The practice of incorporating sustainability factors into investment processes, corporate strategies, and a variety of investment products has grown dramatically in recent years. 

Metrics and analytics around environmental, social and governance (ESG) issues have proliferated to such an extent that the initials “ESG” have now become a common moniker for an entire dimension of “sustainable” investment styles.  Globally, more than $2.5 trillion is now invested in public funds that claim ESG as a central focus in constructing and managing their portfolios.ⁱ

This dramatic growth has drawn heightened scrutiny around ESG investing from many areas, including the press, rating agencies, consulting firms, and government regulators, especially the Securities and Exchange Commission. This scrutiny has focused on such key issues as the standardization, quality, and usefulness of ESG data, as well as the communication of ESG initiatives and policies to various constituencies. Unfortunately, ESG also has become yet another area of polarization in political discourse, where it has been portrayed as a binary choice of being either virtuous or irrelevant.   

In reality, ESG is another important lens that can be used in the mosaic of a broad range of information that goes into a comprehensive investment decision-making process. It is not just a fad or marketing approach. ESG awareness is now becoming deeply rooted in economies, corporate activities, markets, and investment policies and procedures.

Like many other investment approaches and analytical perspectives, ESG continues to evolve, with the development of more refined data, tools, and analytics.  Included in this is the concept of “sustainability,” which often is thought of in environmental terms, but also reaches into economic and social dimensions.

The dynamics of economics, investment, and ESG

At its core, the field of economics is about the dynamic process of allocating scarce resources to supply the goods and services that meet the demands of a society. Investing, at its core, is about committing capital to those businesses or assets that demonstrate the ability to produce goods and services in the most efficient manner, such that an adequate financial return is earned for assuming the risk of capital loss. These businesses, and the returns they generate, also must prove to be sustainable over time such that maximum value can be derived over the long term from the investment.

ESG factors relate to all of the key dimensions highlighted above when weighing investment decisions. Also, the relationship between ESG and companies is a two-way street: companies’ financials may be impacted by ESG factors and, likewise, companies’ operations may impact ESG issues, as well.     

Scarce resources

The war in Ukraine has illustrated the harsh reality of scarce natural resources in modern economies. Surging commodity prices, especially in the energy sector, are the most prominent example.

Critics have charged that ESG mandates are contributing to the near-term energy supply issues due to the reduced amount of capital directed toward energy production. But ESG investments have been helpful in directing capital to transition energy supplies from unreliable and sometimes autocratic foreign governments to more reliable and sustainable sources, including both fossil fuel and renewables. 

Companies that aggressively look to manage costs related to commodity prices through reduced usage, or to find cheaper sustainable alternatives, will not only contribute to an important ESG metric – carbon footprint – but also may enhance corporate profitability and financial resiliency. 

The Covid-19 pandemic has been a catalyst in demonstrating a new reality of increasingly scarce human resources in modern economies. Globally, corporations are dealing with labor shortages and aging populations by not only increasing wages, but also by pursuing other strategies that could be considered socially favorable, such as flexible work scheduling, training, profit sharing, and actively recruiting staff from what may be considered diverse segments of the population. 

Again, these initiatives are being pursued not just because they benefit social ESG metrics, but because they are helpful in reducing turnover, improving efficiency, obtaining a broader perspective, and sustaining the organization for the long term. 

Demands of society

Companies are responding to persistent consumer demand for responsible products. A vast number of consumer-oriented products now are labeled “renewable,” “responsible,” “sustainable” or some other term suggesting that the company that produces it is being thoughtful about the resources it uses in the production process.  Although there are certainly instances where the ESG label may just be greenwashing – the act of disseminating disinformation by a company to present an environmentally responsible public image – the point is that consumers are increasingly demanding products that minimize the impact on the environment and the well-being of communities. 

Companies know that their customers, employees, and other stakeholders care about the way they conduct their business and the impact they have on the world. The number of companies issuing corporate social responsibility (CSR) reports has gone up, and even small companies are increasingly measuring and reporting sustainability data.

The sheer amount of capital that has been directed by investors to ESG-oriented investment policies is further evidence of demand from society. It is estimated that more than $37 trillion in both public and private portfolios globally is now being managed with some form of ESG or sustainability orientation and that figure may surpass $50 trillion by 2025.ⁱⁱ

Financial returns and risk

Historically, there has been a perception that pursuing ESG-oriented investment strategies would diminish returns relative to non-ESG oriented strategies. However, this perception does not seem to be valid. Although it is difficult to comprehensively assess ESG performance information due to the non-homogenous nature of ESG investment strategies, recent performance data indicates that ESG-oriented management practices may be beneficial from a risk/return standpoint.ⁱⁱⁱ

Given that ESG is relatively new as a corporate and investment management discipline, it is somewhat premature to draw absolute conclusions about the performance impact of ESG. Furthermore, as the risks that ESG policies try to mitigate vary considerably across industries and companies, the impact on financial and investment performance will vary across industries and companies, as well.  

However, research conducted by Aaron Yoon, Professor of Accounting/Information at Northwestern University’s Kellogg School of Management, suggests that companies who actively incorporate ESG perspectives into their management practices exbibit higher “quality” factors, such as good governance policies and lower risk financial profiles.^iv

Similar to other investment approaches, some ESG managers have better results than others. Given the myriad of approaches to ESG investing, it is difficult to draw blanket conclusions about whether ESG analysis helps or hurts performance.  

Studies have come to varying conclusions, including that ESG investing has a positive, negative, or no impact on the returns of a portfolio.  Furthermore, time periods over which investment returns are measured have an impact on the conclusion. In a 2019 study of 11,000 mutual funds, Morgan Stanley Institute for Sustainable Investment found that there is no financial trade-off between sustainable funds compared with traditional funds.^v

That same year researchers from the University of Chicago found no evidence that high-sustainability funds outperform low-sustainability funds.^vi Perhaps most importantly, the outcome for any specific strategy is dependent upon the skill of the manager.

Sustainability

Incorporating sustainability into an investment process is not just about the narrow definition of sustainable resources or products. It is a broad term that has economic, social, and environmental dimensions. When considered in an investment process, this may encompass multiple, non-exclusive approaches, ranging from integrating ESG perspectives and metrics with other conventional financial metrics, to dedicated and focused impact investing. The chart below illustrates the broad sustainable investing spectrum:

As the graphic above demonstrates, there are various ways to incorporate sustainability into an investment thesis. Some firms choose to exclude certain industries or product categories, some take a more systematic approach with various ESG metrics, some focus on impacts, and others focus on stakeholders. None of these approaches are mutually exclusive. 

A sound and comprehensive approach is to not limit the investment universe through exclusions, but to allow a sustainability thesis to play out through fundamental research.

At its core, sustainability is about meeting current needs without compromising the ability to meet future needs. As an investor, this means focusing on identifying an organization’s policies, strategies, and risk management philosophy to determine if they really do enhance the long-term viability and value of the organization.  

Sustainability is about an organization’s mission and core competencies persevering through contemporary issues, such that the organization can thrive longer term. A favorite investment concept of famed investor Warren Buffett is the idea of a wide moat that protects an organization from a variety of threats. Sustainability can be considered as one way to help an organization widen its protective moat.