The Challenge of Mainstreaming ESG Investments

Not long ago environmental, social and governance (ESG) issues were the niche concern of a select group of ethical or socially responsible investors. Few investment vehicles were available in the financial markets that enabled investors to target their investments according to ESG factors. Over the past 10 years, this reality has been undergoing a rapid change. On all fronts, be it by asset managers, regulators, or the investors themselves, serious efforts have been undertaken to incorporate ESG criteria into investment analysis and decision-making processes. Some general guidelines like the United Nations Principles for Responsible Investment (PRI) have encouraged a fundamental change in investment practices whereby investors explicitly employ ESG factor analysis to enhance returns and better manage risks. Further, the European Commission has developed a specific EU taxonomy for sustainable activities, which has the ability to not only trigger reporting and potentially accounting, but ultimately prompt funding considerations on the European financial markets as well as for any European investor for transactions abroad. 

Still, there remain challenges for investors when integrating ESG considerations into their decision-making process. First, some still question if considering ESG issues actually adds value to their investment process or might even hurt yields. Even though several recent studies have shown that ESG integration can limit volatility and enhance returns, investment professionals often place a greater weight on their own experience than on third-party research - and their own experience is often still dominated by traditional investment paradigms that were established before ESG factors became an issue. 

Another problem ESG investors face is the lack of high-quality data that can guide their investment decision process. Without access to data sets, modelling capabilities, and valuation techniques, it is not always straightforward to understand the effects of ESG risks and opportunities when planning an investment in a company. The good news is, that there has been a recent surge in specialized data providers for ESG investors. In comparison to market suppliers, these firms concentrate only on ESG research, evaluations, and analysis. Arabesque, Covalence, CSRHub, Ethos, Inrate, Sustainalytics, and Goby are just a few companies that offer comprehensive ESG data services. Each of these firms has its own technique of assessing ESG aspects, grading methodology, and risk analysis tools. 

Finally, greenwashing is a growing challenge to the ESG investment industry. This term originally described misleading claims about environmental practices, performance, or product, but has been used more widely to incorporate ESG factors more broadly. In recent years, there have been serious questions why certain stocks are part of the top holdings of ESG funds even though these companies were involved in significant controversies or undertook controversial activities. This has been a major blow to the credibility of ESG investing. The good news is that certain regulators like the EU have recently launched various initiatives to standardize claims around the green and ESG credential of funds and indices, which will contribute to a clampdown on greenwashing. 

Notwithstanding these challenges, there is a widespread perception that ESG investing is likely to become the market standard within the next five years. At that point, a differentiation between “mainstream investing” and “ESG investing” will most likely no longer make sense as they will have merged into one concept. Most available research today indicates that this will be good news for investors as their long-term yields will increase while volatility will be tamed. 

For our work in emerging markets, this implies several changes. First, more effort should be put in projects combating climate change, the mobilization of funds for that as well as the need for investors to ensure their money is well spent. Next, development of more regulation in emerging markets when it comes to ESG will in turn provide higher incentives to proactively engage in those markets. The incorporation of climate-related as well as technology-related questions into governance will become instrumental in addressing ESG issues along the investment process. Finally, advancement of technology that can be used to improve and support ESG reporting, grievance mechanisms, and risk management will take a front row in many assignments.  

ESMS and ESG Investing in Fintech and Agrotech Firms 

For a number of firms in the nascent fintech and agrotech sectors, LFS has developed and/or reviewed Environmental and Social Management Systems (ESMS). This includes institutions in Africa like MyAGro (Tanzania), Babban Gona (Nigeria), and the One Acre Fund (regional), where the development and review of the ESMS was the main or unique project content.  

ESMS in Financial Institutions 

In conducting due diligence of financial institutions for various investments and projects, LFS has developed and applied a rigorous ESG investment catalogue and has reviewed ESM Systems in banks and other financial institutions in more than 20 countries worldwide. 

In addition, as part of our management mandates for various banks in Africa, the Caucasus and Central Asia, we have implemented ESM systems at these banks. 

Since 2021, LFS has been hired by DEG under an ESMS related Framework contract to support selected banks, where DEG is invested, in the enhancement of their ESMS. Currently, we are working with banks in Paraguay and Mexico, as well as in China. 

ESG in Development and Public Finance 

In 2020, LFS was hired by KfW to support the set-up of a regional challenge fund for job creation. This included the review of project applications from public and private sector partners in Ethiopia, Tunisia, and Côte d’Ivoire, including the screening of E&S risks and review  

Also in 2020, LFS conducted a E&S due diligence of a prospective project executing agency for a new urban infrastructure insurance facility in Latin America, in response to climate change risks. This included developing a guideline for E&S risk identification and the development of an E&S commitment plan for the project. 

Since 2021, LFS has been supporting a project execution agency of KfW in developing and implementing a new ESMS in support of investments in public infrastructure assets to increase climate resilience in the respective cities. 

Main pillars of ESG investing (Source: https://content.ftserussell.com/sites/default/files/research/ftse_russell_step_change_2018_report.pdf)