3.1 Lessons from ESG Integration
3.1.1 ESG Integration – Financial Performance and Risk
While initially mostly applied to publicly listed equities, ESG integration is increasingly reflected in other asset classes and applied by a wider group of investors. This expansion indicates investors’ willingness to consider non-financial metrics in investing decisions and a belief that such metrics may drive long-term risk mitigation and value – a perspective that in the past was not widely held. A growing body of academic research and industry developments indicate that companies voluntarily adopting social and environmental sustainability policies can outperform companies that do not on the basis of stock market performance. While the empirical evidence around how ESG criteria affects financial returns is still preliminary, there are notable efforts that can help investors consider if investments within the ESG spectrum can help position themselves competitively.
- One such study examined 180 US companies segmented into “high sustainability” and “low sustainability” cohorts based on dimensions of corporate governance, active stakeholder engagement and measurement/disclosure from the early 1990s to 2010. The study found that US$ 1 invested in a portfolio of the high sustainability firms would have grown to US$ 22.6 by the end of 2010, while a US$ 1 portfolio in the low sustainability firms would have grown to US$ 15.4.18
- Another recent study focused on institutional investors to determine how they are incorporating ESG into their investment strategies and what’s driving them to do so. The survey respondents represent US$ 7.6 trillion assets under management and include many large institutional investors that provide capital used by companies to finance growth. 80% of these investors are already considering ESG issues in their investment decisions and nearly three-quarters of them cite risk mitigation as a primary reason – more specifically, that upfront consideration of issues like climate change and resource scarcity will reduce risk. Furthermore, approximately 50% of respondents consider these issues in order to enhance investment returns and to avoid investing in firms with unethical conduct.19
- A third study performed by an investment adviser and portfolio management firm analysed over 8,500 investments and funds globally (including corporate debt and equity, government and non-profit muni bonds, private equity, real estate trusts) and has rated nearly 80% of the globally traded equity market to conclude that markets tend to ignore 20 factors of future risk, potential return and impact. Over a three-year time period ending 31 December 2013, higher impact portfolios out-performed a traditional portfolio model based on modern portfolio theory on return (10.5% annualized vs. 8.9%, higher by 1.6% per year) and risk (11.3% annual volatility vs. 13.0%, lower by 1.7% per year).20
- In June 2012, Deutsche Bank released a broad review of academic literature on the relationship between ESG factors and investment returns – findings were based on 56 research papers, two literature reviews and four meta-studies. 100% of the academic research reviewed showed that firms with high ratings for CSR and ESG factors had a lower cost of capital in terms of debt and equity. In addition, almost 90% of studies examined showed that firms with high ratings for ESG exhibit market-based outperformance and accounting-based outperformance (89% and 85% respectively).21
Although the results of these studies do not directly link to impact investing performance, they do indicate correlation between creation of long-term value and incorporation of non-financial criteria in enterprise management. In coming years, we expect studies to shed further light on the risk and return characteristics of impact investing and the link between impact and long-term value.
3.1.2 ESG Integration – Growth in Allocated Assets
The inclusion of social and environmental considerations is resonating with institutional investors as evidenced by the adoption of screening and ESG integration. This trend offers a meaningful precedent for impact investing. From 1995 to 2012, ESG integration assets under management in the United States grew from US$ 166 billion to US$ 3.3 trillion; an increase of nearly 20 times (see Figure 2).22 Similarly, in Europe, ESG integration grew from approximately € 0.6 trillion to € 3.2 trillion from 2005 to 2011, an increase of nearly five times in a six year period (see Figure 3).23 Currently, it is estimated that globally 21.8% of total managed assets employ some form of sustainable investment strategy.24 Furthermore, the number of United Nations-backed Principles for Responsible Investing (PRI) signatories has grown from 100 to 1,188 in the period for 2006 to 2013. Signatories to the PRI indicate that they hold the belief that the incorporation of environmental, social and governance factors affects portfolio performance.25
Figure 2: Growth of US Managed Funds Incorporating ESG
Source: US SIF Foundation, 2012 Report on Sustainable and Responsible Investing Trends
in the United States
Figure 3: Growth of European Managed Funds Incorporating ESG
Source: Eurosif, European SRI Study 2012
Since the investments underlying this growth are predominantly composed of liquid, publicly traded securities, relatively less market-building and ecosystem-development was required to get to a trillions order of magnitude. The growth story of ESG does, however, demonstrate an increasing appetite to incorporate societal and environmental considerations in investment decision-making and as previously mentioned, can serve as an on-ramp for mainstream investors considering impact investing.