In the context of the global economic turbulence, and the politization of the ESG, there has been debate on its relevance and returns. But investors and regulators remain increasingly interested in responsible and sustainable investing, with dedicated ESG funds now accounting for around 10% of worldwide assets, according to the November 2022 EY Global Corporate Reporting and Institutional Investor Survey. The survey also revealed that 78% of investors think companies should make investments that address ESG issues relevant to their business, even if it reduces profits in the short term. At the same time, the green energy transition and new disclosure obligations mean ESG is becoming an ever more pervasive organizational concern. This means the following “excuses” for ignoring ESG factors no longer hold up to scrutiny.
1. We are only a passive investor
Passive equity funds look set to overtake active equity funds in 2023. But this does not mean that the investors flocking to a passive approach are uninterested in ESG factors. The market has seen the rise of more than 1,000 ESG indexes and an increase in AUM in open-ended ESG passive funds, reflecting the growing investor demand for both ESG products and passive investing.
Approaches to incorporate ESG factors into passive investment strategies fall into three broad categories that are often used in combination:
- Screening and thematic approaches — To ensure indexes mirror investors’ preferences for ESG performance, filters are applied, or companies are selected based on their exposure to specific themes.
- Integration — In bespoke indexes, returns are improved by reducing exposure to ESG risk.
- Engagement and voting — Passive asset managers are being encouraged to undertake corporate engagement, including voting, to drive the behavior of index constituents.
In passive investing, active decisions are still crucial for choosing the index and benchmark for performance measurement.1
2. We are only a minority shareholder
As the OECD’s Responsible Business Conduct for institutional investors makes clear, even minority shareholders may be directly linked to adverse environmental and social impacts caused by companies in their portfolios. All investors, including minority shareholders, are expected to undertake risk-based due diligence, consider ESG risks in their investment processes and use their leverage with companies to help them prevent or mitigate adverse impacts.
Investors, including those with minority stakes, can be directly associated with negative impacts resulting from companies that contribute to specific social or environmental issues due to their ownership shares in such companies.2
3. At a portfolio level, we only have a small exposure to high-risk ESG sectors
Given the broader context of responsible investing and risk management, even if overall portfolio exposure to ESG risk is low, ESG is still material to the asset manager if an individual investment comes with high ESG risk.
Activist shareholders are reallocating their investments away from companies with subpar ESG performance histories. Meanwhile, consumers are boycotting goods linked to ethically questionable supply chain practices. Instances of ESG shortcomings going viral on social media are creating severe reputational damage.
Similarly, negative publicity associated with an individual investment with high ESG risk can also impact the asset manager's reputation. Failing to align with client and investor preferences could lead to asset outflows as investors choose asset managers who take ESG factors seriously.
Banks are increasingly building systematic ESG due diligence into their lending and investment decisions. Asset managers must do the same. In this regard, carrying out ESG due diligence is not simply about managing risk, but also a financial opportunity. Companies with a positive ESG commitment are better set up for long-term success.
4. Investing in ESG will reduce our fund’s overall performance
Asset managers do not have to trade performance for “doing good”. ESG can have a positive effect on corporate financial performance, leading to better returns.
Compelling evidence across many regions, and especially in emerging markets, suggests that integrating ESG into the investment process, and investing in companies with better ESG scores, can add to performance. An empirical analysis of A-share listed companies in China from 2015 to 2021 also found that ESG factors can have a positive effect on corporate financial performance.3
ESG integration can also lead to lower risk overall. This was the finding of the World Economic Forum in its Global Risks Report, where the environment accounted for six of the top 10 risks over the next decade. Asset managers focusing on the macroeconomic environment should note that none of the top 10 risks in the list related to economic factors.
Global risks ranked by severity over the long term (10 years) – World Economic Forum
- Failure to mitigate climate change.
- Failure of climate change adaptation.
- Natural disasters and extreme weather events.
- Biodiversity loss and ecosystem collapse.
ESG risks can have a long-term impact on the financial performance of investments. While an individual high ESG risk investment might not significantly affect the overall portfolio in the short term, it could lead to underperformance or unexpected losses over time. Addressing ESG risks at the individual investment level can therefore contribute to the long-term sustainability of the portfolio.
5. Investing in ESG will limit the types of investments we can invest in
Depending on an asset manager’s investment mandate, ESG does not limit investments as long as overall risk can be managed. Notably, regulators (e.g., the Monetary Authority of Singapore) does not mandate that asset managers cannot invest in high-risk ESG companies. Rather, the focus is on ensuring the resilience of investors’ assets against the impact of ESG risk.
