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Abu Dhabi, UAETuesday 21 August 2018

Environmental, governance and social investing goes mainstream

As ESG becomes more commonplace and the de-facto standard of investing, investors will reward “green” companies

Water flows through sediment retention ponds built to reduce heavy metals and chemicals at a US mine. Green issues will become more important for investors. AP
Water flows through sediment retention ponds built to reduce heavy metals and chemicals at a US mine. Green issues will become more important for investors. AP

Financial data, such as profit margins and revenue targets, will always be a vital guide to future business success. But more and more corporations around the world are equally prioritising investments in environmental, governance and social (ESG) concerns, as they realise just how fatal reputational damage can be for raising capital.

ESG has become one of the fastest growing segments in international investment, with assets embedding these factors growing at a pace of around 12 per cent per year. The speed and scale of ESG’s ascent are reminiscent of the surge in popularity of passive investment, which has boosted global ETF assets ten fold since 2005.

ESG considerations are expected to be incorporated into over half of all global assets under management by the end of this year. If the current pace of adoption holds, by 2020 the share will be two thirds (although not all of these will have embraced sustainability with equal depth).

Backed by regulatory support – whether that’s from financial watchdogs keen to promote more stringent corporate governance implementation, or governments keen to fight climate change and pollution – ESG clearly has the potential to become the “new normal” for the investment world.

If that happens, companies will need to embrace ESG to attract customers and investors in the new, sustainability-conscious world. This should also help them avoid sudden and potentially costly official intervention.

The risks of doing nothing can be high, as five of the world’s largest oil companies found out in January 2018 when the City of New York filed a multibillion-dollar lawsuit alleging the industry contributed to global warming. The case is just one of many: there are now well over 100 climate-change litigation cases a year.

Such pressures raise the corporate value of legitimacy and social trust. Tech companies, for example, are already stepping up data privacy controls; in future they could self-regulate content and cooperate with governments on national security issues. Food and drinks makers, meanwhile, are under pressure to ease strains on public health provision, through taxes on junk food and targets on calorie content.

The ascent of ESG won’t stop here. “Robot taxes” could attempt to compensate for the loss of jobs through automation, and businesses may have a role to play in any universal basic income provisions to combat income inequality. This is already being explored by pilots, including one spearheaded by Facebook co-founder Chris Hughes, in Stockton, California.

Corporations that improve their sustainability credentials can reap substantial financial rewards. Academic studies link positive ESG attributes to reduced earnings volatility and higher future return on equity, which over the long term should support a company’s market valuation. For investors, that tends to translate into lower volatility of returns.

ESG concerns also influence the cost of capital – both equity and debt. Notably, Standard & Poor’s has cited environmental risks as the main or contributing reason for 299 corporate rating revisions over a two-year period.

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As ESG goes mainstream and becomes the de-facto standard of investing, investors will reward “green” companies at the expense of their less sustainable peers, both by favouring them in asset allocation and by attaching a higher value to their intangible assets. This will have direct cost of capital repercussions.

If the financial arguments for sustainable investing – that it ultimately selects stronger, more future-proof companies – hold up, then businesses which do not pass muster will deliver lower returns. This, in turn, will fuel investor outflows on fundamental rather than purely ethical grounds.

Additionally, there is a case to be made for index providers to exclude some companies – such as manufacturers of controversial weapons – from mainstream indexes, in line with what is becoming market practice among investors. This could make it much harder for such businesses to find financing. The impact of any such move would be all the more significant given the recent growth of passive investing.

There is the potential to create a virtuous circle, where a focus on sustainability ultimately rewards companies and their investors as well as easing some of the strains on our world. But that can only happen if ESG is applied in a robust way, beyond mere lip service.

Challenges include the need for rigorous, standardised reporting – for private and public companies – which accurately measures sustainability achievements.

There are signs that governments are supportive of the need for such change. Faced with conflicting forces of fiscal constraints and growing social spending needs, authorities are increasingly encouraging both corporates and investors to embrace ESG principles.

With perseverance, better governance could deliver its own rewards.

Laurent Ramsey is chief executive and group managing director at Pictet Asset Management

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