Understanding ESG Part 4: ESG and performance

Asset managers and their clients are increasingly incorporating environmental, social and governance considerations – collectively known as ESG – into their investment decisions. This reflects the spectacular rise of responsible investing – an investment ethos that delivers benefits beyond the bottom line and recognises that modern-day investment should be a matter of long-term ownership and sound stewardship.

In this article we explore the relationship between ESG and performance. We investigate how the narrative surrounding this often divisive issue has shifted in recent years and why, not least in light of the COVID-19 crisis, the notion that ‘vice’ beats ‘nice’ no longer holds sway. Crucially, we explain why ESG looks set to further cement its relevance and why it could present growth opportunities arguably unprecedented in investment history.

Flipping the narrative

Historically, the dominant view of an ESG focus’s impact on investment performance was that it must be detrimental. Even a few years ago it was routinely believed that serving the greater good almost inevitably meant sacrificing returns and that ‘vice’ was therefore highly likely to beat ‘nice’.

The purported advantages of so-called ‘sin’ stocks first earned significant attention in the mid-2000s. One of the earliest arguments to emerge from academic studies in this field was that the likes of pension funds should deem it their fiduciary duty to invest in assets such as tobacco and alcohol, irrespective of the broader implications of these products, if the expected returns could be considered unusually high.

This approach was supported by numerous studies. Among the most high-profile was The Price of Sin, published in 2009, which concluded that sin stocks performed better than their more ‘responsible’ counterparts and that institutions should expect to pay a financial cost for not investing in them.

A landmark challenge to this narrative finally arrived in 2015, when the University of Hamburg produced an analysis outlining ESG’s positive influence on corporate financial performance. Drawing on more than 2,000 empirical studies, the research quickly became a touchstone for ESG’s proponents. The idea that a portfolio with an ESG tilt could generate returns comparable with or even superior to those derived from a conventional counterpart transformed the popular view of responsible investing, as did heightened awareness of climate change and other far-reaching crises.

Today, with many ESG funds outperforming during much of the COVID-19 pandemic, the link between responsible investing and attractive returns has perhaps never been stronger or more widely acknowledged. This is not to say that the narrative has been completely overturned and we should now infer that ‘nice’ invariably beats ‘vice’ – but it is to say that perceptions of ESG as a barrier to performance are justifiably disappearing ever more rapidly.

Embracing unprecedented opportunity

Even in the face of the solid performance that it now consistently delivers, die-hard critics have suggested that ESG represents a niche or a fad – or both. Given that it is becoming more and more central to how businesses and policymakers alike view the world, there are compelling grounds to believe that it is neither.

ESG considerations are already transforming many aspects of our day-to-day lives, and they will continue to do so. Maybe nowhere is this more apparent than in the journey to a net-zero economy, which potentially offers a growth opportunity unparalleled in human history.

It has been calculated that the investment needed to achieve carbon neutrality by 2050 could be as much as US$173 trillion. This figure is itself expected to be dwarfed by the returns generated over time. Bloomberg has stated that the net-zero transition will “create enormous opportunities for investors, financial institutions and the private sector.”

Meanwhile, according to the Climate Policy Initiative (CPI), climate finance flows need to go up by almost 600% in order to meet internationally agreed targets by 2030. Echoing Bloomberg’s analysis, the CPI has said: “Climate investment should count in the trillions.” So the journey to net zero is in some ways barely under way – and the scope for growth over the long term could therefore be uncommonly substantial.

In the wake of COP26, the United Nations Climate Change Conference staged in Glasgow in late 2021, global consultancy McKinsey & Company declared that net zero had become “an organising principle” for business. The same might be said about many aspects of ESG. The reality is that ‘doing the right thing’ is now readily associated not only with corporate financial performance but with corporate sustainability – which is why long-term investors may reason that ESG assets are likely to deliver attractive performance not only today but far into the future.

Growth, profit and sustainability

To understand the case for regarding ESG as an ideal basis for long-term investing, it is also useful to appreciate the distinction between momentum and growth. The ESG space has undoubtedly been home to much of the former, but it is the latter that should especially interest those who measure their investment horizons in years rather than in months, weeks or even less.

Broadly speaking, momentum stocks and growth stocks are similar in their capacity to rise faster than the market average. However, momentum can be relatively fleeting – which is why such assets might attract investors hoping to profit from short-term trades – whereas growth should be for the comparatively long haul.

With ESG having migrated from the margins to the mainstream, businesses are under mounting pressure to demonstrate their environmental, social and governance credentials. This can be a source of ESG momentum – but it can also be a source of greenwashing, with companies expressing support for ESG policies and practices but failing to back up their words with meaningful actions.

Such organisations might not deliver desirable performance over the long term, as their business models could prove unsustainable. An authentic commitment to ESG should be much more likely to produce real growth. In the words of Jonathan Webb, CEO of US agricultural technology pioneer AppHarvest: “ESG principles should be at the core of profitability and the foundation for building a resilient, future-proof company.”

Responsible investing is vital to this construct, of course, with investors allocating funds to those businesses that embrace positive change and shunning those that are determined to perpetuate a harmful status quo. The investment community can also use the power of active ownership to encourage an ever-greater ESG focus within investee entities, again furthering the still-evolving trajectory of genuine ESG growth.

Conclusion

In this article we have examined the links between ESG and performance. We have outlined why they are more robust today than ever, why they seem likely to remain strong going forward and why they might become even more resilient over the long term. Importantly, we have explained why the ESG story can be seen as still in its formative stages and why, as the world confronts global challenges such as climate change, the way ahead for investors could be marked by highly significant opportunity and growth.

We have also briefly touched on the phenomenon of greenwashing – the tendency among some businesses to exaggerate their ESG credentials and commitments, resulting in underperformance and even unsustainability. We will return to this topic in more detail in our next article, which will address the complex question of achieving, measuring and demonstrating ESG impact.