Environmental, social, and governance investing has emerged in financial markets and risen as the superior route to alternative investing. This type of investment uses the ESG criteria to measure the investment’s socially conscious values. A company’s sustainable practices, social impact, and governing operations are attractive measurements for investors to evaluate potential investments. ESG investments have proven to report consistent, positive performance, grant an opportunity for companies who “do good” in light of recent social movements, are favorable amongst new generations, and are not losing speed. These forces are driving ESG into the spotlight, however, there is a lot of work to be done in the space.
Today’s Driving Forces
According to recent findings, companies that put a focus on ESG factors have proven to out-perform those that do not. The S&P 500 ESG measures the performance of companies that meet sustainability criteria yet also maintain over industry group weights. CME Group reports that as of April 30, 2020, S&P 500 ESG outperformed the S&P 500 by 2.68%. Furthermore, as of Q1 2020, 10 out of 12 U.S.- based ESG- focused index funds beat S&P 500 returns. The objective of the S&P 500 ESG is to provide a sustainable alternative to the S&P 500. However, ESG investments prove to remove potential threats and volatility and report better risk- adjusted returns.
Recent global environment and social events have sparked investors to look toward ESG investments. The COVID-19 pandemic resulted in record inflows to sustainability-themed funds. Investments in ETFs tracking ESG indices rose from $22.1 billion in 2018 to $56.8 billion by the end of 2019. From January through November 2020, investors in mutual funds and ETFs invested $288 billion globally in sustainable assets, a 96% increase over the whole of 2019. The pandemic affected supply and demand and disrupted supply chains. As a result, companies with low environmental, social and governance characteristics received little praise and support. This cause-and-effect trend is expected to continue. Environment and social changes will continue making corporate social responsibility popular and separating companies that do good from those which do not.
The changing mix of investor demographics will support ESG growth. Millennials and Gen Z consider investment decisions differently than those of older generations, and they are favoring ESG investments. These two up-and-coming investor generations account for nearly half of the U.S. population. The new investor groups are three times more likely to support and invest in businesses that serve communities and society or have a social cause. Growing up with access to news and social groups at the touch of a button has shaped Millennial and Gen Z’s investment priorities. A recent study from deVere Group found that eight out of 10 millennials chose ESG issues as important investment criteria. There is an expected intergenerational wealth transfer of $30 billion expected to hit millennials and Gen Z over the next 30 years. Therefore, the industry needs to start paying attention to the ESG focused investments that have received the new generation’s attention.
Growth & Effectiveness
Constraints: Unclear Standards
While there are plenty of social factors to drive investment in ESG, it is easier said than done. Right now, there is no standardized framework to measure ESG which makes it difficult to compare metrics across companies. Current frameworks that measure ESG factors include but are not limited to: UNGC, SDG, PRI, TCFD, SASB, and GRI. (For a list of all the different frameworks currently use to measure ESG, click here.) Even if companies choose to use one of the listed frameworks, reporting ESG metrics in financial statements is voluntary. The result is that companies report metrics which make them look good and do not disclose the rest. Incomplete information makes it impossible to compare ESG data across companies so that informed decisions in ESG investing can be made. For example, while 64% of S&P 500 companies report carbon emissions, only 12% report the percentage of their energy consumption derived from renewable sources.
Lack of data in the ESG space causes many ESG funds to use exclusionary investing strategies. Exclusionary screening removes companies or industries from investment portfolios that conflict with ESG goals and values, but does nothing to invest in companies that uphold ESG/SRI values. There is nothing inspiring or ground-breaking about exclusionary investing. It is easy to build a portfolio without oil companies. What is difficult is identifying companies that are socially responsible and hold themselves accountable to ESG metrics. This is where the market needs to drive toward a more sustainable future to capture Millennials and Gen Z as they become a prominent market force.
Wall Street Takes Action
While the ESG market is fragmented, there are some institutions that are pushing the envelope in this space. Blackrock CEO, Larry Fink, challenged CEOs to report “high-quality, material public-information” in alignment with the recommendations of the Task Force on Climate-Related Financial Disclosures & Sustainability Accounting Standards Board (SASB) in 2020. From 2020-2021, SASB disclosures saw a 363% increase, demonstrating at least some progress in reporting data. Fink’s argument for building a more sustainable economy hinges on the argument that companies must achieve Net Zero emissions (limited or well below 2 degrees C by 2050) to avoid the risk that climate change poses to the global economy. While Fink’s call to action addresses climate change, it is not comprehensive in addressing the broader social issues we face as a global community.
Citi launched a $200 million Impact Fund to address workforce development, physical and social infrastructure, financial inclusion and sustainability. Here, Citi is pushing the boundaries of ESG by driving large-scale value-based investment versus solely focusing on environmental risk. Other financial institutions, such as Morgan Stanley, attempt to make ESG more accessible to the masses by allowing customers to use ESG filters to inform their investing decisions. While this concept is fundamentally solid, data transparency in the ESG space needs to improve to increase effectiveness and efficiency of the strategy. Still, other smaller registered investment advisory firms are founded solely on impact-driven mission statements which challenge the idea of what investing’s purpose is in the first place, replacing profit-driven priorities with affecting social, environmental, and governmental change through small business loans, mid-sized investments, private equity, and even large-scale venture capital investment.
ESG investing is necessary to build a more sustainable and equitable future. Lack of data transparency poses a huge risk to the future of ESG and must be addressed on a global scale. Data disclosure is not enough. Financial institutions must commit to creativity in the ESG space and challenge the lazy “exclusionary-investment” strategies in favor of companies that address the environmental and social risks posed to our economy. The financial services community must do this not just because clients, stakeholders, and increasingly investors are demanding action, but because it is the only thing to do if our companies are to survive, sustain, and thrive.