ESG - The New Engine of Finance
This article was written collectively by our ESG Analyst Team (Shabir Torabally, Lewis Coward and Adham Khan)
ESG, or Environmental, Social and Governance, is an acronym that may sound familiar to many. It is a collective term that assesses a company’s performance and behaviour. More specifically, it is used by investors, as a set of standards, to measure and evaluate the practices of a business based on these three factors. The main aim, for investors, is to be able to invest in a more ethical and socially responsible manner. Some common examples of ESG factors that could be considered by investors range from a company’s contribution to greenhouse gas emissions to the treatment of its workforce, or even the gender representation amongst the company’s leadership.
In recent years, ESG funds have been gaining momentum in the wake of various environmental, social, and corporate governance crises. As investors become more concerned about the growing risks of climate change, social uprisings and corporate scandals, investments in ESG funds have become more prominent.
According to Bloomberg, in 2020, the global value of assets under management (AUM) by ESG funds reached $35 trillion from about $15 trillion in 2014. This growth is expected to continue in the medium term, with the value of assets held by ESG funds projected to reach upwards of $50 trillion by 2025.
Besides ethical and social considerations, ESG aims to better incorporate long-term financial risks and opportunities. To elaborate, the various categories of ESG provide a framework to measure often abstracted elements which could play a role in the risk and returns of assets. With a focus on the medium to long run, the integration of ESG metrics allows investors to quantify and incorporate downside risks that could potentially erode equity value. For example, a strong ESG score may be indicative of greater reputation or perhaps, greater employee satisfaction and hence talent retention, suggesting that the firm could possibly have greater risk-adjusted long-term returns. In this sense, ESG integration is driven by one of the core principles of investing, which is "to make more money".
In a survey by BNP Paribas showcased below, asset managers were asked to rank 3 reasons why they make ESG investments.
The data suggests that the driving factors of ESG integration are both social considerations and the desire to achieve improved long-term returns. Asset managers listed pressure from the public and other stakeholders among significant reasons suggesting that socio-ethical considerations are a big force at play. Furthermore, regulatory and disclosure demands have also required asset managers to integrate ESG into their investment practices as governing bodies strengthen their fight against climate change. In summary, society’s greater concern for sustainability and climate change is the main driving factor behind the growth of ESG.
In the market, the new generation of investors, in particular, is driving the demand for ESG products given their commitments to sustainability. iShares, managed by Blackrock, currently offers 1158 funds for investors to choose from, 261 falling under the ESG category spanning across the multi-asset, equity, and fixed-income asset classes.
Within an investor’s portfolio, there may be concerns about the risk level when investing solely in ESG-based assets, as there is less diversification. However, UBS AM Quantitative Equities research concluded that in the long run, the risk that comes with ESG-integrated assets is usually priced appropriately, and once adjusted for the risk, the returns on ESG investments are very similar to non-ESG assets.
Overall, the transition from traditional strategies to an ESG-integrated approach does not necessarily damage the return on investment, but it could also offer to promote sustainable socio-economic growth.