Ground zero for environmental, social and governance (ESG) standards when it comes to investment is San Francisco, California at the headquarters of the Sustainability Accounting Standards Board (SASB) which has set itself the task of setting industry standards for sustainability disclosure.

SASB has to date set ESG standards for 79 industries and sectors, standards which investors are increasingly taking into account when it comes to their asset allocation decisions.

Janine Guillot is director of capital markets policy and outreach at SASB and she says the interest in ESG factors when it comes to investment decisions has increased dramatically in the past five or 10 years.

"It might be central to investing in the future," she says and certainly the names of the firms that have signed up to SASB's Investor Advisory Group points to the part being played in this by the major US-based ETF providers including such leading lights as BlackRock, State Street and Vanguard.

The group's approach is to encourage companies to disclose material and "decision-useful" ESG information to investors. The group's members have signed up to the proposition that defined standards will improve the quality and comparability of sustainability-related information and that SASBs industry-specific approach will succeed in achieving the overall aims.

Injecting ESG in Europe

Similarly, in Europe both index providers and ETF groups are searching to achieve a set of standards in order to satisfy what would appear to be increasing investor demand for ESG products.

German-based index provider Solactive recently teamed up with asset manager Candriam to launch a new family of sustainable factors indices which will provide the underlying indices for five new ETFs issued by Candriam.

Solactive's head of research Timo Pfeiffer points out that there are multiple reasons why ESG investing is coming to the fore. "There is not one main driver behind this trend but a combination of factors," he says. "Investors have started integrating non-financial criteria in their evaluations due to rising expectations on corporate citizenship among consumers and the investment community."

Ossiam recently announced it had added an ESG component to its US Minimum Variance ETF and chief executive Bruno Poulin said such moves were indicative of how the rate of adoption of ESG screening had accelerated. He pointed to the Paris Agreement from 2015 as one of the strongest signals for where we are heading.

"That has had an impact, not only on national policies for energy and environment, but also on the greater economy, including financial services," he says. "In parallel, there is more research which shows that adding ESG criteria to investment strategies does not automatically harm performance."

That research is coming from the major index providers. A recent note from Laura Nishikawa, head of fixed income in ESG research at MSCI, pointed out that institutional investors face a challenge in that selecting only ESG leaders would slash the number of available stocks by half and would also foreclose on the opportunities for dialogue and engagement.

In seeking answers to these quandaries, Nishikawa said that one route is to increase the weightings of companies with strong ESG profiles - including those that had improved this metric in the past 12 months - while minimising exclusions to a "core group of objectionable stocks", mainly around controversial weapons and egregious environmental despoilers.

"This approach can enable investment in a broad, diversified stock universe while allowing institutional investors to engage poor ESG performers," she says.

Yet despite the interest in ESG as a concept, the standards for investing along these lines are by no means set and are, indeed, still at a formative stage.

"One of the main difficulties in compiling SRI indices is the fact that there is not a standardised way of reporting and tracking SRI performance," says Pfeiffer from Solactive.

The data providers all rely of differing methods to evaluate companies and further there are multiple ways that ESG criteria can be integrated into the indices. As indicated by MSCI, the selection of companies can be made by excluding certain sectors, by choosing the best performers or by weighting an index according to the ESG profiles.

"Therefore, different methodologies can lead to very different performance and results," says Pfeiffer.

A 'free lunch'

The key to the evolution of ESG will inevitably be performance. Poulin notes that in the case of the US ETF fund, Ossiam's own recent study of the market suggested that by choosing ESG there was a "free lunch" to be enjoyed. "The caveat is that there is a relatively short history of live ESG data available, similar to emerging markets," he adds.

Indeed, when MSCI back-tested the performance of its ESG Universe Index it showed that it narrowly outperformed the parent index - the MSCI ACWI - by an average of 10 basis points over the seven-and-a-half-year simulation period.

"Thus, targeting companies with stronger ESG profiles than their peers produced a result with similar risk-return characteristics as the parent index," says Nishikawa. "Such approaches could help large asset owners seeking a more systematic way to integrate ESG considerations into their investment strategy."

Pfeiffer points out that one of the biggest misconceptions with regard to ESG factors is that it is achieved at the expense of performance.

"ESG is certainly challenging the performance of companies operating in certain sectors - if seen as a cost - but at the same time it creates opportunities in the long-run for those that are more effectively adapting their businesses to ESG standards," he says.

We can look to recent history as a guide here. Poulin at Ossiam points to the omissions scandal at Volkswagen for an example of how not taking into account ESG criteria can have a severe impact on investment performance. "What we are witnessing is a new form of economy that is more adapted to the challenges that could arise from mismanagement of climatic, social and ethical issues," he says.

"The evolving regulatory environment is pushing companies to adapt their business models to more environmentally-friendly and socially-responsible practices," adds Pfeiffer. "Those that fail to get in line with changing expectations or new regulations might see their reputation and performance affected and might face potential fines."