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2018 ESG Trends

Emerging markets, fixed income and scenario analysis are among the five key trends for the year ahead, says MSCI.

Bigger, faster, more. Whether due to policy, technological or climatic changes, companies face an onslaught of challenges that are happening sooner and more dramatically than many could have anticipated. Investors in turn are looking for ways to position their portfolios to best navigate the uncertainty. In 2018, these are the major trends that we think will shape how investors approach the risks and opportunities on the horizon.

SIFTING FOR MANAGEMENT QUALITY IN EMERGING MARKETS

To help navigate the evolving Emerging Markets investment universe in 2018, investors will increasingly rely on ESG signals to sift for quality in management with the aim of identifying companies that rise above their country’s challenging environment.
As an example, we narrowed the MSCI ACWI Index universe to the top half of companies that meet global governance standards and companies with ESG Ratings that are above their domicile country’s ESG sovereign rating. The result: we found 15% of Emerging Market company constituents of the MSCI ACWI Index in MSCI ESG Research coverage passed these thresholds. If you think of these as “country outperformers,” it highlights how painting a whole market with too broad a brush may miss the quality differentiation that lies underneath.

FIRST STEPS IN SCENARIO TESTING CLIMATE CHANGE

In 2018, we expect investors will expand their view of portfolio climate risk from measuring the carbon contribution of their equities portfolio to testing top-down views of macro climate risks that can better inform long-term asset allocation.
To illustrate this trend, we map “High Warming” and “Low Warming” scenarios built off of academic projections of 2016 GDP costs to countries against a hypothetical portfolio that mirrors the asset allocation of typical public defined benefit plans in the U.S.

Just by looking at assets with exposure to the worst third of warming scenario outcomes, we found that every asset class today for our hypothetical portfolio were more exposed to negative growth impacts from a business-as-usual high warming trajectory than a low warming trajectory with higher transition risks in the near term.The upshot here is fairly simple: while institutional investors have so far focused largely on scrutinising the carbon risks of large-cap developed market holdings in their public equity portfolios, it may be that the majority of risk will come from more poorly positioned asset classes given what we know today.

ACCELERATION OF ESG INTO FIXED INCOME INVESTING

If 2018 is the year that ESG takes off in fixed income, it may not be because fixed income investors are finally ready to adopt ESG principles, but rather because ESG is finally ready for fixed income investors.
A “push” from leading asset owners like SwissRe and GPIF that are trailblazing across asset classes, putting pressure on their managers to integrate ESG in some way into fixed income. On top of that, asset managers are increasingly competing – at the start of 2017, investors could choose from only two “self-labeled” ESG Fixed Income ETFs, but the year ended with at least a dozen ETFs that are identifiable as fixed income vehicles with an explicit ESG reference.

Companies in the bottom 20% of MSCI’s ESG Ratings experienced three times as many incidents of extreme drawdowns

Combine that with the “pull” that ESG could add value to credit analysis, and ESG may take center stage for fixed income in 2018. In a recent paper, we analyzed all constituents of the MSCI ACWI Index since 2007. We found that companies in the bottom 20% of MSCI’s ESG Ratings experienced three times as many incidents of these extreme drawdowns as companies rated in the top 20%.  It is possible that, over the past 10 years, a company’s ESG Rating at a given point in time could have signaled event risk that might not have unfolded for some years – a form of ‘unmatured’ event risk.
Overall, as ESG tools have been sharpened and as extra-financial criteria have emerged as powerful indicators for managing downside risk, fixed income investors have begun to take notice.
h6. LOOKING BEYOND SUSTAINABILITY DISCLOSURE

In 2018, we anticipate that the corporate disclosure movement reaches a tipping point, as investors seek broader data sources that can balance the corporate narrative and yield better signals for understanding the ESG risk landscape actually faced by portfolio companies.

To test this, we examined a sample of our coverage universe, the 2,434 constituents of the MSCI ACWI Index, as of November 30, 2017, to see if different sources of information contribute to different scoring components of the ESG Rating.

What we found helps illustrate both the value and potential limits of voluntary disclosure in our ESG signal. Fully 35% of any given company ESG rating, on average, is composed of scores that rely on what a company has disclosed through voluntary sources, while the other 65% is composed of scores using data from specialized data sources, enforcement and media sources, and mandatory disclosure.  The implication here is pretty simple: more voluntary disclosure may contribute more to the ESG rating, but may only result in improved ratings up to a point.

THE YEAR OF THE HUMAN

As artificial intelligence (AI) assumes more and more tasks traditionally performed by humans, many jobs for people may require higher levels of skills and cognitive abilities. In 2018, investors will increasingly seek opportunities to invest in talent quality.To get a sense of which companies truly value human capital, we use MSCI’s ESG Metrics dataset, which includes Human Capital metrics, to analyze around 1,600 companies that are constituents of the MSCI World Index.

As investors gain access to greater transparency, artificial intelligence may be the spur to test the corporate mantra of “our people are our greatest asset,”

Using a variety of metrics, two things stood out: we found that companies we defined as ‘Leaders’ in talent management tended to enjoy higher growth in revenue per employee than their industry peers (0.8% versus -0.2% for ‘Laggards’), and we found that companies with no evidence of talent enhancement or training practices underperformed compared to their industry peers (1% higher growth between ‘Leaders’ and ‘Laggards’ between 2012-2016).

As investors gain access to greater transparency, artificial intelligence may be the spur to test the corporate mantra of “our people are our greatest asset,” with investors sifting out winners and losers in the race for human capital.

For references to the studies listed in this article, please see the full report here.

Join the ESG Trends Webinar on 18th Jan here.

Linda-Eling Lee is Global Head of ESG Research, MSCI

This article was paid for by MSCI and the RI editorial staff had no role in the creation of this page.