is how.”

“As an investor, you can look at return on equities, return on assets, people plans. However, location will also make a difference – and in that respect data and transparency isn’t immediately obvious,” says Moscardi. “If sea levels are going to rise, they will do so regardless of socio-political factors. It goes back to the owner-versus-trader argument again.”

If the factory’s requirements are put against public needs, there could be a conflict

Moscardi uses the example of factories with water-intensive processes based in areas where there is a water shortage, pointing to future problems. “If the factory’s requirements are put against public needs such as agricultural demands, and there is a finite water supply, there could be a conflict and subsequent pricing issues,” Moscardi adds.

Investors are increasingly acknowledging that there doesn’t have to be a trade-off between returns and ESG factors. But, MSCI argues, there is still much to do when it comes to changing mindsets from short-term gain, to what makes for a long-term sustainable investment. In 2017, investors will need to add the skill of thinking like an owner to their task list.