Evidence is mounting that ignoring environmental, social and governance (ESG) issues will expose investments to the kind of risk that will ultimately undermine their value, erode returns and possibly even lead to the collapse of the companies or other assets involved.
And as sustainable investing goes mainstream worldwide, institutions, fund managers, credit rating agencies and retail investors are demanding more careful scrutiny of the impact of climate change, the quality of corporate governance and the social consequences of investment decisions.
The shift in mindset is only partially driven by ethical considerations, although these are becoming more prevalent – particularly among young people, women, and high-net-worth individuals. There is growing recognition that a narrow focus on financial metrics for short-term gain against the backdrop of a rapidly changing world is simply careless, and ultimately damaging to returns.
There are spectacular recent examples of why the lack of focus on ESG issues has proved disastrous for corporate giants, both globally and in South Africa. US oil giant Exxon Mobil Corp was taken to court in New York in October, accused of deliberately misleading investors over the business risks caused by regulations aimed at addressing climate change.
Earlier this year, California’s biggest power utility went bankrupt after wildfires caused by a record-breaking drought exposed it to liabilities of $30bn, and German car manufacturer Volkswagen has paid out more than €30bn globally for cheating on emissions tests.
In South Africa, Sasol’s joint CEOs resigned on 28?October after an independent review into the company’s disastrous investment in the Lake Charles Chemicals Project in the US, which ended up costing almost double the original amount and wiped more than 40% off the value of its share price.
“What’s really been concerning for a lot of investors is the wasteful expenditure on offshore ambitions that have been impaired,” says Fatima Vawda, managing director of 27four Investment Managers. “We’ve calculated that in the past ten years close to R170bn of failed investments have been made by JSE-listed companies in offshore investments.”
The collapse of Steinhoff and the financial plunge of IT service provider EOH and top sugar producer Tongaat Hulett are prime examples of the consequences of poor governance – an issue which asset managers warn persists among other top JSE-listed companies.
According to a report from Bank of America (BofA) in September, 90% of the bankruptcies on the S&P 500 between 2005 and 2015 could have been avoided by screening out companies with below-average environmental and social scores five years prior to the events.
It also found that during the past six years, ESG-related controversies were accompanied by peak-to-trough market capitalisation losses of $534bn for large US companies. But those are only the consequences of being inattentive.
The good news is that asset managers and companies that incorporate ESG strategy into their decisions often achieve significant returns which outperform their peers – despite persistent scepticism within the investment community, and the general public, across the world.
Buying stocks which ranked well on ESG metrics would have outperformed the market by up to three percentage points per year over the past five years, while the cost of debt for those companies could be nearly two percentage points lower than those with less favourable ESG scores, BofA said.
“Our conversations with clients reveal a split between believers and sceptics, as we too were unconvinced before we embarked on our research into these attributes,” BofA analysts wrote in their report. “ESG is the best measure we’ve found for signalling future risk. It’s superior to leverage or other risk and quantity factors.”
Evidence of the financial benefits of taking ESG factors into account for investment decisions is growing as research into the topic increases.
According to risk and portfolio analytics provider Axioma, the majority of portfolios across the world that were weighted in favour of companies with better ESG scores than their market benchmarks outperformed by up to 2.43 percentage points in the four years to March 2018.
“Framing analysis through the lens of sustainability just makes sense,” says Jon Duncan, head of responsible investments at Old Mutual. “We think it’s a major thematic trend that is reshaping competitiveness across all industries globally.
“Companies that can get ahead of this faster than their peers will show a number of very positive attributes. Those attributes include things like stronger brand recognition, better access to market, lower cost of capital, better resource efficiency, stronger innovation and, relative to their peers, will show long-term competitive advantage and ultimately higher valuation in the market.”
Globally, sustainable investing assets in the five major developed markets stood at $30.7tr at the start of 2018, after surging by 34% since the start of 2016, according to a report released in April by the Global Sustainable Investment Alliance.
Sustainable investing’s market share grew in all regions except Europe – which is still well ahead of the US, Canada, Australia and Japan – possibly because of stricter standards and definitions, it said.
The largest sustainable asset strategy remains exclusionary screening, followed by ESG integration and the combination of corporate engagement with shareholder action – which is fast gaining traction in SA.
The share of retail assets, which are personal investments by individuals, rose from 20% to 25% over that period, while institutional assets managed for pension funds, foundations, insurers and universities remained dominant with a 75% share. Public equity accounted for 51% of the total, followed by fixed income with a share of 36%, the report showed.
More recent data from US global financial services firm Morningstar showed that flows into 271 sustainable open-end and exchange-traded funds (ETFs) in the US were on pace to smash last year’s record – they jumped to $8.9bn in the first half of 2019, surpassing $5.5bn over 2018.
“For some time, we’ve seen growing levels of investor interest in sustainability but, in the fund universe, a lack of availability across the range of asset classes. With record numbers of sustainable funds launched since 2015, the supply side has largely been addressed,” it said in a report.
“As these funds have developed their track records, they have begun to attract more assets. Moreover, the recent fund launches have included many open-end and exchange-traded index funds, which addresses increasing investor preference for passive investing.”
Larry Fink, chairman and CEO of BlackRock, said in an interview with the Financial Times last year that sustainable investing would be “a core component for how everyone invests in the future,” adding that “we are only at the early stages”.
BlackRock, the world’s largest asset manager, intended to become a global leader in sustainable investing, and expected that assets in ETFs which incorporated ESG factors would grow from $25bn to $400bn in a decade, he added. BlackRock already has close to a quarter of that market segment.
Sustainable investing is also becoming increasingly important for private equity firms, PwC maintained in a report earlier this year. “ESG issues have moved from niche to mainstream, with 81% of our respondents having adopted a responsible investment policy and 81% also reporting ESG matters to their boards at least once a year,” it said.
The growing interest in ESG drivers included risk management and corporate values, the report added, noting that 35% of its respondents had set up a dedicated responsible investment professional or a team. The PwC report was based on a survey covering 162 respondents from 35 countries – but three-quarters of them were in Europe.