Last year saw a surge of investment in funds that take environmental, social and governance (ESG) issues into account. In the US and Asia, the amount invested more than doubled, and Europe wasn’t far behind. Globally, ESG investments reached US$40 trillion.

Broadly, ESG investing addresses workers, communities, customers, shareholders and the environment, and interest has been increasing for some time. Did COVID-19 turn up the heat?

“Now we’ve seen how quickly things we take for granted can change, I think there’s probably heightened concern about the future,” says Andrew Grant, a senior lecturer at the University of Sydney Business School specializing in behavioral finance and individual investor decision-making.

The pandemic also challenged the idea that it costs money to invest with a conscience. An AXA IM analysis of the stock and bond market in the first quarter of 2020 showed that companies with the highest ESG ratings were more resilient in the coronavirus market crash than those with the lowest.

“The portfolios I was managing went down by about eight per cent compared to the 30 per cent ASX market average,” says Chris Lang, a financial adviser at Ethical Choice Investments.

OPTING OUT

A decade or so ago, few people knew much about their superannuation account beyond the annual return. Bronwyn King, a radiation oncologist, was astounded to discover she was inadvertently investing in tobacco companies.

“It just seemed so absurd that I would be going to work every day trying to help people suffering as a result of tobacco and yet at the same time my money was being invested in the companies that made the products that were killing them,” she said in an interview for Melbourne University. She went on to found not-for-profit Tobacco Free Portfolios and has been instrumental in persuading more than 150 leading global financial organizations around the world to adopt tobacco-free finance policies.

“Investors have become much more conscious of what their money is supporting,” Grant says. “For instance, they have legitimate concerns about climate change and don’t want to invest in companies that are contributing to the problem. Recently, we’ve seen some of Australia’s largest super funds divest from fossil fuel investors.”

There’s an argument that, by ruling out certain investments, you’ll end up with a less diverse portfolio and, therefore, increased risk. However, Lang suggests the opposite might be true.

“ESG screens tend to remove companies that are badly run and use unethical practices, which means they’re at higher risk of lawsuits, government regulation, fines or losing community support,” he says. “You tend to be left with high-quality, less volatile companies with good long-term prospects.”

Simon Russell, Director of Behavioural Finance Australia, adds that ethical considerations often correlate with other market forces. “Companies with a higher carbon footprint, such as heavy industry and energy, tend to have a more traditional male-centric model, and these have been performing pretty poorly for some time,” he says.

The companies that have been performing well, such as FAANG (Facebook, Amazon, Apple, Netflix and Alphabet, formerly Google), tend to be younger with more diverse workforces as well as a lower carbon footprint. The question is are they successful because of ESG considerations or because the economy is changing?

DIFFICULT TO MEASURE

It can be difficult for investors to pin down ESG performance. “Many turn to the independent agencies that allocate companies with an ESG rating,” Russell says. “Unfortunately, you can end up with widely different views.”

Research bears this out. A team at MIT Sloan recently found that five prominent agencies – KLD, Sustainalytics, Video-Eiris, Asset4 and RobecoSAM – produced ESG ratings that diverged substantially. However, the science is relatively young and, as Grant points out, ratings often include subjective as well as objective measures, which compounds the challenge.

“I believe the companies offering this service are going to great lengths to gain a better understanding of the ESG drivers within each company,” he says. “We’re starting to see a pretty strong link between their scores and the ESG consequences.”

COMPANY BENEFITS

Taking ESG into account could be good for business as well as investors. “Investing in ESG sends a strong signal to the market that your company is trustworthy and transparent,” Grant says. “Overwhelmingly in higher ESG firms we see greater confidence in managers when it comes to things like statements to investors, and having that level of trust can protect you when things aren’t going in your favor.”

Grant’s team is currently researching whether ESG plays a role in how the market responds when companies release their earnings. “At this stage, we’re finding that the market is able to price the returns on high ESG companies more accurately,” he says.

Lang adds that, at a simple level, ESG is a way of pricing externalities such as business risks, social license risks and the ability for the operation of the business to achieve a long-term goal. “These don’t tend to be reflected in a financial statement,” he says. “But they do have a huge impact on a company’s financial results.”