By now you have probably heard the term “ESG” or Sustainable Investing floating around various investment and financial forums. It has been a growing subject of conversation for many years now but in recent years has grown significantly as a reputable investment methodology and adopted into fundamental business operations. But what exactly is “ESG” and why are we talking about sustainable investing now?
ESG stands for Environmental, Social, Governance – a set of criteria used by investors to evaluate a company’s sustainability and global social impact. Many people familiar with the term relate it to climate change and natural resource scarcity but it also considers social factors like how companies engage with and impact their employees, clients and communities; and governance practices like how companies approach business ethics and their culture and values. These set of criteria are used by investors to evaluate real business risks and opportunities that previously were not priced into the financial analysis of a company.
ESG describes the framework for analysis and for understanding the issues that affect the underlying companies you invest in, while Sustainable investing describes the investment activity.
Sustainable investing is a way of analyzing the world, i.e. thinking about how companies are managing their business to avoid risks and capture opportunities in a changing world. It makes good business sense and leads to better outcomes for societies and the environment.
Companies that manage their sustainability issues well will be more successful in the long term. Their performance, and thus returns to investors, will be stronger because they understand the wider risks that their companies are facing and how the global economy is changing.
Our world is evolving
Global sustainability challenges like flood risk, natural resource scarcity, data security and privacy, demographic shifts and regulatory pressures introduce new risks for companies and their investors. Today, companies have no choice but to consider how these risks impact their business. We categorise these risks in three key ways.
One, is physical costs. These are costs directly resulting from climate change. For example, an insurance company insuring houses in an area susceptible to flooding or other climate-change related natural disasters.
Another risk emanates from the evolving regulatory standards that countries are implementing to mitigate climate change. More countries are imposing penalties and fines on companies that pollute or do not meet certain carbon standards.
Finally, the risk of getting left behind, i.e. transition risk – which will expose which companies are managing the economic shift to a lower-carbon economy, or not. As the world transitions to lower carbon energy, it is important to consider how are high carbon generating companies managing the changes to their business models?
Companies that are dealing with ESG issues well are more likely to be around in 20, 30, 40 and 50 years and those that don’t probably won’t have much longevity, so they become less interesting as investment options.
Sustainable Investing is Here to Stay
Investor capital is progressively moving into sustainable investment – according to the 2018 Global Sustainable Investment Alliance (GSIA) review, sustainable investing assets in the five major markets grew by 34% to USD30.7 trillion at the start of 2018 – more than 4x the rate of market AUM growth. While there are a multitude of reasons for this growth we’ll focus here on 2 key drivers: Evolving investor expectations that focus on ESG factors and regulations that promote sustainability.
There has long been the misconception that investors must compromise on returns when investing in sustainable or responsible strategies. However, numerous studies have been conducted illustrating that investing sustainably does not mean compromising on performance. Investors are becoming more conscious of how considering ESG factors translate to better long term performance. They want to know that the companies they are investing in won’t jeopardize the environment, put their employees at risk and are free from corporate corruption.
In tandem with this shift in investor preferences are regulatory changes. Regulation is increasing as policy makers and regulators seek to put the global financial system on a sustainable growth path to address the long-term challenges of climate change and global inequality. We’ve seen this most notably in the EU where regulators now require companies with greater than 500 employees to report on key ESG metrics.
As we can see, sustainable investing is not a fad or trendy word. It’s here to stay and impacts our present and future investment decisions. Those who embrace it first will benefit the most and there is no doubt it’s investment for a changing world. There is simply no other way. The only question is: how much longer until you embrace it too?
