These funds have different investment mandates, but they all aim for the same value proposition: a lower risk profile with higher ESG standards. The problem with ESG investing is that some investors want to take ESG factors into account but may not want to be excluded from investing in particular sectors where ESG performance is questionable.
This leads to a dilemma, for example, for funds with very long-term objectives, such as pension funds or sovereign wealth funds, that have a duty to grow their values over the very long term, while making investments which fit with the strategies of their owners – the future pensioners or the states. Should they invest in companies with proven good ESG credentials, or should they invest more widely but exert pressures on the companies in which they invest to improve their ESG performance?
This article looks at how attitudes to ESG investing have shifted, what impact this may have on investments, and how investors can navigate these changes so as to influence the companies in which they invest.
An ESG approach to investment is based on the belief that investors can improve the world by choosing where to invest. There are several ways to incorporate ESG considerations into investment management.
One popular mechanism is an ESG fund. In the inclusion approach, funds identify companies that meet certain social and environmental standards and invest in them. The exclusion approach finds certain characteristics associated with negative ESG performance (e.g. companies particularly associated with extracting or using fossil fuels) and channels investment towards firms without these characteristics. The thematic approach identifies longer term trends that fund managers believe will support improvements in ESG performance e.g. using solar or wind energy. This approach might be particularly useful for very long-term investors of the kind mentioned above.
As investors realized the potential for ESG investing, more funds were launched, more fund managers entered the space, and more research was completed. Investment managers had high hopes for ESG as a new investment class; some even predicted that ESG investing would soon overtake traditional asset management as the dominant type of investment. The investment community soon became frustrated by the sheer volume, complexity and sometimes opaqueness of ESG funds and with the quality of the research about them and the companies in which they invested. Also, there was a contradiction between the longer-term aims of some ESG investors and the exhortations of some analysts that ESG investing was a route to a quick killing. As a post by the Harvard Business Review identified, ESG investing does pay off but demands a different, more comprehensive and longer term view to be taken.
The first wave of ESG investing created a big demand for sustainable/green assets and drove down their relative returns relative to non-sustainable/brown assets because of the former’s consequent higher prices. Meanwhile, the greater complexity of ESG investing drove up the costs of asset managers. However, some responded by launching low-cost ESG funds, some of which combined good returns with low costs. Not all these funds were good investments, but they did provide an affordable alternative to more expensive investments. As the market matured and supply increased, prices fell back toward more traditional valuations. Low-cost ESG funds have now become a popular asset class.
The success of ESG investing has led to an undersupply of funds, according to a report from PwC, and arguably under-supply of high quality research. One problem with ESG investment is the higher cost of compliance, in turn based on the need to show that descriptions of the ESG performance of firms invested in are accurate. The most likely scenario for ESG funds is a maturing of the market, with returns matching those of other funds with similar risk profiles, together with improved research coverage.
The initial excitement around ESG investing led to creation of a big investment class, initially unsupported by enough high-quality data and research, and sometimes contaminated by greenwashing ESG. As the market matures and increases in transparency and variety, we expect it to become easier to make ESG-focused investment. We can expect investors to be more informed and decisive about whether the funds they invest in should be inclusive, exclusive or thematic. Behind this improvement in the market must be a significant improvement in the supply of data about corporate ESG performance, plans and their fulfilment.