What is ESG, and why is it important?
Environmental, Social, Governance, or ESG, is a measurement and reporting standard commonly used by investors to evaluate how responsibly a company earns its profits. The criteria were first introduced in a 2005 study examining the relevance of environmental, social, and governance factors to asset management and financial performance.
Over the past two decades, ESG has grown in its impact on business and investing. In 2020 alone, investors held assets worth over $17 trillion based on ESG standards. This represented a $5 trillion increase from just two years prior.
Statistics released by the Global Sustainable Investment Alliance revealed that ESG investment strategies accounted for $30 trillion in 2018 and are forecast to grow to $50 million over the next twenty years.
In 2020 alone, investors held assets worth over $17 trillion selected on ESG standards.
The driving factors of ESG investing
Public scrutiny and a greater awareness of climate is at an all-time high, altering the way the investment world responds. Companies are embracing ESG as a way to influence community sentiment in a positive way and better display their brand as eco-friendly and sustainable.
Institutional investors have started to feel the impact of the scrutiny rained down by climate advocates, which influences the actions of asset managers in engaging with companies deploying funds.
The global regulatory environment has grown in strength with nations apotheosizing ESG requirements in their many regulations. In the last decade, studies show global governments have launched more than 500 new measures that focus on ESG promotion.
Major players in the ESG realm now include governments, capital markets, regulators, consumers, and businesses who are all now pushing green technologies with innovative business models.
Throughout much of Europe, Canada, and the U.S., politicians, investors, and senior managers are now starting to measure corporate performance not only by shareholder returns, but also the impact of the company on climate change and global sustainability. This includes challenging factors such as rising sea levels, flood risk, and privacy and data security.
Millennials, or individuals between the ages of 23 to 38, now account for over a third of the world’s population.
The impact and power of millennials on the financial sphere is impossible to ignore. A massive transfer of trillions of dollars worth of wealth is taking place as baby boomers pass on their impressive resources. The funds, coupled with the millennials' rampant financial success, are overflowing into the investment sector with the force of a tsunami.
A global survey carried out by the deVere Group found that 77% of millennial investors are focused on ESG issues as their top consideration when weighing investment opportunities.
Undoubtedly, ESG is being driven largely by a younger and more socially conscious generation of investors who are not just requesting sustainable investments but demanding them.
Companies that fail to listen to the consumer demand for eco-friendly practices run the risk of losing a significant amount of business to competitors who are putting sustainability first. One report found that 57 percent of millennial investors turned down or divested from investment opportunities when they found out that the company was harming the health of consumers or damaging the environment.
77% of millennial investors are focused on ESG issues as their top consideration when weighing investment opportunities.
The market for ESG investing
The current and projected future market for values driven sustaining investing is enormous. A report by Morningstar revealed that U.S. accessible, exchange-traded and open-end funds that are labeled sustainable sailed over $13 billion in 2019. Now there is a meteoric rise in sustainable investing that is impossible to ignore.
The preferences of millennial investors are not the single most important reason to consider ESG. One study carried out by Morgan Stanley found that the performance of 10,000 managed accounts and funds were high performing when they utilized sustainable strategies. Investing in sustainability outperforms traditional investments across all asset classes.
Companies that utilize corporate social responsibility typically command premium prices for their services products and share prices. A Nielsen Global Corporate Sustainability report revealed that two thirds of global buyers willingly pay more for sustainable brands.
The demand for ESG data and analytics
ESG investors demand ample data and products, spurring the growth of data providers who actively track ESG quantitative analytics which are based on qualitative ESG dataset. The information offers a wide angle look at the ESG investment landscape.
Data analytics and ESG research provide systematic, objective, quantitative, and financial approaches that measure ESG issues for better investment decisions.
The impact of ESG
Each leg of ESG addresses how companies either positively or negatively impact the world and society:
- Is the company a significant contributor to carbon emissions?
- Does the company promote race and gender equality in the workplace and supply chain?
- Has the company been involved in any large-scale lawsuits?
- How does it manage customer privacy?
- Have there been any probes related to internal corruption?
- Is executive pay and bonuses linked with key performance indicators?
Many mutual funds, brokerage firms, and other investment institutions now offer products that include ESG metrics to appeal to investors in addition to just financial returns. ESG investing has become a mainstay of modern finance and a significant way for owners of assets like real estate to increase value.
Is ESG investing profitable?
In a decade punctuated by ethical, moral, and environmental issues, the impact of ESG on business and asset management has only grown. Dependence on the criteria was heightened through 2020, a tumultuous year marked by a global pandemic, environmental catastrophes, and the eruption of social justice frustrations.
As the public demand for higher accountability from the business and finance sector has heightened, investors now utilize ESG as a risk indicator and profit forecast tool. From an ethical perspective, ESG investing can most certainly be the “right thing to do,” but is it profitable?
A landmark report by the Morgan Stanley Institute for Sustainability examined the performance of sustainable investing funds compared to traditional funds and revealed the following findings:
- Sustainable investing funds outperformed non-ESG funds.
- Sustainable investing funds proved to be less risky than non-ESG funds.
- Sustainable investing funds weathered the severe economic volatility of 2020 better than non-ESG funds of corresponding market cap or sector composition.
The report also showed that 2020 ended with a record inflow into ESG assets, suggesting that sustainable investing will continue to be a profitable high-growth vertical.
Benefits of ESG investing
With a heightened awareness of climate change, many want a sustainable investment portfolio for moral testaments, but there are other compelling reasons to pick ESG investing.
A 2021 study, “Sustainable Funds Outperform Peers During 2020 Coronavirus,” carried out by the Morgan Stanley Institute for Sustainable Investing found that sustainable equity funds far outperformed non-ESG peer funds with a median return of 4.3 percent in 2020. Sustainable taxable bond funds also outperformed by a median total return of 0.9 percent. In 2019, both sustainable taxable bond funds and sustainable equity funds outperformed traditional funds.
ESG funds have a lower downside risk than traditional funds. In 2020 ESG funds displayed impressive performance. The Morningstar study mentioned previously analyzed 26 sustainable index funds which outperformed comparable traditional funds during the first quarter of 2020.
How ESG benefits companies and investors
Years ago, corporate management and boards paid sustainable practices lip service as a public relations tactic. However, nowadays the business climate has changed and ESG is critical for a company’s long term competitive success.
Institutional investors now expect companies to launch an initiative-taking approach to any ESG messaging or policies.
Blackrock’s CEO Larry Fink wrote in his annual letter to CEO’s, "a company's ability to manage environmental, social, and governance matters demonstrate the leadership and good governance that is so essential to sustainable growth, which is why we are increasingly integrating these issues into our investment process.”
A robust ESG plan presents the opportunity to access immense pools of capital for brand enhancement and to promote long-term company growth which benefits investment.
Increasing stock liquidity
Institutional and individual investors are investing substantial amounts of capital in corporations that support ESG. The US SIF Foundation found that U.S. domiciled investments utilizing sustainable, responsible and impact (SRI) strategies topped $8.7 trillion which represents one dollar out of every six under management.
Investment funds and ETFS are raising trillions of dollars that are being deployed to companies with strong ESG policies which helps increase the demand for the stock.
Investment firms are now using ESG evaluations as a part of their portfolio risk assessment which is a strong indicator that a considerable amount of capital will continue being grown at companies who show impressive and robust ESG programs and practices.
Proactive ESG policies help increase a company’s competitive value. Improving labor conditions, giving back to the community, and focusing on environmentally friendly solutions all strengthen a brand giving them a competitive edge.
Avoiding activist confrontations
Activists regularly campaign against companies that fail to take a proactive stand on social issues or the environment. Companies which focus on addressing ESG issues effectively immunize themselves against the headache and turmoil caused by activists.
ESG-focused activist hedge funds and investment firms are now establishing ESG funds such as Jana Partners, and ValueAct Capital. The investors want to collaborate with companies who are focused on strong ESG policies.
Investors for the long haul
Most ESG investors are value-based. They care more about the next decade versus the next quarter. It is common for investors to collaborate closely with companies who are incorporating ESG to help further strengthen it. They usually want to build long term value over a multi-year time span rather than quickly flipping the stock.
The best talent retention
Millennials care about the world and sustainability. They want to work for companies that share their values and focus on environmental and social responsibility. Employee passion builds loyalty and helps strengthen a brand which improves productivity and grows the bottom line.
ESG investing and real estate
The impact of fossil fuels on the environment has spurred a strong movement towards decarbonization. Commercial real estate has started to adopt sustainable practices to reduce carbon impact. Operational emissions account for 28% of all emissions worldwide. Construction of such structures adds a further 11%.
Increasingly, Environmental, Social, Governance is playing a role in how existing real estate is managed and how new construction is approached. There is a greater emphasis on using sustainable materials as well as switching to clean energy technologies like wind and solar.
ESG is also influencing how real estate investors allocate their funds. CBRE, a commercial real estate services and investment behemoth conducted an industry poll to determine what impact ESG was having on real estate investing. 60% of respondents stated that they had already adopted ESG criteria.
Getting started with ESG
As a society, we’re past the point where a business is asking, “should it implement ESG” instead, the question now is “how.” Your business’ approach to Environmental, Social, Governance will be unique to your industry and mission; however, there are some basic guidelines that can prove helpful:
- Know why you want to implement ESG. Be clear and transparent about your reasons so you can match goals and KPIs to specific initiatives.
- Make sure that all stakeholders in your company are on board. This will eliminate friction and potential obstacles to achieving desired outcomes.
- Assess the current state of ESG in your organization to establish a baseline and identify gaps.
- Develop a roadmap with defined milestones to ensure EGS priorities are met.
- Measure performance. Track KPIs so that you can determine whether or not ESG implementation within your organization is successful.