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ESG Investing
ESG Investing

Sustainable investing is the “new normal” – here are its four key drivers

Why investors are paying more attention than ever to companies’ ESG practices

For as long as anyone can remember, the core purpose of investing has been to intelligently deploy capital in search of positive risk-adjusted returns. Finding the best risk-return trade-off was all that truly mattered.

This is no longer strictly the case. Today, there is a growing awareness in the investment world of the threats posed by external factors such as climate change. Beyond the environment, the Covid-19 pandemic has also sparked increased scrutiny on social and governance issues. Investors are now paying closer attention to how companies are safeguarding their employees’ welfare and whether they are fulfilling their social responsibilities amid a global crisis.

All this has accelerated the trend toward sustainable investing, also known as ESG (environmental, social, and governance) investing. ESG investing – a term first coined by the United Nations (UN) Global Compact in a landmark 2004 study called “Who Cares Wins” – has thus seen its popularity swell.

The sustainable surge

For instance, by the end of June 2020, assets under management (AUM) by ESG-focused funds breached US$1 trillion for the first time – the result of record inflows during the pandemic.

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This trillion-dollar figure might seem less than impressive when compared against the total global AUM, which ended 2019 at about US$89 trillion. But this figure only measures the AUM of explicit ESG funds. All around the world, institutional investors are increasingly applying ESG criteria to their portfolios – even if they are not referring to themselves as “ESG funds”. For example:

–   The Monetary Authority of Singapore (MAS) set up a US$2 billion investments programme in late 2019. Its objective is to promote public market investment strategies with a healthy green focus, as well as to better position its own investment portfolio for long-term sustainable returns.

–   Japan’s Government Pension Investment Fund(GPIF), which has an AUM of over US$1.5 trillion, has enthusiastically embraced ESG. It has announced that no new mandates will be awarded to managers without ESG credentials. In early 2020, it also launched a partnership to promote ESG factors in fixed income investments.

–   Denmark’s largest pension fund, the PFA, plans to allow members to invest in climate-focused investments that will be carbon neutral within five years. And another of its pension funds, MP Pension, has been progressively divesting “negative ESG” companies from its portfolio. Both these funds have a collective AUM of about US$100 billion.

–   In September 2019, the UN convened the Net-Zero Asset Owner Alliance – a group of institutional investors who seek to transition their investment portfolios to net-zero greenhouse gases emissions by 2050. The group now boasts 30 members with a combined AUM of about US$5 trillion.

When these “indirect” ESG assets are included, total ESG AUM is estimated to be closer to US$41 trillion. But what are the fundamental forces driving this trend? We have already touched on some of them above, but let’s take a closer look at the four main drivers behind the rise of sustainable investing.

Driver #1 – Awareness and expectations

The first driver is increased awareness and higher expectations. Beyond improved media coverage and scientific communication, formal accords such as the Paris Agreement have solidified the realisation that the only viable future is a sustainable, low-carbon one. The younger generation, especially, understands this. Research has shown that millennials believe more decisive action on climate change is needed – a generational finding that bridges political divides. This has translated into their expectations of the companies they transact with, including asset managers.

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The impact of the pandemic on the “haves” and “have-nots” has also put the spotlight on rising inequality – the ‘S’ in ESG. Reducing inequality is a vital part of the UN’s Sustainable Development Goals (SDGs), a set of ambitions it seeks to achieve by 2030. Yet, there is still a persistent funding gap of US$2.5 trillion annually that must be bridged to hit those targets. Institutional investors are increasingly embracing the responsibility they must play in closing that gap – especially given the demand from individual investors.

Driver #2 – Outperforming returns

Many people believe that sustainable investing carries with it an element of sacrifice. In other words, lower returns for the greater good. However, the data shows otherwise, and sustainable investing has actually outperformed the wider market.

During the pandemic-induced market selloff in February and March 2020, companies with high ESG ratings outperformed the benchmark S&P 500. The same trend was also seen in the exchange-traded funds (ETF) sector.

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Furthermore, the data shows that this is not a recent phenomenon. Morningstar research has found that, over the past decade, almost 60 percent of sustainable funds outperformed their ‘conventional’ peers. They also had greater survivorship rates: 72 per cent of sustainable funds that were on the market 10 years ago remained open to investors at the end of 2019 versus 46 per cent for ‘traditional’ funds. As evidence of sustainable investing’s performance within traditional investment contexts grows, so will its demand and popularity.

Driver #3 – Long-term resilience

2020 has seen the emergence of a new buzzword: resilience. Companies are now increasingly focused on becoming more resilient in order to improve their ability to weather the uncertain conditions of the future.

That said, companies that scored highly on ESG measures were already more resilient. This should come as no surprise. Simply put, sustainable companies have delivered better performance across areas like culture, supply chain management and customer relations. Furthermore, they are also less likely to be exposed to risks that may be caused by sustainability and governance issues such as scandals. It gives them a greater ability to manoeuvre through uncertain times.

Future crises will likely stem from ESG issues like climate change. Strengthening sustainability factors will be crucial for building long-term resilience and adeptly navigating the future.

Awareness and expectations, outperforming returns, and long-term resilience represent the “organic” components spurring the demand for sustainable investing. On the “inorganic” side, we have the final driver – regulations.

Driver #4 – Regulation

Sustainability is a key guiding principle in many governments’ post-Covid recovery plans. Even before the pandemic, pressure from the industry regulators was already encouraging companies to become more sustainable.

In the EU, for example, the Non-Financial Reporting Directive mandates that large EU companies disclose certain ESG factors in their reporting. And the upcoming sustainability-related disclosure regulations will require investment firms to show how they are integrating ESG risks. European regulators are also planning to introduce “climate stress tests” to assess banks’ climate-related exposure and manage the potential economic impact of climate change.

On the supply chain side, regulations like the California Transparency in Supply Chains Act and the UK’s Modern Slavery Act have served to enforce transparency. The goal is to stamp out exploitation in global supply chains, particularly human trafficking and slavery. Crucially, such regulations place the onus on big corporates to ensure the ethicality of their supply chains. This is forcing a shift in how they operate, as pleading ignorance is no longer an acceptable defence.

Sustainable investing – just normal

The powerful drivers behind sustainable investing are only getting stronger. Not only is sustainable investing here to stay, it could eventually be the predominant engine of capitalism. It may be the “new normal” today, but soon just the “normal” of tomorrow.

                         

This article is written by Fidelity International.

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