Module 1

Recent developments in ESG integration

The European
Federation of
Financial Analyst
Societies
Sophienstraße 44,
60487 Frankfurt am Main
[email protected]
www.effas.com
Learning objectives

This module gives an introduction into the current state of sustainability integration within the financial sector.

The learning objectives are:

§ Understanding what drives the demand for ESG.
§ Understanding what challenges are associated with ESG integration and what kind of barriers exist.
§ Have an overview of empirical studies on ESG investment and the implications for sustainable investment.

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Agenda

1.1. Market drivers

1.2. Empirical evidence about ESG and financial performance

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1.1. Market drivers

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1.1. Market drivers
Drivers for ESG integration

Regulatory
Framework
Investor Demand
Global Challenges
Public Perception

Investor Initiatives ……..

Data Availability

Risk & Reputation Changing Fiduciary

Management Duties

Source: Compare e.g., EFFAS Survey on ESG Integration (2019)

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Global challenges of rising carbon emissions and temperature (1/3)
Global atmospheric carbon dioxide (CO2) in parts per million Global temperature anomalies in °C compared to the
(ppm) for the past 800,000 years average from 1951 to 1980

Earth’s average surface temperature in 2022

Fossil CO2 emissions by continent in gigatonnes 1960 to 2022

Source: IEA (2023); Friedlingstein et al.

(2022), Global Carbon Budget (2023). Source: NASA GISS (2023).

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Global challenges as defined by the World Economic Forum (2/3)
Global risks ranked by severity over the short and long-term

• In the WEF Global Risks Perception Survey (2022-2023),

“Cost of living” is considered as the most severe global
risk in the next two years from 1200+ respondents.
• Climate- and nature-related risks dominate the top 10
risks by severity over the long term.
• “Climate action failure” is seen as the most severe
global risk over the next decade.

Source: World Economic Forum, Global Risks Repot (2023).

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1.1. Market drivers
Global challenges as defined by the UN SDGs (3/3)

Source: UN Sustainable Developments Goals (2015).

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1.1. Market drivers
UN Sustainable Development Goals (SDGs)

§ While ESG is a broader concept that refers to the following categories: environmental, social and SDG-Reporting circle for companies
governance, the SDGs are more concrete goals developed by the UN, which could be assigned to
these three broad categories.
§ UN SDGs are universally known and can therefore act as common reference points. Under these
17 goals, 169 targets are specified.
§ Although the conception of the goals is mainly attributed to economies, companies are
increasingly referring to these goals and outline their contribution towards the achievement of
these goals.
§ In light of global risks and challenges, corporations need to consider and incorporate the double
materiality of these factors.
§ Regarding increased disclosure regulations by the EU for financial corporations, i.e., SFDR (Module
2), sustainability risks and impact assessments must be disclosed.
§ Current developments at an EU-level highlight the increased focus on the financial sector and its
integration of sustainability aspects.
§ Example: The website SDG Investments offers information and a possibility to compare
sustainable funds, although only German funds are covered. Source: GRI & UN Global Compact (2018).

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Investor initiatives (1/3) – Motives

Main motives for investors joining initiatives in sustainability:

§ Active commitment
§ Raising public awareness
§ Competitive advantage
§ Gathering of Information and knowledge
§ Prevent regulation

Prominent investor initiatives:

§ UN Principles for Responsible Investment
§ Carbon Disclosure Project
§ International Corporate Governance Network (ICGN)
§ Climate Action 100+ (CA100+)
§ Climate Bonds Initiative
§ UNEP FI

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Investor initiatives (2/3) – United Nations Principles for Responsible Investment (UN PRI)

§ A group of large global, institutional investors launched the UNPRI under the
patronage of the United Nations
§ A voluntary investor initiative with a clear focus on the promotion of
sustainable and responsible investing
§ Requires:
§ Commitment to the six principles
§ Required mandatory annual reporting by signatories

Source: UNPRI (w. d.).

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Investor initiatives (3/3) – UN PRI signatories

The number of PRI signatories has grown rapidly since it began in 2006, reaching more than 5,300 investors worldwide by June 2023.

PRI signatory growth in 2006-2021 Investors worldwide that have signed the PRI as of 30 June 2023

Source: UN PRI, Quarterly signatory update (2023).

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Data availability – Information flow
Raw data

Edited, normalized data

Additional information on companies, esp. controversies

NGO/Media
Sustainability report as additional information / for verification

Raw data, edited data and ratings

Sustainability reports

Investment Investment
Intermediaries Investors
Broker/ Analysts recommendation management
Asset managers
Company (e.g., rating agencies, data (e.g. Pension funds)
providers, rankings or
funds)

Source: DVFA, PwC, University of Hamburg (2018).

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Data availability – Carbon data & ratings with the CDP (1/2)

§ The Carbon Disclosure Project (CDP) requests information on the Geographic spread of disclosing companies in CDP’s sample
risks and opportunities of climate from the world’s largest
companies on behalf of more than 746 institutional investor
signatories with combined assets of more than US$ 136 trillion.
§ In addition, 340+ of the world’s largest organizations with over
US$6.4 trillion in purchasing power request information through
CDP on climate change, deforestation, and water security.
§ CDP provides information to its institutional investor signatories, as
well as distributing it throughout the global marketplace to
increase transparency around climate-related investment risk.
§ CDP information is utilized in investment research, products,
indices and ratings from i.e., Bloomberg, STOXX, Trucost,
FTSE/Russell, MSCI ESG, and ISS ESG. Climetrics uses CDP data for
Each dot represents one company, the size of the dot represents the size of
climate impact rating for investment funds.
the company’s emissions.

Source: CDP, The business benefits of third-party verification of environmental data (2023).

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Data availability – Growth of disclosing firms to the CDP (2/2)

§ The 18,700+ companies responding to CDP

represent more than 50% of global market cap.
§ Additionally, 1110+ cities, states and
regions measure and disclose
their environmental information through CDP.

Source: CDP (2023).

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Data availability – Rating agencies in the information flow

1. Data generation
Information from NGOs • Public data
• Interviews
• Controversies (NGOs) Ratings and rating reports
Interviews 2. Normalization of data
(incl. phone calls, emails Rating agencies
and questionnaires) 3. Assessment of data Normalized raw data

Company 4. Rating
• Adjustment: annual
Sustainability reports
Website/internet • Sector specific
Annual reports environmental indicators
partly based on standards,
such as GRI

Source: DVFA, PwC, University of Hamburg (2018).

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Data availability – ESG research and data providers

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Data availability – Example of ESG Ratings Environment Social Governance
(56) (58) (34)

§ All these research and rating providers evaluate a set of indicators that Operations (26) Employees (15) Business ethics (16)

reflect the management quality and the performance of a company with Suppliers
respect to ESG topics Supply chains (12)
(10)
Governance (14)

§ These indicators are weighted according to materiality (financial and/or Products (18)
Clients
(14)
Public policy (4)

non-financial) considerations to produce an overall rating

Society,
§ Usually, the set of indicators is divided into a sub-set of indicators common Community and
Philanthropy (19)

to all industries and another sub-set that is specific to an industry

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Data availability – Integrated ESG data by financial data providers (1/2)
Example of Volkswagen AG Equity

Source: Bloomberg (2023).

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Data availability – Integrated ESG data by financial data providers (2/2)

Source: Refinitiv (2023).

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Data availability – Example 1: Sustainalytics

§ The Sustainalytics research focuses on ESG risks and takes into

account the industry classification:
The Methodology of ESG Risk Ratings at Sustainalytics
1. The first step is the identification of a company’s
exposure to material ESG issues initially determined at
the subindustry level
2. The second step is to examine the shares of manageable
and unmanageable risks to see how well the company is
mitigating its exposure
3. Next, a company’s performance is evaluated based on its
policies, programs, practices, and quantitative measures.
Controversies have a discounting effect on the
management score as the management gap
4. Finally, a company’s ESG Risk Rating is calculated by
adding the amount of unmanaged risk for each ESG issue
§ Coverage of 12,000+ companies, that are placed in 42 industries
and 138 subindustries (or peer groups).
Source: Sustainalytics (2023).

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Data availability – Example 2: RepRisk

§ RepRisk as a specialised provider of reputational risk data

§ Using the combination of AI and machine learning with
human intelligence to systematically evaluate public
information and reputational risks in the ESG area
§ Current monitoring of news flow with extensive coverage
§ Establish potential implications for price movements
§ Example benchmarking report:

Source: RepRisk (2023)

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Data availability – Example 3: S&P Global ESG Scores Example of criteria weights for different industries
§ S&P Global ESG Scores measure companies’ exposure to and
performance on key ESG topics, the quality and completeness of public
disclosures, and awareness of emerging ESG issues.
§ The criteria weights of ESG indicators are based on S&P Global Corporate
Sustainability Assessment (CSA), where 10,000+ publicly listed companies
are invited to engage through 61 industry-specific questionnaires.
§ With a scale from 0 to 100, where 100 is the maximum, the points are
aggregated from the data points level all the way up to the final S&P
Global ESG Score.

Source: S&P Global ESG Scores (2022)

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Data availability – Example 4: Sample Report from Morningstar

Source: Morningstar (2023)

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Data availability – Summary

§ ESG data have become increasingly important, as besides regulator interventions, investors become more aware and demanding in
terms of sustainability.
§ Here, several data providers have established and additionally have formed alliances in terms of use of ESG data:
§ Various (partial) acquisitions (MSCI à GMI, Innovest à KLD; S&P à Robeco SAM Research, Truecost; Morningstarà Sustainalytics
à Solaron; Deutsche Börse à ISS à oekom, Southpole; Moody’s à Vigeo/Eiris; 427, Factset à TrueValue Labs, LSE à Refinitiv …)
§ Refinitiv (Thomson Reuters) uses i.e., SASB; Bloomberg includes companies’ DJSI percentiles and Sustainalytics’, ESG Book,
IdealRatings, ISS, CDP, BGEI, Equileap, ATMI
§ Some rating agencies use SDGs as a framework

§ The EU regulations, especially the Taxonomy, provide a joint reference point and will enhance comparability.
§ For financial companies, sustainability data is important not only to provide services to more sustainable-oriented investors, but also as
EU regulations are incorporating all market participants in transforming the European economy.

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Barriers to ESG development and integration

§ Speed of ESG integration is low (PRI 2017, EU Commission 2018), despite comprehensive and high-level commitment of investors and policy makers.
§ Challenges to integrate ESG factors endanger reaching societal goals à What are the obstacles? How can they be addressed?
§ Identified obstacles from company perspective:
§ challenge of measuring ESG performance, concerns about underperformance, lack of ESG data, costs associated with ESG integration, personal
beliefs of the senior leadership or investment committee, regulations / interpretation of fiduciary duty (Eccles et al. 2017);
§ challenge of balancing the investment needs for growth with ESG goals, regulatory complexity (PwC 2021).
§ Identified obstacles from investors and data users' perspective:
§ Lack of comparability across firms, lack of standards in reporting, costs of gathering and analysing ESG information, disclosed ESG information too
general, too inconsistent, too infrequent, reliability of data, materiality of data, no client focus, incomparable results across different assurances
(Amel-Zadeh & Serafeim 2018; Jónsdóttir et al. 2022).
§ Perceived unreliability of ESG data due to the possibility of falsified ESG reporting, greenwashing, impression management (Cho et al., 2015; Callery &
Perkins 2021; Jónsdóttir et al. 2022).
§ Frequent mentioned investor impediments in surveys: perceived lack of business case, insufficient ESG data, no clear standards and definitions,
behavioural biases, lack of investor knowledge, unclear regulation, unclear fiduciary duties, challenges to integrate in valuation/models, challenges to
price externalities, missing management / board support, organizational setup not ready (Friede 2019).
§ The absence of financial incentives and policy intervention, insights from data not yet utilized (Busch et al. 2022).
§ Potential solutions: Transparency (improving disclosure), standardization (taxonomy, benchmarks), labelling (classification systems, green labels), clarifying
investor duties, supervision (EU HLEG 2018); policy intervention to internalize the effects for investors (Busch et al. 2022).
Source: EU High Level Expert Group (2018); Amel-Zadeh, Serafeim (2018); Eccles et al. (2017), Friede (2019), Busch et al. (2022).

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1.2. Empirical evidence about ESG and financial performance

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1.2. Empirical evidence about ESG and financial performance
Perception on ESG and performance: from lousy to neutral, to euphoria and back to normal

100% ESG is viewed as having a positive impact on return

negative view on ESG and financial performance
% of survey respondents with a positive or

80%

60%

40%

20%

0%

-20%

-40%

-60%

-80%
ESG is viewed as having a negative impact on return
-100%
ZEW (20 07) Feri Euro Ban kIn vest Maa stri cht Erste Bank Ri edl & Wins & Gall up/Well s Eccle s & RBC GAM RBC GAM RBC GAM DVFA (201 9) RI/UBS Bafin (2 019 ) MIRA (201 9) McKin sey RBC GAM MIRA (202 1) RBC GAM RBC GAM
Ra ti ng (20 09) (20 09) Un iversi ty (20 11) Smee ts Zwerg el Fargo (2 017 ) Kastrap eli (20 17) (20 18) (20 19) (20 19) (20 20) (20 20) (20 21) (20 22)
(20 11) (20 15) (20 16) (20 17)
Investor samples: ZEW (2007): German institutional investors; Feri Euro Rating (2009): German institutional investors; Bankinvest (2009): institutional investors from Germany, Austria, Switzerland; Maastricht University (2011): German retail clients; Erste Bank (2011):
Austrian retail clients; Riedl & Smeets (2015): Mutual fund investor in the Netherlands; Wins and Zwergel (2016): German retail investors; Gallup / Wells Fargo (2017): U.S. private investors; Eccles & Kastrapeli (2017): global institutional investors; RBC Global AM
(2017/2018): global institutional investors, RI / UBS (2019): global institutional investors, DVFA (2019): German institutional investors, Bafin (2019): German private investors, MIRA (2019, 2021): global institutional investors in Alternatives, McKinsey (2020): global company
executives and institutional investors , RBC GAM (2020-2022, global institutional investors)

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1.2. Empirical evidence about ESG and financial performance
Practical evidence (1/3)
§ ESG index statistics suggest that ESG-integration leads long-term to (at least) comparable
financial returns versus the ESG-unconstrained indices - but this varies over time, index, and
region. E.g., 2022 was a difficult year for most ESG / SRI indices.
§ Often index implementation rules may overlay ESG signals due to construction constraints.
This index performance should therefore carefully be checked for implementation biases
beyond the ESG quality signal.
§ However, companies with high ESG ratings are less vulnerable to systematic market risks and
have lower earnings volatility.
MSCI Worls SRI
vs. MSCI World
MSCI USA ESG
vs. MSCI USA

Source: MSCI (July 2023), S&P Global (September 2023). Sources: BofA Merrill Lynch US Equity & Quant Strategy (2018).

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1.2. Empirical evidence about ESG and financial performance
Practical evidence (2/3)

§ Concept of sin stocks and exclusion strategies lead to selective

inclusion of assets. The table shows the percentage of respective
MSCI World style index removed when applying typical screens.

Source: Schroders (2017).

§ The reduced diversification gives rise to questions on the implications for performance.
Conclusions of academic research
§ “…the sin stock premium and the price of sin aversion could be artifacts of an ivory tower research design and are not necessarily
applicable to the real world.” (Adamsson & Hoepner, 2015)
§ After controlling for exposures of the new Fama and French 2015 quality factors, profitability and investment, “we find no evidence of the
existence of a premium that pertains specifically to sin stocks, such as a reward for bearing the reputation risk involved with these
stocks.” (Blitz & Fabozzi, 2017)
§ “…the exclusion of the companies generally does not harm funds’ performance. We interpret these findings as indicative that, with
exclusionary screening, … , asset owners can meet the ethical objectives of their beneficiaries without compromising financial returns.
(Hoepner & Schopohl, 2018)

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1.2. Empirical evidence about ESG and financial performance
Practical evidence (3/3)
2022

§ Morningstar regularly analyses US- and European-domiciled ESG

funds across different asset classes. 2022 was a difficult year, but
mid to long-term quartile ranking against the funds in their peer
groups look decent.
§ The share of ESG mutual fund assets is larger in Europe, but with
room for growth in US and ROW. ESG fund flows relative and
absolute continue to outperform (also in 2022).
European-domiciled ESG Fund and Conventional Fund Flows [absolute, relative
(rhs)]

Source: Morningstar 2023 Source: Morningstar 2023

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1.2. Empirical evidence about ESG and financial performance
Does the longer-term empirical evidence support the outlined anecdotal evidence?

Number of empirical ESG-CFP studies over time From primary studies to Vote-Count Studies / Meta-Analyses and Second-order Meta-Analysis

3.000
Second-order
Meta-Analysis
Cumulative number of studies

2.500

2.000

Vote-Count Vote-Count Meta Meta

… …
1.500 Study 1 Study 35 Analysis 1 Analysis 25

1.000
+/0/- r/p/σ
500

0 P1 ... Pn
… P2 P3 ... Pn P1 P3 ... Pn
… P4 P5 ... Pn

1970 1980 1990 2000 2010

Source: Busch, Friede, Lewis & Bassen (2018).

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1.2. Empirical evidence about ESG and financial performance
Main findings of the 2015 ESG Meta Study on ESG and performance (1/3)

§ The business case for ESG investing: Roughly 90% of 2200 studies 62,6%
found nonnegative ESG-CFP (Corporate Financial Performance)
relationship, with the majority of studies reporting positive findings.
§ Disproportionate positive relations of ESG factors in all asset classes 47,9%

and specifically fixed income and real estate

§ From a regional perspective, ESG is especially meaningful in North
America and Emerging Markets
§ In terms of the individual E, S and G sub-categories, there did not
appear to be a dominating single factor 0,146 0,150

§ Highlights the difference between portfolio vs. non-portfolio studies 6,9% 8,0%
that may bias the perception of investors
§ Correlation between ESG and CFP in various papers remained on share of positive findings share of negative findings weighted correlation level r
average relatively constant since the mid-1990s in studies

vote-count studies meta-analyses

Source: Friede et al. (2015)

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1.2. Empirical evidence about ESG and financial performance
Main findings of the 2018 ESG Meta Study on ESG and performance (2/3)
0,40
§ ESG-CFP relation is significantly positive, robust and bilateral - across #! / "!!"

various research designs, the E and S sub-groups, and sensitivity checks 0,35

§ Particularly strong ESG-CFP for perceptual and operational CFP, 0,30

highlighting that ESG, affects operational metrics such as energy
efficiency and employee turnover & motivation, and therefore financial 0,25

performance 0,20

§ Corporate reputation (as the most overarching ESG outcome measure), 0,15
followed by philanthropy, which turns out to be highly correlated to CFP
0,10
§ ESG disclosure displays the weakest correlation to CFP à limited
standardization of ESG disclosure practices may encourage companies to 0,05

provide beneficial rather than unbiased ESG information (investors see

0,00
through it) CSP <--> CSP <--> CSP <--> CSP <--> CSP <--> CSP <--> CSP <-->
Perceptual Operational Accounting Growth CFP Market CFP Risk CFP Mutual Funds
§ ESG-CFP relation most likely not distorted by publication biases, CFP CFP CFP CFP

methodologically weaker studies or analyses published in social issues- Second-order bare bones Second-order final summary effect,
oriented journals summary effect, corrected for corrected for first-order sampling error and
first-order sampling error artifacts, and second-order sampling error

Source: Busch & Friede (2018).

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1.2. Empirical evidence about ESG and financial performance
Main findings of the 2018 ESG Meta Study on ESG and performance (3/3)

§ Decade-long academic research finds, at least, a non-negative ESG-CFP relation, while many studies suggest that good ESG
performance can lead to better CFP through various transmission channels
§ 90% of all studies find a non-negative ESG-CFP relation, of which more than 50% of overall studies even exhibit a significant positive
relation; strong relations exist especially in the North America and Emerging Markets, as well as for Bonds and Green Real Estate;
results of portfolio-based ESG-CFP studies are typically somewhat distorted through various overlapping effects; limiting learning
effects of capital markets so far, as correlation patterns have been stable since the mid 1990s
§ Particularly strong ESG-CFP for operational CFP, highlighting that ESG affects operational metrics (e. g. energy efficiency or employee
engagement) and via this financial performance; Corporate reputation (as the most overarching ESG outcome measure) turns out to be
highly correlated to CFP
§ ESG investing as a way to fulfil fiduciary duties, while better aligning investors’ interests with the broader objectives of society:
Embracing a win-win mindset among all stakeholders (instead of the win-lose logic of shareholder theory) can significantly reorient the
opportunity set of investors and increase planetary welfare overall.

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Main findings of the 2023 ESG Meta Study on ESG and financial performance

§ Examining 1,000+ peer-reviewed papers and 27 meta-analysis (based

on 1400 studies) published between 2015-2020 concerned with the
business case for sustainability and the results of ESG investing
§ Positive relationship between ESG and financial performance for 60%
of corporate studies and for 38% of investor studies
§ The bulk of investor studies concluded that there was either no
statistical difference compared to a conventional benchmark or that
results were positive and negative (i.e., mixed).
§ Comparison to other meta-analyses (n = 15) published since 2015
§ Corporate meta-analyses (n=13): positive correlation between
ESG and corporate financial performance.
§ Investor meta-analyses (n=2): ESG investing returns
indistinguishable from conventional investing returns.

Source: Atz et al. (2023).

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Further information on the ESG and CFP meta studies

Friede, Busch & Bassen (2015)

Academic Paper: ESG and financial performance: aggregated evidence from more than 2000 empirical studies: https://www.tandfonline.com/doi/full/10.1080/20430795.2015.1118917

Friede, Lewis, Busch & Bassen (2015)

DWS Global Research Institute Whitepaper: ESG and corporate financial performance: Mapping the global landscape: https://download.dws.com/download?elib-
assetguid=2c2023f453ef4284be4430003b0fbeee

Busch & Friede (2018)

Academic Paper: The Robustness of the Corporate Social and Financial Performance Relation: A Second-Order Meta-Analysis: https://onlinelibrary.wiley.com/doi/full/10.1002/csr.1480

Busch, Friede, Lewis & Bassen (2018)

DWS Global Research Institute Whitepaper: Digging deeper into the ESG – Corporate Financial Performance Relationship: https://download.dws.com/download?elib-
assetguid=714aed4c2e83471787d1ca0f1b559006&wt_eid=2151963337700789577&wt_t=1538929014707

Atz, Van Holt, Liu, & Bruno (2023)

Academic Paper: Does sustainability generate better financial performance? review, meta-analysis, and propositions:
https://www.tandfonline.com/doi/abs/10.1080/20430795.2022.2106934

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Takeaways

§ Several drivers explain the growth of the market.

§ Demand for sustainability is increasing, e. g., in terms of investment opportunities.
§ The whole value chain is influenced by increasing sustainability concerns.
§ Clear empirical evidence for the business, social, and environmental rationale of ESG investing.

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