The term “sustainability” has found its way into our everyday lives. It has also found its way into the finance world, where it has become one of the main drivers to change investor behaviour.
Even though sustainability seems to be omnipresent these days, there is still a lot of uncertainty, especially when it comes to investments. One of the reasons for this uncertainty is the fact that various terms and definitions are used in its context: environmental, social and governance (ESG), responsible investing, sustainable investing and impact investing.
Why is responsible investing relevant?
When talking about the growing relevance of responsible investments, three key drivers can be identified. The first is performance. Evidence suggests that ESG-focused companies fare better economically, which is mirrored in financial markets by better risk-adjusted returns.
Second, there are the investor’s objectives. Sustainability is a structural force, a shift in our society’s mindset. Consciousness about environmental preservation, climate action and social responsibility has grown, leading to more investors aligning their wealth with their beliefs and values.
The third driver – and this is probably the one that is currently gathering the most momentum – is regulation. Even before the pandemic, companies were already facing significant pressure from regulators to become more sustainable and responsible for their actions.
Do responsible investments pay off?
The short answer is yes, they do. The integration of the ESG perspective improves an investor’s ability to identify and understand the opportunities and risks.
The economic logic is straightforward. First, sustainability in part determines the long-term growth potential of a market and business. Second, responsible practices define an organisation’s quality overall.
ESG leaders are long-term thinkers. They are agile, transparent and accountable. They tend to perform financially better in the long term because they are early in adjusting their strategy to structural change and because they control their everyday operations more closely.
The Covid-19 pandemic has proven this logic to a large extent. There are exceptions and dependencies to the rule. Responsible investing is no recipe for everyday outperformance.
Besides the fundamental quality, there is also a market valuation. There are always phases in which some ESG leaders are too pricey or some ESG laggards seem too inexpensive. So far, this year, oil and gas have outperformed clean energy, but the opposite applied in 2020.
What are the challenges with ESG data?
The evolution of ESG data is pivotal to the evolution of responsible investing. It all began with exclusions of values-adverse sectors such as tobacco because of the simplicity of such an approach and because reliable ESG data was not available.
In the meantime, the comprehensiveness of ESG data has improved significantly. In terms of ESG data, we see three categories distinguished by the point of view and the relevance of human or artificial intelligence: reported, reviewed and processed ESG data.
A sound, reliable and comprehensive process builds on sourcing data from different categories to complement each category’s caveats. Several challenges remain. For example, governments as issuers of bonds require a different framework than corporates. Not least due to less reliable and less comprehensive data, the “ESG-ising” of sovereign bonds lags far behind the process of any corporate stock or bond.
The way forward
Responsible investing, ESG criteria and sustainability are the buzzwords investors can no longer ignore. This theme is here to stay and will shape the future of finance, not least as regulations begin to drive the dynamics.
We see a shift from standardised ratings to customisable themes, in part because at its core, the theme will always rest on individual beliefs and personal values.
There is a strong economic rationale investors should care about: sustainable value creation requires responsible practices. Companies that think long term and take a stakeholder perspective tend to show agility, better control of operations, more prudence with financials and often receive a higher valuation by financial markets.
The journey going forward includes anything but boring tasks: establishing ESG frameworks for sovereigns, which are mostly non-existent today, introducing engagement practices to foster investor responsibility, addressing the various forms of greenwashing and giving a reality check to the narrative that investments have a carbon dioxide footprint.
Norbert Rucker is the head of economics and next generation research at Julius Baer