ESG investing goes mainstream

Key takeaways

• Environment, Social and Governance (ESG) covers a wide range of sustainability topics that investors increasingly expect issuers to integrate into their decision-making process.
• Despite countless studies on the matter, whether investments run using ESG criteria outperform remains an open question. However, there is consensus that respect for these criteria does not lead to structural underperformance.
• ESG investing has risen very rapidly, driven by demand, improved data, new offerings and increased regulatory attention.
• Properly integrating ESG criteria into the investment process remains a challenge but should improve over time in parallel with progress in data and methodology.
  

Doing good and doing well?

ESG, which stands for Environmental, Social and Governance, covers a wide range of criteria that investors and society at large increasingly expect public and private bodies to take into account in their daily activities. ESG is not new. It has existed for decades, if not centuries under various forms. The roots of responsible investing might be traced back to Christian and Muslim groups who built investment portfolios that conformed with their ethical and religious values.

But Socially Responsible Investing (SRI) really took off from the 1960s on, when major events pushed public opinion to shun certain sectors or even countries. The Vietnam war, the Three Miles Island nuclear incident and apartheid in South Africa were among the issues that exercised many investors’ conscience.

The denomination ‘ESG’ was coined in the 2000s as part of the United Nations Global Compact, which aimed to encourage the integration of such issues into capital markets. The idea that consciously responsible firms might actually increase shareholder value more than their peers also emerged at the time, as illustrated by the UN report ‘Who Cares Wins’.

What gets measured gets managed

Yet the entire investment industry – and individual investors – needed convincing. Moving towards sustainable and responsible practices required a robust, data-filled ESG framework. This was needed to demonstrate how ESG-tilted investments had performed in the past, and to provide a yardstick for the future as well.

The jury is still out on whether ESG-based investments have delivered outperformance in recent years. Despite numerous studies and meta-studies that concluded ESG criteria did indeed help investments outperform (or “generate alpha”), some argue that this is actually due to other factors known to generate above-market returns, such as ‘quality’ . Yet, the mere proof that responsible investing does not come at the expense of financial performance has been enough to stimulate interest.

The growth of ESG investments has also been helped by regulatory initiatives to prevent ‘greenwashing’ and provide a level-playing field for responsible investments. As the most advanced and largest market (with 50% of all ESG funds worldwide), Europe has spearheaded ESG regulation such as the Sustainable Finance Disclosure Regulation (SFDR) or the green taxonomy.

Helped by public awareness and official initiatives, ESG-related offerings have grown massively in recent years. The Global Sustainable Investment Association estimates that ESG assets surpassed $35trn in 2020 to account for a third of global assets under management.

Proper integration remains a major challenge

Despite the growing body of data and the openness of the investment community, proper integration of ESG criteria into the investment process remains a challenge.

Indeed, work still needs to be done to ensure that ESG factors are fully taken on board by clients, investment managers and investment targets.

There are also shortcomings in existing data. ESG covers a wide range of topics (some highly technical) that still need to be standardised. This is why the International Sustainability Standards Board (ISSB) was created, with the aim to mirror the work of the International Accounting Standards Board (IASB) on accounting practices.

A third, and even greater challenge stems from the complexity and non-binary nature of ESG matters. As always, the devil is in the detail, and simply excluding ‘bad’ issuers is unlikely to result in significant progress towards making an investment ‘responsible’. This is why we, at Pictet, emphasise the role of engagement in our ESG policy.

Finally, the methodologies used to integrate ESG criteria into investment decisions are still in their infancy for some asset classes. While equities were among the first assets to be scrutinised through the ESG lens, work still needs to be done on many others such as government bonds, not to say private markets.