A growing number of companies now put environmental, social and governance considerations on a par with economic ones
Responsible investment: the evidence stacks up
Sustainable investment is not only good for protecting the world for tomorrow's generations; it can also be a route to superior portfolio returns.
The UAE Government has set a clear agenda to prioritise sustainable investment. As part of Vision 2021, the Green Economy for Sustainable Development initiative launched in 2012 and the Green Agenda 2015-2030 frameworks align the nation’s economic growth ambitions with social development priorities and environmental sustainability goals.
The private sector is following suit. In 2016, National Bank of Abu Dhabi (now FAB) committed to lend, invest and facilitate a total of US$10 billion of financing within the next 10 years to projects focused on environmentally-sustainable activities. And a few weeks ago, DMCC became the first free zone in the UAE to commit to the UN Global Compact, the world’s largest corporate sustainability initiative.
So what constitutes a sound investment or business decision? Less than a decade ago, the answer to that question would have been framed exclusively in financial terms.
But thanks to structural trends such as climate change and higher income inequality, a growing number of companies now put environmental, social and governance (ESG) considerations on a par with economic ones. This makes commercial sense, and for several reasons.
First, as governments around the world gear up to meet the Paris Accord targets on global warming, environmental regulation is likely to become a bigger risk to the bottom line.
Second, the effects of the steady decline in the cost of renewable power and energy storage promise to be transformative, particularly for companies operating in energy-intensive industries such as energy, utilities and transport.
The third incentive for businesses to embrace ESG is consumer power. In recent years, consumers have become increasingly aware of how corporations affect society and the environment. As a result, brand perception and customer loyalty – the non-tangible assets which make up a part of a company’s market value – are increasingly linked with ESG credentials. That applies both to the long-term strategic development of the business, as well as to its day-to-day practices.
Neglecting ESG can inflict lasting reputational and financial damage. Shares in BP, for example, slumped in the aftermath of 2010 Deepwater Horizon oil spill. Volkswagen saw sales fall sharply after the emissions test cheating scandal. And, most recently, Transport for London refused to renew Uber’s operating licence, saying the firm's “approach and conduct demonstrate a lack of corporate responsibility".
Academic research on ESG shows that companies that follow sustainability principles tend to exhibit better and more stable financial performance.
Investors need to take note too, particularly because sustainability leaders tend to deliver stronger risk adjusted returns on equities and debt.
For example, good resource management – from waste to energy consumption – doesn’t just reduce a firm's pollution, but also its production costs. US companies that score highly on climate change management within their industry have delivered higher returns on equity, reduced earnings volatility and shown stronger dividend growth compared to low-scoring peers.
Social and governance credentials also have an impact on the bottom line. Companies with high employee satisfaction ratings have a track record of outperforming their industry benchmarks.
In general, firms that focus on sustainability benefit from a lower cost of capital and higher credit ratings than their peers. Those that have been ineffective in managing environmental risks have, on average, 20 per cent higher borrowing costs. They also tend to have higher cost of equity.
What practical significance does this have for investors? According to one study, every $1 invested in highly sustainable US companies in 1993 was worth $22.6 by 2010, compared with $15.4 for low-ESG peers. Research suggests that, overall, investing in ESG leaders carries no performance penalty and has the potential to boost returns.
And some evidence suggests that the better ESG rating a company has, the less volatile its share price trends to be, particularly in turbulent times.
No wonder, then, that the investment community’s approach to ESG is also having to change. Historically, ESG-oriented portfolios have focused on excluding certain types of companies. But now the investor's role is broadening. An increasing focus is being placed on promoting sustainable business practices through active ownership and engagement, as well assessing the impact of ESG factors on companies’ valuations, returns and creditworthiness.
That is not to say investors should focus exclusively on ESG leaders. Within moral and legal limits, there could still be a case for investing in well-priced sustainability laggards, as long as their future potential outweighs the risks.
As well as shaking up existing industries, the rise of ESG is opening up new opportunities for business and investment. For example, we forecast that the environmental products industry will grow by 6 to 7 per cent per year until 2020 – more than twice as fast as the global economy as a whole.
ESG analysis, therefore, can be a route to identifying companies with strong growth prospects, efficient cost management and the right attributes to win brand loyalty from an increasingly demanding public. Conversely, it can also help avoid falling foul of changes in economic trends, consumer preferences and government regulations.
Sebastien Eisinger is the head of investments for Pictet Asset Management