ESG Investing: A Futuristic Responsible Investment

To address the global ecological issues and in line with the Sustainable Goals of the United Nations, Environmental, Social and Governance (ESG) has been increasingly gaining traction. ESG is the underlying criteria of measuring financial operations and investments by the companies worldwide. ESG measures the social and ethical impact of an investment by a company. This article underscores the radically changing priorities of global investments over time to more sustainable, socially responsible investments for long term financial success of an organisation. ESG funds are getting increasingly popular amongst investors who wish to contribute towards cutting global warming and human development, without compromising on the financial returns.

Briefly, ESG factors can be perceived as :

Ideally, an ESG Fund should be a combination of only those securities which have scored high on their sustainability and should exclude companies which have a dismal or unsatisfactory approach towards sustainable factors e.g. causing environmental pollution, improper employee management or unsound management practices.

ESG factors are highly considered in the longevity or sustainability of a company. In other words, companies that follow high quality environmental, social and governance standards are more likely to outperform their peers in the long-run.

A study by MSCI reveals that companies with higher ESG ratings are associated with

 Higher profitability: Better rated companies generate abnormally high returns leading to higher profitability

 Lower idiosyncratic tail risk: Such companies are better at managing their

company specific operational and business risks

 Lower systematic risk: High ESG rated companies are less exposed to systematic,

macro-economic factors leading to lesser risks hence more stability.

“ESG momentum” is a term indicating a relationship between a change in company’s ESG

characteristics and changes in the company’s idiosyncratic and systematic risk. As per

MSCI, the there is a time lag of three years between change in ESG characteristics and a

resultant change in the above three transmission channels and the valuation variables of

a company. The graph below exhibits a direct relationship between ESG momentum and

cumulative returns of securities.

The above parameters, of late, have become very critical for investors to choose their

investments. Research has shown that selection of ESG securities leads to betterinformed

investment decisions, and that sustainability funds can perform better than

non-sustainable ones, to an extent because of better risk management over contentious

issues. For example, companies with a lower carbon footprint would face lower

regulatory or societal risk than a polluter, and so its shares should be less volatile over

time.

ESG factors can significantly impact the company’s financial performance. For example,

Volkswagen’s emission’s scandal in 2015 cost the company $7 billion to cover the costs

and more than $4 billion in penalties. Besides, the company’s stock experienced dramatic

declines throughout the scandal.

In 2007, European Investment Bank issued its first Green Bond worth EUR 600 million.

The proceeds of this issue were used for funding renewable energy and energy efficient

projects. By 2017, over $155 billion worth of public and corporate green bonds had been

issued (https://hbr.org/2019/01/the-state-of-socially-responsible-investing). The world

has since been flooding with a gamut of similar investment instruments making the size

of sustainable investing- which includes environmental, social and governance (ESG) and

impact investing – to grow by 34% since 2016 to $30 trillion in the year 2018, as per the

report from Global Sustainable Investment Alliance.

Amongst all the developed and emerging nations, the traction on ESG investing has been

found to be the highest in the regions of Europe, US, Japan, Canada, Australia and New

Zealand; Europe having the maximum share of global sustainable assets and

Australia/New Zealand the least. Japan has shown the maximum leap of 360% in its

investments since 2016.

As per the Forum for Sustainable and Responsible Investment in US, in the beginning of

2018, 25% of the professionally managed assets of US i.e. $11.8 trillion were under ESG

investment strategies, a stark rise from 2010, when the amount was close to just $3

trillion overall.

ESG investing, while it has the generous objective of financial returns coupled with social

responsibility, poses a challenge of not being driven by any global standards hence there

is no set framework of ESG investing. Companies have the discretion of choosing their

own ESG components which sometimes become expansive enough to get diluted and

may lead to Greenwashing.

Appetite for ESG investing has been on an upward trend in India. Fund houses are actively

introducing new ESG funds or changing the constitution of existing funds to make them

more socially responsible. As per some eminent fund managers, investors here are more

concerned about the ‘G’ (governance) than about ‘E’nvironment and ‘S’ocial. That, in my

opinion, is because any slip on the governance aspect has a direct impact on the returns

of a company. Environmental and Social are relatively distant since a lot of emphasis is

expected on these fronts at the political and regulatory level e.g. solar energy covers the

Environment aspect of ESG but these companies are reeling under huge losses clearly

because there is comparably lesser emphasis on moving our preferences to this source of

energy.

ESG investing is still a niche market here though the regulatory bodies realise the

importance of socially responsible investing. The Ministry of Corporate Affairs came out

with the ‘National Voluntary Guidelines on Social, Environmental and Economic

Responsibilities of Business’ in 2011. Since 2012, the top 100 listed companies as per

market capitalization disclose their Business Responsibility Report as a part of their

Annual Reports.

A sample look at the MSCI ESG Leaders Index exhibits better returns from ESG funds in

India against the non- sustainable funds, well in tandem with the global trends.

A deeper look into the constituent companies of these indices illustrates primarily those

companies which have been historically categorised for sound financial performance and

public trust. Secondly, by virtue of their market status, the companies have had a track

record of being the leaders in socially responsible initiatives in addition to their consistent

financial performance and financial returns.

The propensity of investors towards ESG is extremely critical for bigger participation into

such investments by the companies. The success of these instruments represents the fact

that investors investment decisions are largely based on the commitment of funds

towards sustainability. Retail investors seem to be inclined towards ESG investing

primarily because of the impetus at the institutional level.

A continued propulsion of ESG may help address the global issues of sustainability to a

great extent in the coming years. A deeper research and analysis into the effective

weightage of various components of ESG in the overall growth and success of the

economy may encourage more informed ESG investing.

Environmental, social, and governance criteria are very subjective and accurate

assessment of the factors can be extremely challenging. Development of a suitable

framework or model for ESG investments is vital for bringing greater legitimacy to this

new investment model.

Disclaimer: The views, opinions and content on this blog are solely those of the authors. ISME

does not take responsibility of content which are plagiarized or not quoted

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