Ireland’s Michael D’Arcy expects ESG to win more fans despite difficult 2022

Despite challenges in 2022 and lack of clarity around definitions of what constitutes a sustainable investment, research shows companies with good ESG credentials have good financial performance, writes Michael D’Arcy, CEO of the Irish Association of Asset Managers.

The managers of more than 30% of professionally managed global investments now consider ESG factors at some level, and many incorporate them into each and every investment decision.

That’s a lot of financial muscle and what’s really interesting is that, in a world where governments are turning more inward, capital flows are becoming more outward-looking and, to a meaningful extent, are starting to tackle cross-border challenges such as climate change, resource scarcity and biodiversity, as well as industry and company-specific issues relating to equality, labour conditions and of course corporate governance.

For example, many large institutional investors have started to transition their portfolios away from fossil fuels and some have already made that transition completely.;

Retail and high-net-worth investors are also increasingly looking for ways to make their investments work towards the achievement of a more sustainable global economy and in the past few years, there’s been an exponential increase in the number of ESG-themed funds in both public and private markets.

At the same time, we’re seeing a top-down impetus with regulators engaging in a meaningful way on ESG, and government policy is shifting very quickly with green stimulus packages in all regions, most recently the Inflation Reduction Act in the US.

Increase in UNPRI signatories

Ten years ago, there were 890 signatories to the United Nations-backed Principles for Responsible Investment, representing $24 trillion in assets. At the end of last year, that figure had grown exponentially to 3,826 signatories who collectively represent $121.3 trillion in assets and the majority of the world’s professionally managed investments.

So, momentum is not just being driven by the regulators or the product providers – the real driver is asset owners who are looking to get capital to the right places – and make good risk-adjusted returns while doing so.

We’ve seen strong leadership from certain US states, such as some of the funds in New York, New Mexico, California and Hawaii, as well as the Swedish state funds, the massive GPIF in Japan and many more. This is being reflected in their investment portfolios in terms of the mandates they are issuing to tender – for example, increasingly, they are expected to be fossil-fuel free, incorporating measurement and reporting of ESG factors, alignment with Sustainable Development Goals and more recently going as far as to have targeted reductions in carbon intensity in equity portfolios.

Ireland also became the first country globally to divest public monies from the fossil fuel industry, so we are seeing government policy shifting to leverage the change in investor awareness.

There is lots of momentum, and all for the right reasons. Of course, it’s not a one-way street; there are still many investors who see responsible investing as being more costly and as limiting investment choice.

At the extreme end of the spectrum, we’ve seen pushback in the US, where there are polarised views between red and blue states. Maine is an example of a state that has ordered state funds to fully divest from fossil fuels. On the other hand the Texas state comptroller is required to maintain a list of financial companies that are seen to ‘boycott the fossil fuel industry’ – all government investment funds must pull their investments from these companies within 12 months of being added to the list (including the Texas Retirement System which is one of the biggest public pension funds in the world).

Such cases are proving to be more the exception. On balance, the business case for responsible investing is hugely compelling, with moral, economic and technological forces all aligning.

What is driving this change of mindset?

Investment decision-makers in both institutional and retail segments have always been seeking the best possible risk-adjusted returns in their long-term savings. The difference now is that, especially amongst the younger generation of decision makers, they’re looking not just at how much purchasing power their savings will command in the future but also what that future world will look like.

There’s also a growing realisation from corporate leaders that if they don’t consider the long-term impact of their actions they will be punished by markets, and those who do address it will be rewarded.

The risks of inaction are increasingly stark and well-understood.

Between 2030 and 2050, climate change is expected to cause approximately 250,000 additional deaths per year from malnutrition, malaria, diarrhoea and heat stress, says the World Health Organisation.

If left unchecked, climate change could cost the global economy US$178 trillion over the next 50 years, or a 7.6% cut to global gross domestic product in the year 2070 alone. Of course, all things are not equal, and if Miami or a country such as Bangladesh is permanently flooded, then that region or country faces a 100% impact.

Most importantly, there is a growing acceptance that it will cost less to take action than do nothing. Estimates from the World Bank find that climate inaction could reduce global GDP by at least 5% annually while the price of necessary action is 1%.

This would result in devastating human cost but also long-term investors may get much reduced returns if the global economy is severely damaged, as is likely, by climate change. In other words, focusing on climate change makes sound financial sense.

Net-zero is “greatest commercial opportunity of our age”

However, long-term investors don’t just look at risk – they are, most importantly, looking at returns also.

There are compelling investment opportunities to invest in companies providing solutions to global resource challenges, which, many analysts believe, will offer a long-term source of secular outperformance. Former Bank of England governor Mark Carney has said that moves to net zero will create “the greatest commercial opportunity of our age”.

So, mindsets and behaviour are changing – as is the thinking on fiduciary responsibility, which in the past was seen as a reason not to adopt responsible investing principles. It is now widely accepted that it may be a violation of fiduciary duty not to consider ESG factors in building portfolios because, if not adequately addressed, these long-term societal challenges will impact on corporate profitability and valuations.

While ESG investing has many facets, it is clear that climate change and decarbonisation are absolute priorities. This is an area where the investment management industry is responding and showing leadership – significantly, this is evidenced by the Net Zero Asset Managers initiative, which is 291 asset manager signatories representing nearly $66 trillion with the aim of achieving net zero emissions in portfolios by 2050 or sooner.

What ‘s behind ESG underperformance in 2022?

There’s no doubt that recent events are making asset owners and investors more aware of how and where their capital is being deployed. There is certainly a lot of dislocation in markets currently, with rising bond yields, a global energy crisis, war in Europe, supply chain challenges and inflation at the highest level in many decades.

Against this backdrop, some commentators point to the fact that ESG investment strategies generally have underperformed during 2022. This is mainly attributable to two factors.

The first is that traditional energy stocks, which are normally excluded from ESG portfolios, have outperformed – especially during the first half of 2022. This is an inevitable short-term consequence of recent events. Short term, we are seeing more tolerance for transitional energy sources such as gas and nuclear, with some decommissioning plans for fossil fuel facilities likely to be stalled, as in the case of Moneypoint in Ireland.

In recent months we have started to see some rebalancing as investors take a longer-term focus and recognise that longer-term energy security and supply issues can be addressed by accelerating the transition to renewables. Of course, most governments and policymakers also recognise this and are themselves under pressure to achieve net zero targets – to support this, they will look to maintain a stable regulatory regime for companies in renewable space in order to encourage investment.

Market rotation from growth to value

The second factor in ESG underperformance is that we have seen technology stocks, which typically score highly on ESG criteria, underperform during a market rotation from growth to value stocks. This has led to relative underperformance of some ESG strategies – particularly those which tracked the benchmark indices.

While much has been made of the fact that fund flows are down on previous years, ESG funds are still attracting more investment than others. Morningstar research shows that $120 billion was invested in ESG funds in the first half of this year and while down a third of flows over the same period last year, broader market funds saw net outflows of $139 billion for the same period.

These numbers, for the most part, exclude the large institutional investors who normally invest in direct portfolios across the various asset classes rather than funds. While short-term capital flows from these massive investors are not as readily available there is definitely increasing momentum in terms of new ESG mandates being put to tender. It is also very significant that the global investment consultancy firms that provide advice to institutional investors are committing more resources to ESG research activity and are rating investment managers on their ESG capabilities.

Are listed companies changing behaviour?

Think about it. By considering a company’s ESG criteria asset managers are getting a much better picture on its risk profile.

Companies acting inappropriately are now being called out by increased shareholder activism, regulatory sanctions or even divestment by ESG-focused asset owners. All are bad for business and likely to result in higher cost of capital.

Research from Sustainalytics found companies that experienced high to severe ESG incidents lost 6% of their market capitalisation on average.

While it varies across regions and market capitalisation segments, there is clear evidence that changing capital allocations are having an impact on corporate behaviour and business models.

In Europe, firms such as RWE and Veolia are undergoing massive transitions. Another good example is Italian firm, Enel, which historically was a large-scale manufacturer and distributor of electricity and gas. For several years the company has had interactions with the investor engagement group CA100+, which has ultimately resulted in a revised strategic plan accelerating its investment in renewables and phasing out coal production. Significant climate-related announcements at its capital markets day in 2021 included bringing its net-zero emissions commitment across all scopes forward by ten years, to 2040.

While there is still some way to go on ESG-related disclosures, more than 90% of S&P 500 companies now publish ESG reports and around 70% of Russell 1000 companies do so.

We are likely to see a lot of regulation around ESG-related disclosures over the next few years, which will give investors much-improved transparency. As this evolves, investors looking to implement responsible investing strategies will focus on firms that have a commitment to science-based targets, especially in the more challenging sectors, and will retain a healthy scepticism to the more aspirational statements of intent from corporates looking to ‘greenwash’.

Sustainability-focussed funds generate returns for investors

Determining whether sustainability-focussed investments perform better or worse than “mainstream” investments is not easy to determine, as much depends on the start date/time period chosen and the exact definition of “sustainable” investment, especially given that there are many ways of integrating sustainability into investment decisions and investment portfolios.

However, several pieces of research indicate that companies with good ESG performance also have good financial performance. Interestingly, one study (published by the academic Journal of Sustainable Finance and Investment) combined the findings of about 2,200 separate earlier studies, creating the most exhaustive overview of academic research on the topic, and it found that the business case for ESG investing is “empirically very well founded”, as roughly 90% of all studies found a material relationship between ESG and corporate financial performance.

Also, moving from the academic to the practical, more than half (56%) of US sustainable funds beat rival category groups in the three-year period to the end of September 2022, according to researchers at Morningstar.

According to Hortense Bioy, global director of sustainable research at Morningstar: “Sustainable fund flows are more resilient in times of market volatility than their traditional peers as ESG-focused investors — who are typically more values-driven and long-term-oriented — are slower to pull money from the funds they are invested in.”

*Michael D’Arcy is chief executive officer of the Irish Association of Asset Managers.

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