Institutional money managers and regulators, particularly in Europe, have profoundly changed the landscape for ESG (environmental, social, governance) focused investors in recent years.

They’ve done this, namely by demanding that companies do a better job of providing ESG-related metrics along with their balance sheets, to help investors better understand all of the risks associated with the securities they’re invested in.

“The fact of the matter is that the capital markets community and those that work within it have embraced this,” says Michael Jantzi, CEO of ESG ratings company, Sustainalytics (now owned by Morningstar Inc.). “It is largely based on growth in the institutional side of the market. It has been driven by the belief, by portfolio managers and chief investment officers, that adding an ESG or sustainable lens to their traditional investment processes helps them identify risks and opportunities they might otherwise miss.”

Europe, he adds, has the largest pool of institutional and retail ESG assets in the world. This is expected to grow even larger in the coming years as the European Union continues to examine ways to integrate sustainability considerations and financial policy.

No longer optional

“ESG is no longer optional for companies. There is a seismic shift happening in the investment industry which is cascading down from regulators, particularly in Europe,” says Morningstar’s head of research, Haywood Kelly. “If a company wants to maximize its access to capital, it is going to have to prove it can manage its ESG risk.” He adds that the level of scrutiny that corporate management teams are subjected to has risen substantially.

Economic growth and societal well-being

Most notably, Morningstar experts say the European Commission’s action plan on financing sustainable growth, in particular, is a massive shift in the way regulators have thought about the need to regulate capital markets.

“By changing the investment culture, the EU hopes that they will put a stronger onus on corporate CEOs to think much more about the sustainability of their operations.” - Aron Szapiro

Where they traditionally focused on protecting investors from fraud and from substandard and conflicting advice while working to ensure markets are fair, transparent and free from liquidity or systemic failures, Aron Szapiro, Morningstar director of policy research says the European Union (EU) plans to harness financial markets as part of a broader policy-making agenda which promotes sustainability as core to economic growth and societal well-being.

“They have a goal of reorienting capital flows towards a more sustainable economy, what they call mainstreaming sustainability and risk management,” he says. “The EU wants more investors to consider sustainability factors as they make investment decisions. They want them to put their money in sustainable investment products. By changing the investment culture, the EU hopes that they will put a stronger onus on corporate CEOs to think much more about the sustainability of their operations.”

Of increasing interest

He adds that asset managers in Europe also need to invest in companies that disclose ESG metrics. “They have to do that because they have to demonstrate the extent to which they have a sustainable portfolio. U.S. companies will need to report those metrics to be attractive investments. The bottom line is ESG investing, as it goes mainstream, is increasingly of interest to regulators.”

Jantzi echoes the sentiment, pointing out that regulation reflects trends in the industry. “Generally, when you look globally, you are seeing a trend towards regulation,” he adds. “I expect that ESG is going to remain on the agenda in a serious way for a long time to come.”