What is Sustainable Investing?
Sustainable investing takes into account environmental, social, and corporate governance (ESG) factors, as well as traditional financial metrics, to identify companies that will generate long-term competitive financial returns while contributing to positive social change.
Key Learning Points
- Financial decision-makers are seeking more sustainable investment solutions.
- Regulators are beginning to monitor ESG ratings as they seek to increase transparency and ensure the integrity of ratings.
- ESG research and analysis can potentially identify investment risks such as:
- Inconsistent ESG disclosures: The SEC has witnessed a lack of adherence to global ESG frameworks, despite claims made by investment funds or companies that they are committed to ESG practices.
- Weak monitoring of ESG-related investing guidelines, mandates, and restrictions.
- Unsubstantiated and misleading ESG investment claims.
- Inadequate control mechanisms for ESG-related practices. Inconsistencies between actual practices, ESG-related disclosures, and marketing materials were traced back to weakness in control mechanisms.
- Failure of compliance programs to address relevant ESG issues.
There is a growing recognition that some ESG factors are economic, particularly over the long term, and it is essential to incorporate material ESG factors such as the following:
- The quality of governance and political and economic institutions plays a crucial role in macroeconomic performance, particularly in emerging and frontier markets. Robust governance contributes to the policy environment’s quality, stability, and predictability. It typically goes hand in hand with more robust growth potential and greater resilience in the face of domestic or external challenges. It contributes in an essential way to determining the risk from financial and economic crises. A new administration that can radically shift policy direction can be a reason to enter or exit a market. Some governance factors, for example, corruption or the attitude towards foreign investment, also present significant risks.
- Social conditions influence a wide variety of political issues, including stability and the policy mix, while also directly impacting a country’s macroeconomic development through competitiveness and efficiency. Although many social factors affect long-term growth potential, they can also have a significant short-term impact. Lack of social stability can lead to armed conflicts or create opportunities for political manipulation, often to the detriment of the population. At the same time, factors such as wage pressures and infrastructure development have real effects on both domestic and external economic activity.
- Environmental factors also play an essential role, particularly in emerging and frontier markets with weaker regulation and more limited ability and resources to react. Natural disasters like droughts, floods, earthquakes, and hurricanes can have devastating economic and human consequences. Other than the human costs, they can spark disruptions that cause issues like skyrocketing inflation or interfere with supply chains. Unsustainable practices and pollution can cause social instability, and cleanup costs can cut into an economy’s growth potential.
While no investment’s success is guaranteed, the performance of sustainable funds has often been similar to the performance of traditional funds, and some research has shown that sustainable funds may perform better. A study by Morgan Stanley, titled “Sustainable Funds Outperform Peers in 2020 During Coronavirus” outlined the following;
- U.S. sustainable equity funds outperformed their traditional peer funds by a median total return of 4.3 percentage points.
- U.S. sustainable bond funds outperformed their traditional peer funds by a median total return of 0.9 percentage points.
- U.S. sustainable equity funds’ median downside deviation was 3.1 percentage points less than traditional peer funds.
- U.S. sustainable taxable bond funds’ median downside deviation was 0.4 percentage points less than traditional peer funds.
Interest in sustainable investing continues to grow, and the pressure is on for investment organizations to move toward the sustainable investing model.
Three Pillars Define Sustainable Investing:
- Economic – Investments in a company should support long-term economic growth in the region where the company is located as well as contribute to the company’s growth. However, these contributions shouldn’t come at the cost of corporate profits.
- Environmental – If a company’s actions damage the environment, the business is not considered sustainable, and the company may face regulatory or legal consequences that will imperil future profits. Companies that make a positive contribution to protecting the environment will be rewarded.
- Social- If a company’s actions have negative social consequences, this could create a risk to performance. However, companies that invest effort in social good are often rewarded.
These pillars determine a company’s sustainability rating, which in turn influences their attractiveness to investors. Companies with high sustainability ratings often perform better, and those companies that implement sustainability best practices may be likely to do well going forward.
What is the difference between sustainable investing, ESG investing, and impact investing?
Sustainable investing includes ethical, socially responsible, green, impact, and ESG investing. These are general terms that mean more or less the same thing. These strategies all look at a company’s environmental and social impact and will invest in companies that perform well based on these factors while still generating attractive returns.
These strategies may seek to achieve their goals in different ways. Some “sustainable” portfolios only include positive-impact investments, while others are based on excluding companies with negative impact. Still, others use both inclusionary and exclusionary methods. The various names (socially responsible, sustainable, impact) are often used interchangeably, without much consensus on which are exclusive, inclusive, or both.
From niche to mainstream
Since ‘environmental, social and governance’ was coined as a term by the UN Global Compact, ESG investment has grown from a niche strategy to one that influences tens of trillions of dollars in AUM. The significant debate on what qualifies as an ESG investment is still a hot topic. Still, there is no escaping that ESG is dominating more and more conversations within the investment community. There are three possible reasons for increasing emphasis on social responsibility in investing:
- Asset owners increasingly seek to align their investment decisions with their values. Demographic and social shifts have supported this trend.
- There is evidence that ESG factors capture non-financial information that is material to financial performance. Asset managers are increasingly aware of risks and opportunities stemming from environmental and social issues. This represents a potential source of alpha for active managers, helping to broaden the appeal of ESG investing.
- Many regulations and voluntary codes of practice either require or encourage investment managers to report on ESG considerations. Global initiatives such as the UN Principles for Responsible Investment are helping to increase awareness of ESG considerations and require money managers to incorporate ESG into their investment processes.
Five critical steps to creating and executing a sustainability and ESG strategy
- Define stakeholder expectations – to deliver long-term value to shareholders, companies need to understand and respond to the needs of all the communities they serve. By aligning the board, management, employees, partners, and suppliers in pursuit of a common goal, companies can embed sustainability to generate significant environmental, social, and financial value for all.
- Establish commitments and ambitions – ambitious, measurable goals need to reflect a broader purpose and vision that the whole company can support. A robust unifying culture that is inclusive and inspiring can catalyze change across an organization, creating its own dynamic. By describing broad ambitions for addressing the impact on climate and the environment, improving diversity, equity & inclusion in all company relationships, and strengthening governance measures to drive accountability, companies can unite their stakeholders for a common purpose.
- Infuse ESG into organizational strategy – to bring sustainability and ESG programs to life, the perspective must cover the business as a whole. Every function within the business has a part to play, from upstream and downstream operations across an organization’s value chain to product and service development, talent management, customer experience, and supplier relations. Embedding sustainability into an organization’s integrated strategy should inform the company’s decisions, investments, and actions. Leaders must demonstrate their commitment through accountable and transparent processes, policies, controls, and reporting mechanisms.
- Create value through innovation and technology – minor improvements to existing business practices can rarely achieve sustainability ambitions. They need radical innovation that harnesses advanced technologies and human ingenuity to rethink how products and services are designed and delivered. Innovation that transforms whole ecosystems can provide exponential growth, fueled by data analytics and future proofed by a commitment to constant improvement cycles that propel the organization along with its sustainability transformation road map.
- Communicate outcomes through governance and disclosures – monitoring and reporting on progress toward sustainability goals is vital to maintaining the trust of all company’s stakeholders. It is also a critical part of the board’s and management’s governance responsibilities, subject to increasing regulation in some countries. But beyond legal requirements, the company needs to be accountable and transparent. Communicating progress effectively requires reliable systems to manage, track, and report data while creating meaningful metrics that will allow a company to benchmark its progress. Non-financial reporting and disclosures, both statutory and voluntary, are essential elements in a company’s overall sustainability narrative.
ESG refers to a class of investing known as “sustainable investing.” This is an umbrella term for an investment strategy that seeks to generate positive financial returns by investing in companies that have a positive long-term impact on society and the environment. For many investors, the ESG profile of the companies in their investment portfolios has become a significant consideration, along with investment performance. Consequently, these investors now expect any robust investment process to integrate material ESG characteristics and increasingly seek to define, measure, and enhance the total impact of their investments.