The Cyprus Securities and Exchange Commission (CySEC) unveiled its comprehensive “Investor Guide to Sustainable Investing” on Monday, shedding light on the growing importance of sustainable investing and providing essential insights into this rapidly expanding investment landscape.
Understanding Sustainable Investing
Sustainable investing has witnessed a remarkable surge in recent years, gaining even more momentum in the wake of the global pandemic. Environmental, social, and governance (ESG) factors have emerged as pivotal drivers shaping investment decisions.
In response to this transformative shift, financial regulators worldwide are introducing new regulations designed to channel investments towards sustainable options, enhance transparency, and combat the issue of greenwashing.
Defining Sustainable Investing
At its core, sustainable investing, often referred to as ESG investing, centres on investments that prioritise environmental, social, and governance considerations. Such investments are made with a focus on their impact on the environment, societal well-being, and the broader economy.
These three factors serve as critical yardsticks for measuring the sustainability and ethical implications of an investment. This approach is also known as “socially responsible investing” or “impact investing.”
Socially responsible investors meticulously assess companies against ESG criteria when evaluating potential investments, while sustainable investing encompasses a more comprehensive commitment to responsible and ethical business practices.
Guarding Against Greenwashing
A pressing issue in the sustainable investing landscape is “greenwashing,” where organisations make sweeping claims about the sustainability of their investments without substantiating their claims or exaggerating the positive environmental effects.
Greenwashing tactics can mislead investors into believing that an investment has a more substantial environmental impact than it genuinely does.
To address this concern, regulators have ramped up efforts to combat greenwashing. In 2023, Europe will witness more stringent disclosure requirements for firms.
Additionally, the European Securities and Markets Authority (ESMA) is finalising its rules governing the use of ESG-related terms in fund names, further bolstering investor protection against misleading claims.
Examples of ESG Investing
The Investor Guide also highlights several areas within sustainable investing, providing investors with practical examples:
- Clean Energy: Includes companies engaged in renewable energy generation and related products and services.
- Energy Efficiency: Encompasses companies offering products and services that significantly enhance energy efficiency across various sectors.
- Water: Encompasses companies providing access to water, improving water efficiency, and contributing to sustainable water resource management.
- Health & Wellbeing: Includes companies involved in manufacturing medicines, equipment, and technologies addressing diseases, improving health and wellness, and increasing life expectancy.
- Sustainable Agriculture & Food: Encompasses companies participating in sustainable food systems, from agri-tech to sustainable food retail and packaging.
- Sustainable Forestry: Encompasses companies engaged in sustainable forestry practices and the use of sustainable forest products.
- Sustainable Transportation: Includes companies providing sustainable transportation products and services, spanning vehicles, technologies, equipment, and infrastructure.
- Circular Economy & Resource Efficiency: Encompasses companies promoting resource efficiency, recycling, and resource recovery in support of a circular economy.
- Sustainable Real Estate: Involves companies specializing in the development or management of sustainable buildings, focusing on energy efficiency, the use of sustainable materials, renewable energy, and eco-friendly design.
Comparing ESG Investments to Non-ESG Investments
The rationale for investing in companies and products that have a strong ESG impact stems from the belief that channelling capital into firms that champion positive trends for the betterment of humanity and engage in ethical and sustainable business practices can drive the widespread adoption of these policies. Over time, this can lead to lower capital costs for these companies, enhance investment returns, boost demand for their products and services, and promote ethical labour practices. Consequently, ESG investments are perceived to offer relatively strong investment performance.
In contrast, any investment that does not adhere to ESG principles falls under the category of non-ESG investments. Non-ESG investments typically do not incorporate sustainability and social responsibility considerations into their decision-making processes. These investments are often considered more traditional and may overlook their impact on the environment, society, and governance.
The bulk of sustainable investment funds worldwide are concentrated in funds domiciled in Europe, accounting for approximately three-quarters of all such funds and representing nearly a fifth of all European assets under management. In other markets, sustainable funds constitute a modest 2-3 per cent of total invested assets under management.
Although stocks representing key constituents of ESG funds experienced significant underperformance in 2021 and early 2022, the crisis in Ukraine has led to an improved sentiment towards ESG funds. Additionally, new government policies addressing energy security and trends related to clean energy and energy efficiency products have further boosted ESG funds. In preceding years, sustainable funds outperformed traditional funds, both relatively and in absolute terms, in both 2019 and 2020, contributing to the growing popularity of sustainable investments.
Over the longer term, sustainable funds, as an asset class, have marginally outperformed traditional funds across various longer-term 5-year performance measures. However, this performance gap significantly narrowed in the past year.
Exploring ESG vs. SRI Investing
Aside from ESG investing, there is another approach known as Socially Responsible Investing (SRI). SRI involves screening investments to select and exclude companies based on specific criteria. While financial returns remain important for SRI investors, they must strike a balance between profitability and their beliefs and principles. SRI investors typically exclude companies engaged in activities that contradict certain ethical values while focusing on those that make a positive societal impact. For instance, many SRI investors exclude companies involved in gambling, tobacco, weapons, and alcohol.
Key Themes in ESG Fund Management
CySEC’s Investor Guide also highlights the key themes ESG fund managers consider when constructing their portfolios:
- Climate Change & the Transition to Net Zero: ESG investing places a growing emphasis on evaluating a company’s climate commitments and the credibility of its targets for reducing carbon emissions. Companies are expected to provide verifiable action plans in line with scientific standards. Tax incentives and legislation encourage carbon reduction strategies, such as photovoltaic solar and wind energy, as they become more cost-competitive.
- Biodiversity and Natural Capital: Increased attention is directed toward biodiversity in investments. Enhanced transparency regarding nature-related impacts, risks, and opportunities, alongside the adoption of global biodiversity frameworks, has led to the creation of thematic funds exclusively focused on biodiversity and ecosystem restoration.
- Human Capital & Labour: The COVID-19 pandemic and subsequent inflationary environment have heightened investor attention to social issues, particularly labour practices and personnel management. Companies are increasingly publishing employee turnover data and the results of internal employee engagement surveys to enhance transparency and accountability in this area.
- Human Rights & Supply Chain Due Diligence: Regulations addressing corporate obligations and transparency concerning environmental and human rights risks have gained global prominence. In Europe, the EU Corporate Sustainability Due Diligence Directive imposes obligations on companies to identify potential environmental and human rights impacts in supply chains, particularly affecting the Consumer and Technology sectors.
- Board Effectiveness & Director Accountability for ESG: Company Annual General Meetings (AGMs) and director elections are increasingly viewed as indicators of corporate ESG governance practices. This is evident in the reduced support for director nominees in recent years. Proxy solicitations targeting governance committee chairs that fail to provide explicit disclosures regarding the board’s role in overseeing ESG issues have also increased.
- Executive Compensation: Remuneration committee proposals on director pay have historically received majority support, but this trend has evolved since the pandemic. Consultations with institutional investors regarding the inclusion of ESG metrics in executive compensation have gained traction in Europe, particularly concerning the inclusion of significant ESG considerations in long-term incentive schemes.
CySEC’s “Investor Guide to Sustainable Investing” underscores the regulatory commitment to promoting responsible investment practices and aligning Cyprus with global efforts to create a more sustainable and ethical investment environment.
