Why companies that focus on ESG criteria outperform those that don't and how you can benefit

Environmental, Social and Governance (ESG) investing has become increasingly popular in recent years, both in terms of the amount of money being invested and the availability of investment opportunities.

In fact, the market has grown exponentially, with the pandemic only increasing its popularity and we don’t see this slowing down anytime soon. Why is this important to investors and companies alike? Because all companies will need to be ESG compliant in the future and those with higher ESG rankings will likely be the most profitable.

Here’s why.

ESG investing incorporates recognised standards or principles which companies must adopt. It aims to reduce negligent corporate behaviour that can damage the environment, harm human rights or worker rights by directing investment to those companies compliant in these areas.

Compliant companies rank high against ESG criteria and are included in more investment funds. This creates a positive feedback loop; ESG standards weaved into the corporate fabric, looking after staff and planning for long term growth, positive values reflected in employee behaviour and consumer interest, all improving performance. Improved performance results in inclusion in more investment funds ultimately meaning more investment. This cycle continues until companies that focus on ESG criteria successfully outperform those that don’t.

Rising public awareness, regulation and generational transfer of wealth are some factors explaining the increase in demand among almost all millennials - 95% of which are interested in sustainable investing.*

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The current ESG landscape is best reflected by data; fund research house Morningstar quotes annual European sustainable fund flows increasing from €50bn (£45bn) in 2018 to a record-breaking €120bn in 2019, bringing total assets under management to €668bn.

Morningstar also analysed the impact of the market downturn in the first quarter of 2020 caused by the COVID-19 pandemic and subsequent lock-down and found that 51 out of 57 (89%) of the sustainable indices outperformed their broad market counterparts. During times of market distress there is a “flight to quality” which benefits higher ESG-rated firms; companies that focus on these standards tend to be more robust, with strong governance, strong balance sheets and sustainable cashflows.

Pandemic aside, historically reduced performance or lower return from responsible investing such as ESG has been a key concern for investors, but over the last five years ethical indices still outperform non-ethical counterparts.

Many investors understand that long term stability and sustainable investment rest on how well companies are governed as well as their impact on society and the environment. FTAdviser explains that companies that incorporate ESG risk management are better long-term custodians of investor capital, offer greater downside protection and can generate better long-term risk-adjusted returns. 

Companies failing to improve their ESG scores will in turn fail to attract investor assets, and their stock will likely decline in value as a result.

In five years’ time, we anticipate a fight for capital because, ultimately, corporates want investors. It won’t just be their company accounts that matter, their ESG score will be equally important.

Is there a difference between Ethical Investing & ESG investing?

Originally, Ethical Investing - or Socially Responsible Investment (SRI) - focused on excluding ‘sin-stocks’ from investment selection based on an exclusionary or negative screening process. An example would be avoiding investment in companies generating profits from alcohol, tobacco, or weapons sales, or companies ignoring human or worker rights. Through exclusion, corporate behaviour was positively influenced with positives for society and the environment.

With less ability to diversify, as well as inability to select the most “efficient” market investments available, these funds generally had lower returns and higher risk.

Comparatively, ESG investing is less straightforward. It involves researching companies against ESG criteria instead of simply excluding firms with undesirable business activities. The technique incorporates a systematic understanding of specific ESG criteria during the entire investment process to reduce risk and increase returns. 

For example, a fund manager’s team of analysts are likely to question: ‘What is the environmental impact of this company?’, ‘What are the potential risks and rewards for society?’, ‘Is the company governed by competent, law-abiding leadership?’. They will be scored, ranked and included in investment funds. The point to understand is although a fund may rank high against its peers, without negative screening it may still have holdings in a company considered unethical. A company can be adept at managing their carbon footprint, so score highly on the environmental ESG criteria but pay their top executives’ excessively, therefore scoring low on the governance scale. 

Ranking & criteria 

In recent times, a strong winner for incorporating ESG fundamentals has been Microsoft which has benefitted from prioritising climate and social concerns. This has attracted more investment and an increase in share price.

Another tech giant, Alphabet and entertainment company Disney are not far behind, highlighting that it is not only smaller, lesser known companies agile in this sector but major players leading the way.

Large companies focussing on ESG criteria have benefitted from increased investment and those who have not – paid the price. Volkswagen’s emission scandal in 2015 cost the company $7 billion in costs and over $4 billion in penalties seeing Volkswagen’s stock value dramatically fall.

ESG criteria are in part subjective, and accurate assessment of factors is challenging.

Given the huge amount of data points in the investment universe, each provider with their own criteria, their own weighting, and the different processes each fund house undertakes to reach their results, there is currently low correlation between agencies. This makes it hard to rank companies 1-10. However, agencies such as Defaqto & Morningstar conduct thorough research on companies’ ESG principles and there are ESG indices such as MSCI’s, against which funds can be compared.

However, a lack of consistency between ESG rating providers - both fund and company ESG ratings – is a challenge and a call for standardisation of assessment within the industry.

If you’d like to learn more about ESG investing or would simply value speak to an expert, independent financial adviser why not get in touch

Learn more about ESG investing at our next free webinar where our experts will take you through the key principles of ESG Investing and how it might benefit your financial future. Click here for more information.

Past performance is no guarantee of future returns. The value of investments and the income from them can fall as well as rise, you may not get back what you originally invested.

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