The growing uptake of ESG investments and practices has been steadily coming to the forefront, but 2021 could be the year that adoption skyrockets.
Half of all professionally managed investments will be ESG mandated in the US by 2025, according to Deloitte. It’s thought that the Covid-19 pandemic, subsequent lockdowns and societal shifts have all accelerated the adoption of ESG investment habits, globally.
Data from Google Trends reveals the rapid, unprecedented growth in interest. So much so, that searches in October 2020 reached record levels in the UK.
From a business perspective, the novel coronavirus highlighted how intricately linked corporate activities are to the environment and society, like never before. At the same time, the quality of organisations’ corporate governance has also been tested.
From an investors’ perspective, Covid accelerated interest in funds that explicitly place a heavy onus on ESG. Once considered “niche” strategies, ESG adoption is now widespread and mainstream. For asset managers yet to embrace ESG-rooted analysis or sustainable investment approaches, there is now a real risk of being left behind.
A driver for change
The novel coronavirus has been a catalyst for change over the past year. While advocates for ESG investment strategies had previously been heralding the steady, yet subtle, shift towards a focus on sustainability, Covid has increasingly brought attentions to both the reasoning for supporting environmentally and socially conscious businesses, and the success they can offer to investors.
The rapid recognition of the role that “ESG-aware” strategies have in investment portfolios has partly been influenced by the changes that investors have experienced in their own lives.
On the environmental front, Covid reshaped our travel habits, reframed the ecological damage of industry, and improved the quality of the air we breathe. It also had a tangible effect on the amount of CO2 produced around the world. With governments already placing greater regulatory pressures on companies to decarbonise our industries, Covid-19 has acted as a trigger for many organisations to think about their approach to reducing their carbon footprint.
The grounding of flights, travel restrictions and our own reluctance to travel have had myriad consequences, both economically and environmentally. As such, companies which traditionally scored poorly on many environmental metrics, such as airlines, car manufacturers and oil producers all took major hits to their share price. Recently released data shows that car sales in the UK have fallen to their lowest levels since 1992. Sales peaked at 2.7m in 2016, but 2020 represented a record low of 16.3m new vehicle registrations.
The pandemic’s influence on behaviours has not been limited to the environmental element of ESG, however. Covid-19 has brought how a company looks after its people, customers, and communities to the forefront. Remote or socially-distant working practices have become the new norm, along with unprecedented notions of flexibility within individuals’ working lives.
At the same time, actions to reduce inequality and racial injustices are becoming normalised and celebrated. The virus highlighted the gulf in society between the ‘haves’ and the ‘have nots’ in terms of healthcare, wealth and living standards. Individuals and communities that live in poverty were affected far worse than others. Non-white communities were also disproportionately affected in both the United States and the UK.
The resilience, and the risk liability, of companies has been tested to no end throughout the pandemic. “We don’t want to invest in companies that take irresponsible risks.” Jens Peers, CEO & CIO of Mirova US and Portfolio Manager on its Global and International Sustainable Equity strategies wrote in an investor update.
“We are significantly underweight companies with high levels of debt, and in a crisis those debt levels are obviously bad for performance.”
Increased fund flows
With such a compelling investment case, investors have been embracing ESG-focussed investment strategies with increasing enthusiasm.
The sums invested in ESG funds is repeatedly breaking records, year on year, as investor demand for conscientious investments soars. This has been echoed by the fund management industry who are increasingly marketing ESG funds through environmental, sustainable or ESG focussed advertising and PR campaigns.
It is good business for fund managers too, with better margins to be made, compared to the margins available on conventual OEICs and unit trusts.
Edward Glyn, head of global markets at Calastone, told Interactive Investor they are an “area of real strength for active equity funds, which are otherwise suffering at the expense of their passive counterparts.”
The ongoing positive inflows to ESG funds have been driven by investors have seen their own habits and behaviours shaped by Covid-19, but also by their decision to reward companies that have responded to the crisis positively, as well as those with a focus on long-term goals. The increasing demand of investors wanting to be financially involved in positive societal and business changes, while not compromising profits, is a huge driver, according to Fidelity, with investors hoping to future proof reputation alongside returns.
A report by PwC concluded that ESG funds are likely to outnumber conventional funds by 2025. In Europe, ESG funds are forecast to reach €7.6tn (£6.86tn) over the next five years, overtaking conventional options, as the trends of investor behaviours and practices towards climate change action and social inequality propel these strategies into the mainstream.
The report also found that, in a best-case scenario, ESG funds will experience a more than threefold jump in assets by 2025, seeing an increase in their share of the European fund sector from 15% to 57%.
Covid-19 has triggered a clear acceleration in the adoption of sustainable ideas and practices, with investors using data to identify countries with existing sustainability qualities. But the long-term success of ESG funds hinges on whether they outperform conventional funds after the pandemic. It also rests on whether the investee companies within those funds – with superior ESG credentials can also outperform.
Data from Morningstar suggests that they will. It found companies that ranked in the top 10% of their sustainability rating scale significantly outperformed those in the bottom 10% in the first quarter of 2020, amid a volatile backdrop as coronavirus took hold in China. This outperformance continued in the second quarter, as lockdowns caused unprecedented levels of disruption both in the UK and the US, where 18 of Morningstar’s 26 American ESG-focused index funds outperformed conventional index funds that cover the same parts of the market. It reported that an impressive 72% of sustainable equity funds rank in the top halves of their categories, refuting speculation that the first quarter performance was an anomaly. Data from Refinitiv Lipper draws similar results.
Morningstar’s research, across a 10-year period, also found that ESG funds have greater survivorship rates than non-ESG funds. It found that an average of 77 per cent of ESG funds that were available 10 years ago still exist, compared with 46 per cent for traditional funds. These data suggest that funds with a stronger ESG profile may simply be better at weathering the storm.
‘Sin it’ to win it
The contrast to the positivity of ESG funds are sin stocks. The abnormalities in the returns offered during crises has sometimes led investors to invest in companies involved in the manufacture of arms, alcohol, gambling or pornography. Arms manufacturers, for example, boomed during the global financial crisis. Yet it is a viable possibility that the growing popularity of ESG funds may leave some sin stocks a role to play in the market. As behavioural trends cause an increasing shift away from companies that do not adhere to ESG principles, sin stocks may find themselves in a position as outliers, where willing capital is eager to cover the deficit in demand. While research has both refuted and supported the idea that sin stock’s premium was a reward for its reputational risk, the tremendous shifts towards ESG dominance will only intensify this notoriety.
As we head deeper into 2021 investors’ attention has shifted to the prospects for the year ahead. An increased scrutiny as to what qualifies a company as upholding ESG ideals can be expected, according to a Wall Street Journal report, with potential crises and scandals for those who are found to be failing in some regard. Similar changes are expected in the EU, although Britain’s potential post-Brexit alignment to this is unclear.
In 2020, UK online clothing retailer Boohoo, which had scored highly on some ESG measures and featured in several prominent ESG funds, was found to be paying workers an illegally low wage at its factory in Leicester, contravening the ideals of its investors.
Similarly, the recent emission scandal duped investors in carmakers around the world, fooling many by falsifying emissions data on environmental tests conducted on vehicles.
The teaching from these, and other scandals, is that companies that integrate ESG into the fabric of their business and operations, successfully, are proven to be better at navigating crises, whereas those who fail to uphold the necessary standards are hugely susceptible to an investor backlash.
What is apparent is that the trends of ESG’s emerging dominance are likely to continue, and investors will be increasingly seeing ESG as both socially and financially profitable.
Here at Research in Finance we are experts in researching the development of ESG across the institutional, wholesale and private investor market in the UK and beyond. We have conducted numerous bespoke studies on behalf of some of the world’s leading asset managers alongside subscription studies and research reports.