In this issue…
- MSCI study: more transparency needed about ESG integration by investors
- Using Islamic finance to manage social and governance impact of leverage adds value to traditional ESG approaches
Investors have been waiting eagerly for the European Central Bank’s policy decision and it’s impact. Despite an interest rate cut and increase in the volume of monthly bond purchases, by the end of the day the expected fall in the Euro’s value had largely dissipated. Although it was probably not what the ECB hoped for, the continuation of a falling dollar and rising commodity prices is better news for economies in the Middle East North Africa Southeast Asia (MENASEA) region, which have been hit hard by the steep drop in commodity prices during 2015.
Recent data on integration of an Environmental, Social & Corporate Governance (ESG) framework into investment decisions is shifting the terms of the debate around responsible finance. The shift is from from whether ESG can help improve or impair financial performance, to how to evaluate and compare approaches to ESG integration. Research from MSCI – whose VP of ESG Research, Emily Chew, will speak during the upcoming groundbreaking Responsible Finance Summit – found that many funds are falling behind on their integration of ESG, while others not formally integrating ESG are invested in companies that score well on ESG measures.
The MSCI report authors specifically highlighted the gap in transparency: “A deficit of objective measurements of the ESG characteristics of fund holdings leaves investors facing several important gaps” related to how ESG strategies translate into practice. For example 6,900 of the 21,000 funds analysed by MSCI still invest in companies that are producing controversial weapons like cluster bombs and landmines – constituting the most common exclusionary screen among responsible investors.
However, there are bright spots in unexpected places too. MSCI found that many funds (about 15% of the funds they reviewed) were either not marketed as being socially responsible, or were using ESG integration to invest in companies with high rankings on ESG criteria. The two ends of the spectrum—funds still investing in widely excluded activities (by both traditional responsible finance and Islamic finance) and those whose holdings have good ESG screens—highlight some next steps for the wider responsible finance industry.
Two particular ones come to mind.
First, there is a substantial case for investors to demonstrate more transparency and consistency about how they implement their ESG strategies in order to highlight the value brought about by ESG integration. With greater consistency about how ESG integration is approached, it will facilitate a greater awareness that ESG integration is not an entirely new concept for analyzing investments; but rather that it is a way to formalize the consideration of non-financial factors in traditional financial analysis.
Second, the additional transparency around existing ESG approaches can broaden the outreach into new markets such as emerging markets where ESG is not prominent but where alternative approaches like Islamic finance constitute an important avenue. In markets where Islamic finance has expanded the most, financial institutions are being squeezed by cost pressures from rising competition (many Islamic financial institutions are looking for new markets).
Put simply, what is needed is a clearer explanation of how to integrate ESG as well as a better way of understanding how investors might already be using non-financial factors in a way that is aligned with ESG. This will help reduce the perception that ESG is outside existing approach.
A popular perception of responsible finance is that ESG is that it is solely driven by environmental issues (and climate change in particular) and so finding an approach in Islamic finance that incorporates the environment is the only way to bring the two together. SEDCO Capital, which has built their investment strategy around a concept they call ‘Prudent Ethical Investing’, has doubled their assets under management in the last 5 years. A unique aspect of their approach is the way they factor in the social and governance impacts of debt with Islamic finance practices to enhance their approach to ESG integration.
The financial crisis and the European debt crisis brought the social impacts of leverage to the fore. Islamic finance has attracted more attention from a global audience because Islamic investment strategies shun highly leveraged companies (from screens designed to avoid companies that pay or receive too much interest).
However, the Islamic approach is not solely focused on interest income and expense but also considers the impact of excessive leverage for encouraging speculation in a way that represents a governance and social risk factor. Integrating this side of leverage into investment decisions represents a type of ‘Islamic ESG’
As Hasan Al Jabri, CEO of SEDCO Capital, described in the Thomson Reuters-RFI Responsible Finance Report: “it is impossible to construct a responsible investment framework that ensures sustainable growth without addressing the ill-effects of excessive debt and risky speculation”. Data from SEDCO’s analysis indicates that today’s common Islamic screens for leverage are a reasonable starting point for consideration of ‘prudence’ within the ESG approach that is consistent with better long-term performance.
In addition to the impact from debt through the social impact, high debt levels at an individual company can indicate an imbalance in governance tilted towards shareholders over other stakeholders. The benefit from using higher leverage will accrue primarily to shareholders while the costs if things don’t work out are borne by other stakeholders (workers, customers, suppliers, lenders).
Even outside of markets where Islamic finance has grown, the data from ESG index provider MSCI backs up the contention that lower debt levels are associated with better ESG scores and improved financial performance. In India, companies included in the ESG index are not only better performing than the index as a whole in terms of return on equity, they do so with lower leverage.
In the responsible finance world there is little explicit cooperation between Islamic finance and traditional ESG. However, there is already an approach used today in Islamic finance which addresses the social and governance aspects. Some leading practitioners like SEDCO have pushed forward using a more systematic approach to leverage as a part of ESG integration; the Responsible Finance Summit coming up at the end of March will identify more areas for cooperation.
The Responsible Finance Summit will be held from 30-31 March 2016 at Sasana Kijang in Kuala Lumpur, Malaysia. The Summit is hosted by Bank Negara Malaysia, organized by the RFI Foundation and co-organized by Middle East Global Advisors. A complimentary pass will be provided to the first 5 people who email firstname.lastname@example.org and reference FFMar14@RFS.