ESG factors have always influenced businesses and investors, but they were not necessarily obvious or given special consideration. Today, awareness of these topics and of their investment relevance has never been higher. Corporate incidents ranging from a wildfire-induced bankruptcy to data privacy issues and supply chain issues and, most recently, a global pandemic that exposed unethical corporate behavior (see Human rights case study below) have illustrated for investors the tangible impact of environmental or social risks on financial performance.
We see three main areas where ESG topics matter to investors:
- Managing investment and portfolio risk
- Participating in the upside potential of disruptive innovation
- Engaging with the prevailing social and political agenda
Investing with a sustainability focus can help investors understand how their investments will be affected by a changing physical world and evolving social trends, identify investment opportunities in sustainable industries that are experiencing increased demand or in certain cases invest to catalyze needed positive change. There are numerous approaches to investing sustainably, andimportantly they are not mutually exclusive.
Some ESG factors have direct, quantifiable impacts on a company’s business model and profitability. For example, additional capital expenditure may be needed in energy-intensive industries to replace manufacturing processes with more energy-efficient alternatives. Or in service-oriented industries, more stringent laws to protect employees in the aftermath of the pandemic could substantially increase workforce costs.
Other ESG factors may have an indirect influence on business models and competitive positioning. These may be more difficult to quantify, such as the value of a robust environmental management system that helps companies keep costs down and manage environmental risks, or the benefits of strong corporate governance. But over time these factors can affect the financial performance of companies, and the effects could materialize quite suddenly.
All investors need to explicitly consider material ESG factors in their decision-making. Numerous tools exist to help in making these evaluations, including ESG ratings that use standardized, rule-driven assessments to rank companies based on sustainability “performance” and research frameworks such as the Sustainability Accounting Standards Board (SASB) Materiality Map, which aims to help investors make better decisions by understanding the impact of ESG factors on a company’s revenue potential, profitability, and cost of capital. Some investors develop their own frameworks for evaluating ESG factors. Most important is that any framework takes into account both the financial and sustainability objectives of the investment approach. Simply attaching a “sustainable” label to an investment can help to match investments with investor preferences, but that is not in itself the ultimate goal of SI.
Participating in the upside potential of disruptive innovation The drivers of many long term investment themes are inextricably linked with sustainability. Population growth, aging, and urbanization are all trends that exacerbate sustainability challenges such as access to food, clean water, healthcare, and education, as well as the impact of the sheer number of people living on the planet and using up its finite natural resources. The scale of these challenges means that potential solutions can be commercially attractive while providing critical social or environmental benefit. These long-term sustainability or impact themes provide a roadmap for investors seeking to drive positive impact with their investment capital.
A few examples of key SI themes:
- Transition to a low carbon economy, encompassing all the industries in the renewable energy and energy efficiency value chain. Many are technology-driven, seeking solutions that will disrupt the fossil fuel industry and enable a shift to a more efficient, less polluting, and less resource-intensive energy system.
- Waste management, including reducing plastic packaging volumes which are expected to more than quadruple by 2050 (95% of the value of such plastic is lost after one use). Innovative waste reduction solutions can also increase businesses financial returns.
- Shifting food consumption trends, such as alternative proteins snagging market share, and the modernization of the global food supply chain, a shift that has been accelerated by the risks of the global, just-in-time supply chains that were exposed in the coronavirus-triggered economic and travel lockdowns.
The prevailing social and political agenda
As we stated earlier, SI is not new. But investor adoption and assets under management have both grown strongly in recent years. Much of this growth has been organic, driven by demand and new business opportunity. Regulatory attention has been, to date, mainly focused on improving ESG-related disclosure among public companies. For example, Hong Kong’s Securities and Futures Commission has made it com-pulsory for public companies to report on ESG factors, and mainland China will introduce a similar requirement this year.
The introduction of regulation governing the investment industry’s approach to SI is a genuine milestone in mainstreaming SI. Peer pressure and the desire for a “social license to operate” can be powerful drivers, but embedding requirements in law makes even the most ardent skeptics pay attention. The EU aims to be a first mover in this respect, with comprehensive regulation encompassing the development, marketing, and advisory process surrounding sustainable investment products. This seems likely to influence regulatory developments in other regions, and in the absence of local standards or taxonomies, the EU version could become the default.