Why ESG criteria and sustainability are buzzwords investors can no longer ignore.
The term “sustainability” has found its way into our everyday lives, be it through the food we eat, the clothes we wear, or the means of transport we use. The term has also found its way into the finance world, where it has become one of the main drivers to change investment behavior. Even though sustainability seems to be omnipresent nowadays, there is still a lot of uncertainty, especially when it comes to investments. One of the reasons for this uncertainty is the fact that various terms and definitions are used in its context: ESG, responsible investing, sustainable investing, or impact investing.
Responsible investing began as a very simplistic approach based on the exclusion of companies that are harmful to society or the environment, like the tobacco industry. Back then this strategy was often referred to as a “socially responsible investment” with a focus primarily to align portfolios with values and ethical considerations. Over time, with broader investor interest, a shifting focus from values to performance and the improved toolset with regard to data availability and quality, among other things, responsible investing became what it is today, a framework that in its core is all about the integration of the Environmental, Social and Governance (ESG) perspective into investment processes.
Despite the political common grounds such as the UN’s Sustainable Development Goals (SDGs) or the Paris Agreement, sustainability in its core is subjective rather than objective and is a key characteristic that will become more crucial as responsible investing gains in importance for investors from different cultural backgrounds. As a consequence, the integration of the ESG perspective is expected to shift from ratings, which are used to standardize and simplify, to themes, which become building blocks for alignments with individual preferences. Such themes cover certain aspects of interest such as climate, natural capital, governance, or diversity, and they are enabled by the further evolution of ESG data, which goes beyond the usual economic and financial perspectives to provide a toolset that broadens and sharpens our understanding of what we are invested in, and the trend towards using artificial intelligence for data creation. The journey going forward includes anything but boring tasks: establishing ESG frameworks for sovereigns, which are mostly non-existent today, introducing engagement practices to foster investor responsibility, addressing the various forms of green-washing and giving a reality check to the narrative that investments have a CO2 footprint.
ESG criteria especially have created quite a buzz around the world lately yet many investors are beginning to recognize the value of integrating them into their portfolios without fully understanding them. When talking about the growing relevance of responsible investments, three key drivers can be identified. The first is performance. Evidence suggests that ESG-focused companies fare better economically, which is mirrored in financial markets by better risk-adjusted returns. Second, there is purpose. Sustainability is a structural force, a shift in our society’s mindset. With the help of technology and social media, consciousness about environmental preservation, climate action, and social responlity has grown. This change in people’s mindset and values is also spilling over to the investment world, changing the way investors make investment decisions. Today’s investors are seeking to achieve not only a financial return, a profit, but also to channel their wealth in a way that makes a difference in areas that matter to them—a purpose. The consequence is an increased reward as doing well and feeling good come together. While the former is objective, the latter is subjective. The third driver—and this is probably the one that is currently gathering the most momentum— is regulation. Even before the pandemic, companies were already facing significant pressure from regulators to become more sustainable and more responsible for their actions. The corporate and finance world have key roles to play to support common political visions such as the Paris Agreement or the UN’s SDGs, and the pressure to do so is set to increase. The European Union’s sustainable finance and taxonomy efforts serve as a good example.
CEO at Bank Julius Baer Monaco Albert Henriques with chairman
of the board at Julius Baer Wealth Management (Monaco) Bruno Dumitrescu and executive director Samantha Avizou-Durante, Julius Baer sustainability ambassador.
But does responsible investing pay off? The short answer is yes, it does. There are exceptions, of course, and dependencies to the rule. The integration of the ESG perspective improves an investor’s ability to identify and understand the opportunities and risks. The economic logic is straightforward. First, sustainability in part determines the long-term growth potential of a market and business. Second, responsible practices define an organization’s quality overall. ESG leaders are long-term thinkers, not short- term tinkers. Beyond the shareholders’ interests, they also care about all the stakeholders. They are agile, transparent, and accountable. Companies that embed these characteristics in their culture and their practices tend to perform financially better in the long term, because they are early in adjusting their strategy to structural change and because they control their everyday operations more closely.
The corona crisis has proven this logic to a large extent. When push comes to shove, the leaders can outgrow the laggards, as they are less distracted by fixing balance sheets and redefining strategies. In addition, responsible practices tend to resonate in lower risks of being caught up in a scandal leading to reputational backlash, litigations, and financial risks.
The investment logic is straightforward too. Financial markets value the likely economic success of ESG leaders, and their likely reduced risk profile. The corona crisis has largely confirmed these assumptions. Such strategies outperformed their benchmarks. However, responsible investing is no recipe for everyday outperformance. There is always a price for every asset, and especially the rally over the past months pushed valuations in some sustainability-related market niches to rather stretched levels.