The case for ESG investing: Five value-adds of ESG
The case for ESG investing: Five value-adds of ESG
Until the mid-2010s, few investors paid attention to ESG (Environmental, Social, Governance) issues such as a company's carbon footprint, labor policies, and board composition. But in 2021, investors are favoring ESG over non-ESG funds to help assess a new set of financial risks and harness capital market opportunities, due in part to the COVID-19 epidemic and green recovery in the United States.
Investors are using ESG in a variety of ways, such as screening out poor performers and risky investments, identifying high performers, and urging companies to embrace sustainable, responsible business practices. According to Bloomberg, global ESG assets are on track to exceed $53 trillion by 2025, representing more than a third of the $140.5 trillion in projected total assets under management (AUM).
Regardless of the motivation, there’s mounting evidence that ESG investing can provide a clear win for both investors and companies.
What defines & differentiates ESG?
ESG investing focuses on three specific, foundational pillars that are crucial to today’s corporate management and investors alike. Environmental issues can include pollution, climate risk, exposure to extreme weather, carbon management, and the use of scarce resources. Social issues can include product safety, human rights, worker safety, customer data protection, and diversity and inclusion. Governance issues can include factors such as accounting standards compliance, succession planning, anti-competitive behavior, and a strong ESG management process.
Essentially, the goal of ESG investing is to maximize returns while prioritizing optimal ESG factors and outcomes.
ESG-focused funds screen for equities based on value and growth but also account for ESG factors such as corporate governance procedures, sustainability scores, disclosure policies, fossil fuel exposure, a religious adherence, and workplace diversity. A company must have a history of aligning its operations to support programs that benefit the environment, employees, local communities, and shareholders to be considered a good ESG investment. ESG ratings, such as MSCI and Sustainalytics, can be used to verify a company’s ESG activity.
ESG ratings are often used by institutional investors to set high standards and expectations of company behavior. Investors can support broad programs to conserve energy, reduce waste, improve working conditions, enforce ethical corporate practices, and much more by promoting ESG alignment and investing in firms with ESG commitments.
A decade of proof that ESG funds outperform
Sustainable investors, like all investors, are looking for a competitive financial return on their investments, and the research shows that aligning investments with ESG principles has tangible benefits.
Over the last decade, numerous studies have continued to demonstrate the effectiveness of ESG investing.
Mercer published a report in 2009 that reviewed 16 academic studies on socially responsible investment (SRI) and financial performance. Only three of the studies showed evidence of a negative association between ESG characteristics and financial success, whereas ten found evidence of a positive relationship.
The study importantly noted that “a variety of factors, such as manager skill, investment style and time period, is integral to how ESG factors translate into investment performance; therefore, it is not a ‘given’ that taking ESG factors into account will have a uniform impact on portfolio performance, and we expect significant variation across industries.”
In 2013, DB Climate Change Advisors published a meta-analysis of over 100 academic studies. DBCCA found that incorporating ESG data into investment analysis was “correlated with superior risk-adjusted returns at a securities level”, whereas socially responsible investing approaches that only used exclusionary screens had little upside.
In 2015, Oxford University and Arabesque Partners conducted a meta-study that categorized over 200 sources, including academic studies, industry reports, media articles, and novels. According to their results, "88% of reviewed sources find that companies with robust sustainability practices demonstrate better operational performance, which ultimately translates into cash flows."
In 2016, Barclays Research created broadly diversified portfolios that tracked the Bloomberg Barclays US Investment-Grade Corporate Bond Index to investigate the link between ESG integration and corporate bond performance. They matched the index's key characteristics while giving different ESG issues a favorable or negative skew. Barclays Research found that “...a positive ESG tilt resulted in a small but steady performance advantage...” and did not find evidence of negative performance.
In 2019, the Morgan Stanley Institute for Sustainable Investing published Sustainable Reality: Analyzing Risk and Returns of Sustainable Funds. The Institute used total returns and downside deviation to compare the return and risk performance of ESG-focused mutual and exchange-traded funds (ETFs) versus traditional counterparts from 2004 to 2018. It found that that there is “no financial trade-off in the returns of sustainable funds compared to traditional funds, and they demonstrate lower downside risk.” Moreover, during a period of extreme volatility, the study found “strong statistical evidence that sustainable funds are more stable.”
Now, in 2021, the Institute released a study that found funds focused on “ESG factors, across both stocks and bonds, weathered the year [of extreme volatility and recession] better than non-ESG portfolios.” Sustainable equity funds outperformed non-ESG peer funds by a median total return of 4.3% in 2020, according to the study, which looked at over 3,000 U.S. mutual funds and ETFs.
Five ways ESG adds value
Incorporating ESG into your portfolio or business can provide an abundance of value to your company. Here are just some of the benefits.
#1: Risk mitigation
Many major investment funds with ESG criteria outperformed the broader market in the first 12 months of the COVID-19 outbreak. In fact, S&P Global Market Intelligence examined 26 ESG exchange-traded funds and mutual funds with AUM of more than $250 million. They discovered that from the time World Health Organization declared COVID-19 a pandemic on March 5th, 2020, to March 5th, 2021, 19 of those funds outperformed the S&P 500.
Furthermore, recent research has revealed that competitive ESG strategies help corporations lower their risk of negative government action, allowing them to attain greater strategic independence. This contribution is undeniably important, especially when one-third of corporate profits are in danger from government action.
#2: Sales growth
Strong ESG policies have been found to significantly contribute to improved corporate investment, revenue, and sales growth. Individual and institutional investors are increasingly committing resources to companies that emphasize sustainable governance and operational processes from an investment standpoint.
Consumer preferences have been shown to be highly influenced by ESG strategies. According to a study conducted by global management consulting firm Mckinsey and Co., 70% of consumers surveyed on their purchase behaviors across a variety of industries, including electronics, building, automotive, and packaging, said they would be willing to pay an extra 5% for a responsibly produced products that met the same performance standards as a non-green alternative.
#3: Cost reduction & valuation improvement
Businesses that apply good ESG practices can generate long-term efficiencies to offset rising operating costs. Management can also benefit from an ESG focus by lowering capital expenses and increasing the firm's valuation. Because more investors are looking to put money into companies with better ESG performance, ESG-focused companies will have access to greater pools of capital. As more global regulators and governments enforce ESG disclosures, positive action and transparency on ESG issues can also help companies safeguard their valuations.
#4: Talent retention
Having a robust ESG strategy in place might provide your organization with a competitive advantage over competing businesses. According to a recent Mercer survey, top-performing employers had much higher ESG scores than their counterparts. Companies with robust ESG frameworks in place were found to have high employee satisfaction and attractiveness to talent.
#5: Creating long-term shareholder value
ESG adds value to all of its stakeholders, including the financial return that shareholders seek by providing specific, quantifiable indicators of a company's sustainability and corporate social performance. Shareholders can better evaluate the impact of social responsibility efforts by looking at quantifiable results like the company's financial and operational performance using ESG data and metrics. ESG disclosures and endeavors can also have an impact on a company's value and financial success. Finally, stronger ESG performance has been demonstrated to positively influence other operational and stakeholder-related criteria such as long-term growth and reputation.
Getting on board with ESG
BlackRock CEO Larry Fink drove home the importance of ESG in his 2021 letter to CEOs. He stated, "The creation of sustainable index investments has enabled a massive acceleration of capital towards companies better prepared to address climate risk. As more and more investors choose to tilt their investments towards sustainability-focused companies, the tectonic shift we are seeing will accelerate further. And because this will have such a dramatic impact on how capital is allocated, every management team and board will need to consider how this will impact their company's stock."
Not sure where to begin with ESG? Companies can get a jump start by utilizing ESG solutions designed to help portfolios develop and implement ESG initiatives that provide an imperative to attract and retain capital, accelerate sustainable and responsible growth, and mitigate enterprise risk.
ESG materiality assessments
With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.
An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.