ESG Investing – doing good, without compromising on financial performance

Among the various misconceptions associated with environmental, social and governance (ESG) investing, perhaps the most persistent is the belief that prioritising ESG factors correlates with financial underperformance. But with the costs and benefits of global crisis mitigation becoming clearer – and the potential value and resilience of ESG stocks increasing in evidence – the reality may be quite different.

In terms of global market share alone, ESG investing has increased significantly in recent years. In 2018, the Global Sustainable Investment Alliance (GSIA) reported that sustainable investment assets across the five major markets stood at $30.7 trillion – up 34% from the GSIA’s findings in 2016 and ten times the total recorded in 2004. The scale of investment flows and mounting evidence of the costs of unsustainable corporate practices and business models suggests that ESG investing is more than just a “feel-good” adjunct to more traditional investing strategies.

At both a corporate and societal level, ESG can be inextricably linked to economic, operational and reputational wellbeing. The presence of a coherent sustainability strategy is increasingly key to securing future growth, profitability and market share and is already a significant factor in attracting investment capital, especially among an emerging caucus of younger investors. 

Environmental crises like climate change, resource scarcity and biodiversity loss are projected to cost global economies hundreds of trillions of dollars in lost benefits and revenue opportunities by 2100 if mitigation efforts aren’t stepped up significantly. The UN estimates that $90 trillion of investment is required over the next 15 years to meet global climate change targets and replace ageing and ineffective infrastructure. 

Without that investment, increasingly stringent regulatory responses to emissions from carbon-intensive industries are likely to affect energy costs and potentially lead to operational restrictions. With a more proactive approach, however, efforts to control chronic air pollution in China alone are projected to generate over $3 trillion worth of investment opportunities over the next decade. 

In the business world, companies with a poor consideration of ESG issues may experience lower levels of staff retention and productivity, increased costs of capital and limited scope to uncover and profit from new opportunities. Failure to respond to emerging environmental trends could prove costly: restrictions or bans on the use of diesel vehicles or single-use plastics, for example, may limit operational capacity. A strong ESG proposition is more likely to prove resilient during periods of market stress or increased industry scrutiny; a weak proposition potentially exposes companies to greater risks and more materially adverse events.

While ESG stocks may present a good long-term proposition for values-driven investors, strong financial returns are central to securing future retention and investment growth rates. An increase in the availability of performance data has enabled research institutions to analyse and track the historical financial performance of ESG investments against non-ESG benchmarks. In 2017, the Principles for Responsible Investment (PRI) along with Deutsche Asset & Wealth Management and the University of Hamburg conducted the largest aggregated study to date of independent ESG performance reviews and found that 62.6% of over 2,300 data sources revealed a positive correlation between ESG investing and financial performance. 

Market volatility during the ongoing coronavirus pandemic has also helped to demonstrate the comparative resilience of ESG investments against non-ESG benchmarks. Assessing the performance of highly rated ESG stocks from the beginning of the crisis to the peak of volatility in late March, HSBC calculated that they had outperformed global equities by around 7%. Likewise, Morningstar reported in April that 70% of sustainable equity funds had featured in the top half of their fund categories for returns in the first quarter of 2020. Of course, past performance is not necessarily a reliable indicator of future performance. However, ESG resilience was also observed through a general limiting of losses across markets (given such funds low exposure to the oil and gas sector) and signs of growing investor confidence that ESG investing potentially makes for a good recovery strategy.

The value of ESG is also being recognised as economies affected by the pandemic work to stimulate recovery. The consequences of such a unique event have magnified calls for economic recovery plans to prioritise social and environmental needs and ‘build back better’ to limit vulnerabilities and encourage widescale behavioural change. 

Assessing the fallout from the 2008 financial crisis, the Smith School of Enterprise and the Environment analysed the results of over 700 stimulus policies. They found that green stimulus programmes created more jobs, delivered higher short-term returns and generated greater long-term cost savings. Programmes that managed climate risk could also be enacted quickly and generated significant returns on investment. 

The evidence of resilience and strong performance in ESG investing suggests a course for future recovery that delivers more than just financial value.

Written By: Rathbone Greenbank Investments