ESG investing is a broad investment class with many nuances. ESG investing can also be known as ethical investing, socially responsible investing. impact investing, or simply sustainable investing. Whatever the name, ESG investing could be neatly summarised as ‘Doing well by doing good’.
The term ‘ESG’ was first coined in a 2004 report called Who Cares Wins, Connecting Financial Markets to a Changing World. The report created by The World Bank was endorsed by a host of financial institutions and offered recommendations for integrating ESG issues into financial analysis, asset management, and securities brokerage. The goals of the recommendations were
ESG investing helps achieve all four recommendations and comes with a number of other benefits for organizations and investors that adopt an ESG-focused approach. In fact, according to ‘Finance Alliance’, there are 7 major benefits to ESG investing (see table below).
| 7 Benefits of ESG Investing | Why |
|---|---|
| Risk Management: Mitigating hidden E, S & G risks | The more proactive a company is at risk and opportunity management, the more likely it is to succeed over the long term through what EY calls ‘preparedness and adaptability’ in its ‘How ESG cultivates a new paradigm in risk management’. |
| Enhanced Portfolio Performance: Morningstar analysed the performance of sustainable funds versus traditional funds over a 10-year period and found that ‘58.8% of sustainable funds outperformed their traditional peers.’ | Higher equity returns turbocharged by operational efficiency, superior risk management, talent retention, and reduced compliance costs. |
| More Positive Environmental Impact: ESG investing can be a powerful tool in tackling climate change and environmental degradation. | Prioritizing ESG can influence businesses to undertake initiatives to reduce their carbon footprint by increasing energy efficiency and sourcing renewable energy. This can lead to significant emissions reductions at the corporate level. |
| Greater Innovation and Adaptability: ESG investing helps encourage more efficient use of resources. | ESG investing pushes companies beyond short-term gains. It plays a huge role in creating a future-focused mindset. This can spur innovations that help companies reduce waste, save energy, lower costs, and remain competitive in the market. |
| Attracting and Retaining Talent: ESG investing provides social benefits and fosters a positive working environment. | When business policies help protect employee welfare and promote a healthy work-life balance, this ensures a safe working environment, helping attract and retain top talent. |
| Strengthened Regulatory Compliance: ESG investing helps businesses prepare for regulatory changes and avoid potential penalties. | ESG-focused companies can stay ahead of the curve and transition to greener technologies ahead of stricter environmental regulations, avoiding future compliance costs. For instance, total annual payouts for corporate misconduct grew from around $7 billion per year in the early 2000s to more than $50 billion in recent years. |
| Contribution to Global Goals: ESG investing helps reach the ambitious goals set out by the United Nations in 2015: the 17 Sustainable Development Goals (SDGs). | Investing in renewables and clean tech while promoting equality, diversity & inclusion can directly fuel environmental and social progress in their value chain. |
Though ESG investing has its earliest origins in ‘socially responsible’ investing pioneers of the 1960s, today it is now a fundamental part of any prudent risk management strategy. In general, ESG investing refers to any investing which prioritizes optimal environmental, social, and governance (ESG) factors, or outcomes when allocating capital. ESG investing is more focused on the implications of these non-financial factors than traditional investing, with ESG investors carefully assessing the impact of ESG factors on an investment’s risk exposure and upon its growth potential.
As the climate transition gathers pace, so-called non-financial factors are increasingly having big financial implications, as companies deal with potential risks such as ‘Stranded assets’, litigation risks, as well as the physical risks directly posed by climate change, to name just a few. This can be seen in the insurance industry, which perhaps more than any, has and will continue to contend with a number of possible future climate scenarios, and be prepared for all of them. It could be said that this ‘scenario analysis’ that has always been integral to the underwriting activities of the insurance industry even before the climate crisis, has now gone mainstream. This is because sustainability and climate risks affect every aspect of the value chain in virtually every sector, necessitating a much more in-depth assessment of risk, both from within a business and from without. ESG investing therefore aims to mitigate or avoid negative ESG outcomes by identifying material risks and investing in more sustainable growth opportunities.
There are countless ESG investing frameworks, some are sector-based, some thematic. For instance, in institutional investing, environmental factor integration is widely done via impact and thematic investing. Whatever investment strategy an investor chooses, it will always depend on the investor’s personal values or the values of the company they are investing on behalf of. ESG investing therefore is as much about ‘values’ as it is about ‘economic value’. These values may necessitate excluding some stocks or even entire sectors from an investment portfolio. This can be seen by the shunning of Tobacco stocks (so-called ‘sin stocks’), or by concentrating on ESG themes, perhaps by only investing in climate leaders, or the ESG leaders in one sector. Similar to the funds universe itself, there are thousands of options to choose from.
To help companies and investors there are many popular frameworks to utilise, such as ‘Schroders: Sustainable investing’, or ‘MSCI Principles for sustainable investing’. MSCI’s approach focuses on three pillars: Values-based investing, Impact investing, and ESG integration. These principles are mapped against two benchmarks: 1-A market benchmark, which aims to measure the return and risk characteristics of the unconstrained relevant market. 2-A Policy Benchmark that aims to reflect the investment objectives and strategy of an asset owner and typically incorporates many dimensions such as risk tolerance, liability profile and eligible asset classes.
While ESG frameworks, scorecards, negative screening, and sector-based research are all great; it’s Crucial for a company or investor to define their own approach to ‘ESG’. This could be through creating an ESG investing policy, that helps you define your allocation approach at a high level. Some good general ‘responsible investing’ principles can be found in MSCI’s ‘Integrating ESG into the investment process’. More broadly there are the excellent ’Responsible Investing Commitments’, outlined by the Principles for Responsible Investment (PRI). The PRI Principles were developed by an international group of institutional investors reflecting the increasing relevance of environmental, social, and corporate governance issues to investment practices. The process was convened by the United Nations Secretary-General, as part of the UN Global Compact.
Despite recent and ongoing political challenges, Global ESG assets are still predicted to hit $40 trillion by 2030. This would represent 25% of global AUM, according to a recent Bloomberg Intelligence report. According to Morgan Stanley’s 10-year sustainable investing outlook report, this growth in ESG AUM is being partly driven by a ‘proliferation of regulations and voluntary standards across the world’ set to reshape corporate strategies, disclosures, and the availability of transparent data. This will in turn create a virtuous cycle of momentum for the growth of Sustainable finance and ESG-related investing. Three broad accelerators for this are outlined below:
With growing regulatory pressure and multifarious ESG investing approaches and opportunities, it’s never been a better time for investors and organizations to define their ESG values and enshrine them in an ESG investment Policy that will guide your organization as the climate transition gathers pace exponentially.
In our next article, we will explore the growth of ESG investing in the Middle East and assess which industries are leading, as well as touching on the importance of ESG to Sovereign wealth funds and the opportunities for private wealth more generally.
