Once a niche area of finance, environmental, social and governance (ESG) investing is now very much a mainstream phenomenon. We believe ESG factors can play a role in the long-term financial performance of companies and therefore can have a material impact on investment performance. Below, we break down the component parts of ESG to explain how each factor can be taken into account in the investment decision making process:
The E in ESG is the most well-known component. It regards issues relating to the quality and functioning of the natural environment and natural systems - for example, carbon emissions, environmental regulations, water stress and waste. These are some of the biggest challenges currently facing our planet and tackling them will require collaboration between governments, companies and consumers around the world. This factor is more than just encouraging people to turn off their lights; it is a vital consideration for companies in all lines of business. While renewable energy producers and electric car makers are some of the most well-known solution providers when it comes to environmental factors, companies looking to develop ways to preserve the environment can be found across all sectors of the economy.
Social factors cover a broad array of considerations for companies, from diversity and inclusion to the treatment of their workforce, customers, suppliers and the wider community. These issues are increasingly in the spotlight and the risks for companies are clear. A company that doesn’t provide a safe and healthy working environment, for example, is less likely to have a happy and productive workforce. Similarly, a company that cuts corners on product safety or mis-sells products risks long-term reputational damage. These factors are likely to have a direct impact on bottom lines.
Governance relates to how companies are structured and run from the top down. A robust corporate governance system that ensures high levels of transparency, accountability, oversight and respect for investors and key stakeholders is imperative for a well-functioning company. This includes making it clear what company management are paid and how they are incentivised. Another key component is the diversity of company boards. An independent and diverse board with the relevant knowledge and experience often results in more effective, objective decision-making and improved long-term value creation.
Why is ESG important for investment decisions?
A large and growing body of academic evidence has found a positive link between ESG characteristics and the financial performance of companies1. Here are some of the main reasons we believe ESG factors will play a material role in the long-term financial prospects of companies:
Consumer sentiment: Recently, there have been powerful shifts in consumer sentiment away from firms with poor ESG ratings towards more responsible alternatives. There is now a greater consideration by consumers as to the impact of their spending on the planet and society. These changes create compelling opportunities for investors to favour those companies that have responded by incorporating ESG considerations into their operations, or those offering products and services that directly address sustainability challenges.
Regulatory risks: Not only are companies under pressure from their customers to act responsibly, they are also under increasing scrutiny from governments. Significant policy changes will be required to get the climate trajectory back on track, both in the form of “carrots”, such as new spending on climate-friendly projects, and “sticks”, which include new taxes and regulations. Those companies that are already addressing environmental issues, for example, are likely to be more insulated from the regulatory risk associated with the transition to a net-zero economy, such as the increasing costs associated with carbon-intensive activity.
Capital costs: Research from MSCI found that companies with strong ESG attributes benefited from a lower cost of capital compared to companies with poor ESG scores, in both developed and emerging markets during a four-year study period2. Lower capital costs make it cheaper for companies to invest and grow their businesses.
Considering ESG criteria when making investment decisions is as much about doing well as it is about doing good. We believe that the assessment of financially material ESG factors is integral to an effective and holistic risk management process, which can not only align portfolios to sustainable outcomes, but also potentially enhance returns.
1 Gunnar Friede, Timo Busch and Alexander Bassen, “ESG and financial performance: Aggregated evidence from more than 2,000 empirical studies,” Journal of Sustainable Finance & Investment, 5:4 (2015), 210-233.
2 MSCI, “ESG and the Cost of Capital" (2020)