A closer look at ESG Investing
Halfway between traditional philanthropy and return-driven financial investment, ESG investing – i.e. directing capital to companies which yield environmental, social and governance benefits in addition to profits – enables investors to “do well by doing good”. Lying within the broad range of responsible investments, ESG can be virtually any asset class or investment vehicle.
First coined in the 1960s in reference to the portfolio exclusion of companies involved in tobacco production or the South African apartheid regime, ESG investments are nowadays part of an exponentially growing market, fuelled by the rising public awareness of climate change and the diversification benefits it provides. The PWC’s 2022 report on European mutual funds, The Growth Opportunity of the Century, estimates the size of the European ESG market at €1.7 trillion in 2019 with an estimated CAGR of 14.3%, almost twice as much as non-ESG investments’ CAGR. Other estimates forecast that ESG mandates will govern 95% of total managed assets by 2030(1).
Following this trend, a growing number of responsible investment strategies have emerged. Called “Socially Responsible Investing”, “Impact investing” or even “Sustainable investing”, they share the underlying desire to offer a financial return while being in line with an investor’s conscience. This article will provide an overview of different strategies and look at the challenges facing ESG investments.
ESG, SRI, and Impact Investing: Which investment for which strategy?
From our old finance classes, we remember H. Markowitz’s Modern Portfolio Theory (which is now modern only in its name) and the need for diversification. Institutional investors remember the theory particularly well since it still shapes the way they integrate investments into a client’s portfolio – through the incorporation of additional risk factors. Hence, with the rising demand for responsible investments, banks and institutions started creating different types of alternatives. ESG, SRI or impact investing appeared, and whereas they look largely identical, they have considerably different approaches which can affect the global footprint of one’s portfolio.
Renowned institutions (MSCI, PRI, …) have specific definitions for each of them. Broadly we can recognize the following 3 investment strategies:
- Socially Responsible Investing is recognized as a negative screening strategy which excludes “businesses that conflict with the investor’s values” – firearms, tobacco, alcohol, fossil fuel, etc. It is the simplest and often least expensive value-based investing approach.
- ESG investing is, on the other hand, recognized as a positive screening strategy which focuses on companies “making an active effort to either limit their negative societal impact or deliver benefits to society”. The investment decision is generally derived from companies report on ESG criteria.
- Impact investing is recognized as going even one step beyond ESG investing by directly connecting the investor’s capital to his or her own priorities. The selected companies and projects shall not only limit their negative societal impact but actively seek an “impact thesis”, clearly stated, measured and disclosed.
The table below demonstrates the pros and cons of each approach:
Challenges for a sustainable growth
For ESG investments to achieve an appropriate capital allocation, two main challenges need to be addressed. First, the lack of regulations concerning the responsible investment labels. Indeed, following the growing demand for responsible investments, major investment banks have expanded their offerings, often with their own terminology and definition of a “social and environmental benefit”. Albeit EU’s ongoing efforts to develop a strong sustainable regulation, this “alphabet soup”(2) often leaves the investor with the responsibility to verify the validity of the expected benefits.
Second, integrating a company within an ESG portfolio is often subject to interpretation. Whereas investment banks easily find tools to estimate an asset’s expected financial yield, they lack a standardized counterpart to measure social and environmental benefits. In fact, accustomed to building new considerations as additional risk factors, the main issue with responsible investments comes from the validity of the data gathered. As primarily soft data(3), the consistency and comparability of ESG information from companies is poor.
The lack of national reporting standards leaves companies to determine which ESG factors are integral to their business and what information to disclose to investors. ESG data providers, such as Sustainalytics and MSCI, try to address this deficit by providing an ESG score for companies based on their own practices. Naturally, different methods are conducted and these discrepancies lead to considerable variations for a single company. A research conducted by State Street Global Advisors established a 0.53 correlation coefficient for Sustainalytics and MSCI ratings across companies inside the MSCI World Index. Other correlations across company credit ratings have generally been above 0.9.
Aimed to direct private capital towards sustainable development, responsible investments, with almost €35 trillion AUM globally (2020)(4), are in the front line to limit the negative effects of human activities. However, the social and environmental impacts of such investments is sometimes unclear and misleading. In fact, the lack of regulations and standardization amongst responsible investments are strong challenges that persist despite increasing awareness of environmental problems.
As part of the EU Sustainable Finance Agenda (2018), the European Commission has introduced several measures to mitigate these risks. From the Ecolabel to the Sustainable Finance Disclosure Regulation (SFRD), the Commission has developed European standards and enhanced disclosure on a broad range of sustainability metrics. However, company compliance keeps falling below expectations. Around 80% of funds labelled “light-green” under SFDR are investing in fossil fuels companies, and in a few cases fossil fuels account for more than 50% of the fund’s portfolio(5). Other recent measures, including the EU Taxonomy, have emerged in the last months with the aim of addressing such challenges and providing stronger transparency across the European Union.
Much remains for ESG investments to meet expectations and fuel sustainable growth. Sustainable growth will only be achieved once the impending issues are resolved in a way that increases transparency and accountability among investors. Regulatory bodies have a great role to play in defining and protecting the exponentially growing trillion-dollar market. ESG investments are here to stay but their full positive impact is yet to be seen.
Authors: Théophile Grand
(1) Deutsche Bank, Big data shakes up ESG Investing, 2018
(2) IFC, Creating Impact, The Promise of Impact Investing, 2019
(3) Soft data are data that are difficult to measure and express, generally gathered from assessment, opinion, interpretation or experience.
(4) Bloomberg, ESG assets may hit $53 trillion by 2025, a third of global AUM, 2021
(5) Capital Monitor, Is SDFR failing ? Eight in ten ‘sustainable’ funds in Europe hold fossil fuel stocks, 2021
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Big data shakes up ESG investing. (2018). Deutsche Bank.
Bloomberg – ESG assets may hit $53 trillion by 2025, a third of global AUM. (2021). Bloomberg Intelligence. https://www.bloomberg.com/professional/blog/esg-assets-may-hit-53-trillion-by-2025-a-third-of-global-aum/
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CREATING IMPACT – The Promise of Impact Investing. (2019). International Finance Corporation.
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Investing for Impact: The Global Impact Investing Market. (2020). International Finance Corporation. https://www.ifc.org/wps/wcm/connect/publications_ext_content/ifc_external_publication_site/publications_listing_page/impact-investing-market-2020
Maguire, E. (2021, July 25). ESG vs. SRI vs. Impact Investing: What’s the Difference? Kiplinger. https://www.kiplinger.com/investing/601240/sri-vs-esg-vs-impact-investing
Meager, E. (2022, February 21). Is SFDR failing? Eight in ten ‘sustainable’ funds in Europe hold fossil fuel stocks. Capital Monitor. https://capitalmonitor.ai/institution/government/is-sfdr-failing-eight-in-ten-sustainable-funds-in-europe-hold-fossil-fuel-stocks/
The Evolution of ESG Investing. (2020). MSCI. https://www.msci.com/esg-101-what-is-esg/evolution-of-esg-investing