Our latest CIO special report looks at the changing landscape of ESG investing, what to expect in future and the portfolio management implications.
We argue that:
- ESG investment has moved to a new third phase characterised by a degree of consolidation and reorientation. Information will be key to this phase.
- Managing the ESG transformation will involve achieving consensus on ESG definitions, and multiple initiatives for improved disclosure will continue.
- There is also likely to be a greater focus on measuring the “real world” impact of ESG investment and better understanding the different types of associated risk.
Introduction
ESG investment has moved in recent years from a niche concern to a central consideration for many investors. After the first two ESG investment phases – of acceptance, then rapid growth – we have now entered a third stage.
This third phase of ESG investment is characterised by a degree of consolidation and reorientation. Investors are becoming increasingly conscious of ESG investment performance – both in terms of financial returns and “real world returns” (i.e. positive effects on the world around us).
Information will be key to this third phase. It has always driven expectations about the two traditional investment dimensions of business and economic development. Information will also now allow us to assess the new third dimension to investment: the limits that a deteriorating natural environment put on how investors and companies can act. This exogenous reality of environmental (E) collapse may also demand a different approach that more endogenous social (S) and governance (G) concerns.
ESG represents a major shift in the social, economic and financial environment, and such regime shifts always raise questions about how investors should assess them. As this report notes, there have been many studies into the effects of ESG on investment returns, but any deductions here still need to be carefully qualified.
As with any investment, the relative performance of ESG investments will of course be dependent on what you are comparing them against and on the time period chosen. One example of the difficulties that investors face in evaluating performance is that ESG investment ratings vary between rating agencies and have also changed over time.
So, for all these reasons, any analysis or presentation of ESG performance needs to be treated with great care. Similar measurement issues apply to comparisons of ESG assets’ relative volatility.
So why invest on an ESG basis? One initial response might be that it is better to invest in firms that are trying in some way to address the complex environmental and social challenges faced by the world, rather than those firms that appear to be ignoring them.
This altruistic (if perhaps simplistic) response is likely to be supported by practical considerations. We think that companies with strategies to address environmental, social and governance issues are likely, in general, to prove better at navigating an increasingly complex environmental and regulatory environment.
From a portfolio perspective, this ability of firms with ESG strategies to navigate a difficult environment may be valuable. Conversely, investing in firms without a coherent ESG strategy may result in a bumpy ride over the longer term, with less ESG- compliant firms struggling to adapt to regulatory and other developments. If this results in more chopping and changing of investments to replace non-performers, this will have costs for a portfolio – not least because “market timing” mistakes in entering or exiting investments can be expensive.
Clearly, over the short-term, ESG strategies can however underperform. This has been evident in 2022, with many ESG strategies lagging their traditional non-ESG peers. This has been mainly due to the fact that energy and defence-related companies (gainers from the ripple effects of the Russia/Ukraine war) are often excluded from ESG strategies.
ESG investment will continue to evolve. Provision of more standardised data is only a first step and debate about how best to incorporate ESG into investment processes will continue: ESG is increasingly seen as an additional level of quality assessment on top of traditional economic and financial metrics. Issues such as risk need very careful definition and analysis, for reasons we discuss below. Investors will also continue to look for new ways of measuring the real positive effects of ESG investment on the world around us (e.g. on biodiversity, and via understanding “nature as capital”).
But this is a journey that you need to be part of: ultimately, all investment is ESG investment. Whatever the exact extent of future global temperature rises or biodiversity loss, environmental issues will not go away and social and governance factors will also stay under the microscope. Against this background, it is rational to take non-financial factors into account when assessing investment, and digitalisation makes accessing the information to do this easier. ESG investment has become an effective way of adapting portfolios to this new global reality.
