Is Sustainable Investing worth the growing traction?

Is Sustainable Investing worth the growing traction?

Sustainable investing, the new buzzword, is a framework that relies on financially material environmental, social and governance (ESG) information for long-term sustainable financial return. With growing emphasis on ESG (especially climate change), pressure is mounting on companies to develop sustainable offerings and comply with emerging regulations. This has compelled many of the world’s largest companies to work towards reducing their carbon footprint and have dedicated timelines to become Carbon neutral/ negative.

For example, Amazon and IKEA are pushing ocean shipping industry to adopt zero-carbon fuel sources for vessels by 2040, Microsoft claims to become carbon negative by 2030. Investors globally are following a four-pronged approach to sustainable investing:

Sustainable Investing chart

Fund managers are increasingly applying ESG – a set of data and factors – across different processes, correlating them with risk-reward characteristics and stock price movements to create the right investment strategies and mitigate risks. Hence, firms are using the following five levers of ESG to create shareholder value over the long term:

  • Top line growth: Focusing on sustainability and promoting sustainable products
  • Cost reduction: For example, using solar power, reducing water consumption (beverage company)
  • Better relationship with the regulators: Companies focusing on ESG and community to have enhanced relationships
  • Improved productivity: Strong correlation between employee motivation and productivity
  • Lower infrastructure spending: Using smart building solutions and creating facilities at lower costs

The growth story: During the 2020 market turbulence due to COVID-19, many companies with strong ESG track record witnessed lower volatility than their non-ESG counterparts. ESG investments peaked in 2020 and outperformed the equity market, with new assets into ESG funds growing to $51b in 2020 and ~$70b in 2021 (with maximum exposure in tech and EV stocks). However, many ESG investors are reporting their portfolio values declining significantly in 2022 and many ESG funds are already experiencing outflows. This is primarily due to thematic shift from technology to energy sector, which largely falls in the exclusionary strategy of ESG.

As ESG investing, to an extent, limits the types of stocks for investments, it may lead to stock concentration risk(s). For example, a major concentration of ESG investment during 2020-21 focused on FAANG and Tesla stocks in the US. Further, ESG investing has no clear standards, lacks transparency, and has insufficient disclosure of data and factors analyzed, coupled with significant inconsistency by fund managers. For example, JP Morgan announced that it will stop financing oil & gas developments in Arctic on one hand, while it supported the biggest IPO in the world in oil & gas (Saudi Aramco). Moreover, ESG investing is plagued by higher expense ratio as investors are paying ‘greenium’ for ESG funds compared to conventional funds. For example, expense ratio of ESG funds in the US 2021 stood at 0.61%, against their traditional peers (0.41%).

In practice, ESG investing tends to weigh more on the environmental (E) aspects, and less on social and governance factors (SG). The duality in the approach towards ESG investing manifested by fund managers raises the obvious question, whether the principles of ESG are being leveraged only for branding and positioning by companies and investors, or is ESG really going to create a paradigm shift in the way one invests and thinks about the society in general?

Author: Manish Mishra,

Head, Strategy Consulting

Photo credit: Edward Howell on Unsplash

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