The Code for Responsible Investing in South Africa (CRISA) became effective in February 2012. The code is intended to give guidance on how institutional investors such as pension funds and insurance companies should execute investment analysis and investment activities. It also looks at how institutional investors exercise their right to ensure they are promoting sound governance.
Across the investment universe the theme of environmental, social and governance (ESG) investing is coming out very strongly and there is more focus on ESG.
What are ESG investments?
ESG investments look at the long-term impact on the environment, society, and the performance of the business. It is a strategy where you invest in companies that strive on making the world a better place and those companies that are less harmful to the environment.
ESG investments add an extra component to the risk/return equations, as investors will also be considering the impact of their choices. The investment method can reduce portfolio risk as the stocks with higher ESG scores are often less volatile.
Factors looked at to derive ESG Scores?
- Climate change policies;
- Water-related issues;
- Recycling and safe disposal practices;
- Environmental benefits for employees;
- Employee training and development;
- Customer service friendliness and responsiveness;
- Employee safety policy;
- Diversity of the board of directors and management team; and
- Transparency of communications with shareholders.
These are just some of the few factors which are considered when deriving the ESG score for a company.
Is ESG investing a short term theme that will go out of fashion again?
That is the buzz question on some proponents’ lips. However, ESG is here to stay as most valuations now encompass the contribution of ESG factors to the overall company value and performance. For instance, ESG valuations in fixed income securities focuses more on the downside risk. If for example, a company is subject to a lawsuit, the analysts might make adjustments to the liquidity ratios, cashflow ratios, credit ratios or credit spreads to cater for that. Thus, the lawsuit might affect the company’s ability to honour its debt obligations if the lawsuit drags far into the future.
ESG factors on equity valuations focus on both the upside and downside. For instance, a lower discount rate or required rate of return might be used to value a manufacturing company that has implemented new manufacturing practices that are environmentally friendly. Overall, the value of this company will be higher relative to its competitors.
Valuations are based on going concern assumption be it in mergers and acquisition, stock selection etc, therefore this points to the notion that valuations incorporating ESG factors are here to stay.
Is it in the investor’s best interest?
Global warming is becoming a reality at a faster rate. As a result, more and more corporates are becoming more inclined to cost reduction measures that are environmentally friendly and have established good corporate citizen structures that seek to give back to respective communities of domicile. Above all, corporates have comprehended diversified corporate governance issues in the structure of their board of directors with an aim of inclusion. All these efforts are targeted at value addition thus maximising shareholder value. Therefore, this modern-day dynamic has become part and parcel of most investors’ toolkit and should be of interest to a potential investor or a seasoned investor.
Being a responsible investor is slowly and surely gaining momentum in South Africa in tandem with the rest of the world. ESG factors are now a mainstay in most valuations and portfolio formations.