The Future of ESG Investing
Updated: Dec 9, 2020
As institutions and the general public alike become more aware and concerned about environmental conservation, human rights and corporate governance, ESG investing has emerged as a path for investors to back companies that share the same values as themselves. Over recent years, the domain has transformed from a peripheral consideration for companies and investors to a core factor in evaluating operational strategy and investment desirability. Yet its rise has also been met with its fair share of scepticism, sparking debate over the compatibility of ESG values with the inherently profit-driven financial market. This article explores what ESG investing entails, its applications to company strategy and investment decision-making, and the challenges it faces today.
What is ESG Investing
As covered briefly in our theme introduction, ESG, or Environmental, Social and Governance investing, is a method of investing that focuses on the internal qualities and practices of companies and how it engages with the society and natural environment around it. ESG investing is often oversimplified and seen to be equivalent to “green investing”, with a sole emphasis on the environmental dimension. In actuality, it goes much beyond that, also incorporating social considerations and management structures in its analysis.
Environmental factors refer to how a company treats the natural world. This can be gauged through analysing a company’s pollution emission, energy use, waste production, and how it engages and impacts its surrounding eco habitat.
Social factors refer to how companies treat the individuals and the societies that surround them. This involves a focus on the treatment of workers, such as fair labour practices, racial diversity, and gender equality. Social factors also extend to companies’ treatment of customers - how they approach privacy and data confidentiality, client experience as well as community engagement.
Governance factors refer to the corporate administration of companies. This covers corporate risk management, executive compensation, accountability of leaders, shareholder rights, workplace gender equality, as well as transparency in corporate practices.
Successes of ESG Investing
The actions of key institutional players in the field of investing speak strongly about the ongoing shift in emphasis towards ESG objectives as a factor in company evaluation. For instance, JP Morgan Alternative Asset Management has launched a new US$100m fund with ESG values at the heart of its investment strategy, while Lazard has launched an emerging markets fund with a keen focus on ESG attributes. Meanwhile, Asset Management giant Blackrock has unveiled three ESG-based ETFs in March this year. This is in line with the company’s broader emphasis on sustainability, with its co-founder and CEO Larry Fink stating that “sustainability and climate integrated portfolios can provide better risk-adjusted returns to investors”.
Interestingly, many have suggested that an increased focus on ESG investing has had the positive effect of influencing companies to channel focus towards improving their ESG standards. A study by scientific beta has identified that investors can effectively convince companies to increase their ESG efforts through increased engagement, which influences companies to cultivate better working environments. With ESG targets tied to investors’ investment mandates in certain instances, the threat of divestment further serves to spur companies to take relevant action.
Despite criticism that ESG values will take a back seat in favour of a “pure profit” approach in difficult investing environments, market data suggests that ESG companies have stayed strong despite the ongoing Covid-19 crisis – in 1Q2020, ESG equity indices have largely outperformed their broader parent indexes.
Fig 1: Performance of ESG-integrated index funds in 1Q2020
This offers the observation that the perception of the ESG dimension has significantly shifted from what was once a “luxury consideration” in good times to a core consideration in evaluating the sustainability and stability of companies, and that positive ESG performance holds a causal relationship with the operational and market performance of companies. For instance, based on research by the Carlyle Group, there is evidence suggesting that positive workforce management and management diversity are significant contributors to the superior operational performance of portfolio companies, and that an energy transition towards more sustainable options has been associated with positive valuation multiple adjustments.
Challenges facing ESG investing
Despite these successes, there are still challenges that could hinder further acceptance of ESG-centric strategies within the corporate world and investment community.
Firstly, companies’ ESG performance are often viewed in terms of broader company characteristics - size and industry, for instance - rather than their actual day-to-day operational behaviour. Many have identified that ESG metrics tend to favour companies and industries that have fewer employees such as Tech and Healthcare sectors – companies with fewer employees are naturally likely to have fewer social issues compared to their larger counterparts. Certain industries are also naturally more associated with ESG attributes than others. In evaluating ESG attributes, investors thus need to look beyond these broader metrics and consider whether the day-to-day decisions and culture of the company are in line with the ESG goals.
Fig 2: Negative correlation between ESG rating and company size
There also exists the broader issue that ESG performance is subjective, and so there is significant variation in what firms and companies consider to be ESG attributes. In the 2019 Credit Suisse Global Investment Returns Yearbook, it is identified that ESG rating providers FTSE, Sustainalytics and MSCI hold varied perspectives on what ESG entails. This had led to substantial differences in their ESG ratings of certain companies such as Facebook, JPMorgan Chase, and Johnson & Johnson. SEC chair Jay Claton has criticised ESG metrics as generally being ‘imprecise’, stating that the inclusion of too many factors clouds the proper judgment of companies.
Additionally, some have argued that ESG factors’ impacts on investment decisions have only been at a surface level. With reference to the United Nations’ Principles for Responsible Investment (PRI) initiative, a recent study has identified that only a limited subset of funds that have signed on to the PRI initiative has made visible ESG changes, with the rest using their PRI status simply as a method to attract capital.
However, disputed definitions and increased scepticism do not take away from the fact that many institutions have taken concrete and tangible efforts to increase efforts. For instance, HSBC has begun to provide mental health support to its employees, and have taken steps to ensure increased corporate transparency and greater gender equality in their governance structure.
Going forward, sustainability – both in environmental considerations and corporate decision-making – is poised to be ever more tied with the profitability of companies, the returns profile of investments, and the structural performance of funds. Regardless of where one stands in this matter, it is important to be acutely aware that a “pure profit” mindset is increasingly obsolete in today’s landscape, and to be well acquainted with what ESG entails and its implication for corporate and investment strategy. It is most compelling to see how the boundaries and interpretation of ESG evolve with the times, and how companies and investors adapt to and drive further innovations in this domain.