Getting the buy-side on side

By focusing on environmental, social and governance issues, investors can prompt changes in corporates’ approach to sustainability.

Ethical investing – selecting companies because of their commitment to sustainability (or more often, excluding certain types of companies) – has been around for decades. It’s been popular with some institutions and individuals, such as university endowment funds and environmentally-minded retail investors. However, to most people, it’s been a fringe concern. And there’s been a widespread belief that investing in ‘good’ companies produces lower returns.

Now investment strategies which consider sustainability as well as economic performance may be coming of age.

In July 2017, Japan’s Government Pension Investment Fund, which is the world’s largest with $1.3 trillion under management, selected three environmental, social and governance (ESG) indices for Japanese equities. It said that the decision was based on a view that ESG-based investment would “enhance risk-adjusted return over the longer term”. That same month, Swiss Re, one of Europe’s biggest insurers, benchmarked its $130 billion portfolio against ESG indices.

The clincher came in January, when Larry Fink, CEO of BlackRock, one of the world’s largest fund managers with over $6 trillion in assets, wrote to CEOs of companies BlackRock invests in. He said that “to prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate”

To outside observers, Fink’s comment might seem unremarkable. But for much of the asset management industry, it was momentous.

While not making an explicit reference to ESG investing, Fink’s edict perhaps did more to shift the ground in the investment world than dozens of ESG announcements. He said that all investors – even passive index funds – have a responsibility to continually engage with companies and spur them to understand the societal impact of their business, as well as the ways that structural trends – from slow wage growth to rising automation to climate change – affect companies’ potential for growth.

What’s driving change?

Mark Milders, head of investor relations at ING says that among asset managers – and especially pension fund managers – there is a palpable change in attitudes towards sustainability. One driver is pressure from end investors. “End-users want to know what is being done with their money,” he notes, “reflecting a general increasing level of public awareness about sustainability.”

However, Milders says that there is also a growing recognition of the performance benefits that result from taking a more holistic view of the world. “We believe that those companies with higher ethical codes are more risk averse and more sustainable – not just in terms of their green credentials but in terms of their ability to survive and prosper over the long term in a competitive environment,” he says, explaining why ING charges a lower interest rate for loans linked to borrowers’ sustainability.

A series of recent reports appear to back up Swiss Re’s chief investment officer Guido Fürer, who said the rationale for the insurer’s switch to ESG indices is that “it makes economic sense” – in other words, sustainable companies perform better.

Analysis by the Boston Consulting Group, published as Total Societal Impact, found a positive relationship between ESG performance and margins. For example, in consumer packaged goods, companies that sourced more responsibly had gross margins 4.8 percentage points higher than the average; in biopharmaceuticals, ebitda margins were 8.2 percentage points higher for companies that expanded access to medication; and in oil and gas, ebitda margins were 3.4 percentage points higher for top performers in health and safety.

Why is this the case? A report by index compiler MSCI in November 2017, Foundations of ESG Investing, showed that ESG affects the valuation and performance of companies, both through their systematic risk profile (because it lowers the cost of capital and results in higher valuations) and their idiosyncratic risk profile (such companies are more profitability and are less exposed to so-called tail risk; in other words they will perform better than other companies should an unexpected event occur).

A paper by Ravi Jagannathan of Northwestern University puts these observations in context and explains why they matter more now than in the past. Focusing on the environment, he notes that cumulative environmental stress has not only made environmental crises more severe and more likely to occur, but has also changed how governments and consumers respond. “Now, when a crisis occurs, it is more likely to incite sudden changes in regulation and consumer behaviour, causing large swings in asset prices over a short period of time,” he explains.

Assessing such risks, and their impact on long-term returns, requires understanding about how environmental crises, from global climate change to regional pollution, may lead to political disruptions and subsequent regulatory changes, says Jagannathan. “Even investors who only care about maximising returns may [use] ESG criteria to identify firms which are well prepared to deal with changes in regulations and consumer preferences and potential threats from new technologies.”

Hurdles to overcome

It’s important to note that the many encouraging statements about the growing importance of sustainability to investors are not a reflection of all parts of the market. As ING’s Milders notes, many analysts’ conception of the world remains based on spreadsheets while share portfolio managers often focus on returns and dividends; consequently they are P&L– and quarter-to-quarter – orientated rather than considering strategic issues such as sustainability.

Moreover, the lack of generally agreed standards in relation to sustainability can make it challenging for investors to get to grips with the many facets of sustainability – from environmental performance to gender diversity. “When a coal-fired power plant can issue a green bond because it meets certain criteria, it raises issues about whether sustainability is a valuable, believable label,” says Milders. “All industries are responding to the growing public interest in sustainability and companies see no downside in adopting appropriate language.”

However, progress is being made on common standards. For example, the Financial Stability Board’s taskforce on climate-related financial disclosures is providing a foundation for investors to assess and price climate-related risks and opportunities, according to Ronald O’Hanley, president and CEO of State Street Global Advisors, the investment management division of State Street Corporation and the world's third largest asset manager.

Ratings from organisations such as EcoVadis and Sustainalytics are also giving investors and other stakeholders common standards by which they can judge companies. Another way to cut through the confusion about what sustainability means is to focus on the UN’s sustainable development goals (SDGs). “ING has picked two relevant SDGs and seeks to provide evidence that its actions are aligned with them,” explains Milders.

Measures of sustainability may never become as clearly defined as financial metrics – its breadth might prevent that. Nevertheless, ESG investment is certain to continue to grow: as it does so, more companies will work to ensure their inclusion in ESG indices and a virtuous circle will develop.

Meanwhile, the ESG investment community continues to innovate: Legal & General Investment management recently launched a fund that prioritises investing in companies where women are well represented, for example. At the same time – and perhaps most importantly – mainstream investors look set to embrace the long-term approach that defines ESG investing – simply because sustainability will produce more sustainable returns. Sustainability’s tipping point may be just around the corner.


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