ESG Is Not Enough - Part I: What Makes an Investment Successful?
Author: Anas Attal | Editors: Massiel Valladares, Isabelle Pierotti, Saeyeon Kwon | Managing Editor: Jaishree Singh
Investing in Environmental, Social, and Governance (ESG)-oriented companies has proliferated over the past decade, becoming a trillion-dollar industry. This trend is likely to grow at a higher rate in the coming years due to regulatory, legal, reputational, and market risks.
Contrary to recent negative sentiments from U.S. states such as Texas, Georgia, and Florida, ESG investments generate impressive financial returns and could leave a positive social and/or environmental impact.
A 2022 PwC report shows that the total amount of ESG assets under management (AUM) globally reached $18.4 trillion in 2021, up from $2.2 trillion in 2015. This figure is expected to reach $33.9 trillion in 2026 under a baseline scenario, accounting for 21.5% of all AUM. Impact investment in North America alone is forecast to reach $10.5 trillion in 2026, compared to $0.8 trillion in 2015. The surging demand is prompting asset managers to increase the supply of ESG funds, as nine out of 10 institutional investors stressed the need to develop new ESG products in the coming years, according to the same report.
Lowering the Cost of Capital
Companies implementing ESG measures reduce regulatory, environmental, and litigation risks, enabling them to secure capital at a low cost and have a higher valuation. McKinsey concluded that a better ESG score led to about a 10% lower cost of capital. Furthermore, a global provider of financial and portfolio analysis tools MSCI indicated in 2020 that companies with high ESG scores tend to secure capital, equity, and debt at a lower cost than those with low scores. MSCI also found that a lower cost of capital is more likely to lead to higher valuations when comparing high-ESG-scoring MSCI-selected stocks to the traditional market-cap-weighted MSCI Index analyzed from 2011 to 2019.
How Have ESG Funds Performed Financially?
A 2015 Oxford University and Arabesque Asset Management report showed that sustainable business practices led to better operational performance in 88% of 200 studies evaluating impact investing outcomes. The report further indicated that higher operational performance usually translates into greater cash flows. A Global Impact Investing Network (GIIN) report disclosed that 88% of 294 impact investors surveyed met or exceeded their financial return expectations. Furthermore, 99% indicated that they met their impact expectations.
Financial gains from impact investments require a commitment to realize the intended objectives and financial goals. U.S. financial services firm Morningstar revealed that 80% of impact funds outperformed traditional ones over 10 years. Data reveals that ESG funds are more resilient than non-ESG funds over long investment periods and are better able to weather market volatilities, as 77% of impact funds survive over 10 years, compared to 46% of traditional funds, according to Morningstar.
What Makes a Fund Resilient & Financially Successful?
Financial professionals use “ESG” as a catch-all-term for resilient, long-term investing, but they should properly understand each type of risk and opportunity (aka types of “capital”). Material risks across most industries include regulatory, legal, reputational, and climate risk.
Source: Our World in Data
The number of US companies publishing sustainability reports and meeting the minimum requirements reached 475 in 2020. Regulatory and legal risks as well as market opportunities will likely drive more companies to adopt sustainable practices.