Institutional investors are now quickly catching up to private investors who have led the way on sustainable investing and are now mobilising to drive a permanent change on how investors examine investment opportunities and overall corporate behaviour.
No longer a nice to have, managing resources sustainably is now a community expectation and private investors are demanding their money managers, companies, and governments act in a meaningful way on sustainability issues. Importantly, this will not come at the expense of lower returns as capital is flowing towards companies that demonstrate sustainable practices. Those businesses that fail to tackle sustainability seriously will suffer through the sheer weight of money going elsewhere and potentially losing their social licence to operate.
Private investors have long used exclusionary screening and value judgments to shape their investment decisions, aligning their ethics on the investments they were prepared to make. Increasingly private investors have been using their collective power to focus a greater pool of capital to encourage more sustainable business practices on a much wider scale.
It was over 15 years ago that the United Nations launched the Principles of Responsible Investing out of belief that an economically efficient global financial system needed to focus on the sustainable use of resources to create long-term value. By mobilising the professional stewards of capital to focus on responsible investments, the UN held a belief that investors would drive long run investment performance along with significant benefits to the environment and society more broadly.
Finally, these principles are getting real momentum through a growing community looking for a more sustainable approach to economic development. Private investors have driven a grass roots expansion of capital seeking more sustainable investments and forced institutional investors to add positive environmental and social impacts to their more traditional objective of generating positive financial returns. Corporates have responded with considerable efforts to promote their sustainability credentials and a new focus on the triple bottom line of economic, social, and environmental outcomes. An ever-increasing number of communities and corporate groups are building campaigns designed to make significant environmental changes, including groups like RE100 which is a global initiative bringing together the world’s most influential businesses committed to 100% renewable electricity.
Institutional investors have now been forced to incorporate Environmental, Social and Governance (ESG) factors into their investment processes and public super funds are being outwardly challenged to demonstrate their focus on their ESG processes and specifically their focus on the impact of climate change on their future investment returns. Typically, environmental factors focus on climate change and sustainability issues and can include issues such as a business’s energy consumption and production, greenhouse gas emission, pollution creation, and the conservation of natural resources. Social factors tend to focus on human rights and consumer protection issues and can include their diversity policy, working conditions, supplier relationships, and health and safety policies.
Governance has long been a factor that professional investors have focussed on. Many argue that good governance does lead to better social and environmental outcomes. Governance has evolved to focus on issues including executive remuneration, board structure, practice and diversity, financial statement accounting methods and transparency on a range of policies.
However, while the shift to a greater focus on ESG issues is welcomed, the terminology and measurement practices associated with sustainable or responsible investing vary considerably. It is a space that is incredibly difficult for private investors to get comprehensive and accurate data to inform their decision-making process. Increasingly, regulators are concerned with the practice of greenwashing, a process where businesses and investment products inflate their environmental credentials. Governments and global NGOs are looking for ways to promote transparency, consistency of metrics, comparability of ratings methodologies, and an alignment with financial materiality. Ahead of that, we are now starting to see groups mobilise activist campaigns to encourage better corporate behaviour on a case-by-case basis.
Somewhat counterintuitively, the empirical evidence on whether the focus on ESG factors adds to superior economic returns is somewhat mixed. Much of this can be linked to issues regarding the scoring of ESG factors and the timeframes over which analysis is conducted. Some institutional investors argue that they are more of a risk indicator than a factor that would drive superior financial return. We have certainly seen recent examples where a company failure in ESG factors has led to a loss of their social licence to operate along with fines and other serious penalties. Increasingly, in a world focused on the negative externalities of not looking after your people and the planet, the cost of capital for companies failing to make it a necessary focus must surely be rising. The weight of money flowing to better ESG credentialed investment opportunities supports this hypothesis.
Despite its shortcomings, the scoring and reporting of ESG factors has the potential to unlock a significant amount of information on the management and resilience of companies when pursuing long-term value creation. It could also represent an important market-based mechanism to help investors better align their portfolios with environmental and social criteria that align with sustainable development. Companies that do the right thing are likely to experience a material advantage in a lower cost of capital and investors should never underestimate the personal impact of earning well while doing things that are more meaningfully better for the planet.