President Donald J. Trump’s decision in June to pull the United States out of the Paris Accord was met with hand-wringing in nearly every corner—with one notable exception. While politicians, business leaders, and activists made their voices heard, loudly, the financial markets, which typically react strongly to such headline events, were unperturbed. In fact, the S&P 500 closed up 19 points that day and has since risen another 1%.
This shrug of the shoulders comes as investors chart their own course through the climate change debate and the clarion call from the broader market that sustainable growth matters.
For everyone from activist shareholders to mainstream money managers, the assessment of companies’ environmental, social, and governance (ESG) profiles—those activities and considerations that go beyond merely financial—has evolved from a simple measure of corporate responsibility to a key driver of investors’ decision-making. As such, the standardization of an ESG framework, which the market currently lacks, is a critical part of an increasingly values-based economy.
The potential power of this new market dynamic, rooted in corporate responsibility and accountability, is clear: responsible growth buttressed by broad inclusivity and low volatility.
Current State of Play
Markets continuously evolve, with a history of change driven by innovation and investor demographics and desire. And what investors want now are companies that can achieve long-term, sustainable corporate growth while practicing responsible behaviors from an ESG perspective.
For many companies, embracing ESG has meant adopting the 17 Sustainable Development Goals (SDGs) of the 2030 Agenda for Sustainable Development, established by the United Nations in 2015 as a strategy for investing in the future of the planet and its inhabitants. These goals don’t talk about cutting business costs or expanding profits, but instead about how enterprises can make an environmental and societal impact while still pursuing their business goals.
About $22.9 trillion of investments under management globally, including $8.7 trillion in the U.S., are oriented broadly toward ESG. The U.S. figure represents about one-fifth of the country's investments under professional management in 2016, according to The Forum for Sustainable and Responsible Investment. Examples of how ESG has taken hold in the market and as a key concern for investors include:
power of this new market dynamic, rooted in corporate responsibility and accountability, is clear: responsible growth buttressed by broad inclusivity and low volatility.
- PIMCO, the world’s biggest bond fund, has developed a “sustainability initiative” to support ESG–focused investment solutions. Other large investors, such as UBS and BNP Paribas, have undertaken similar efforts.
- The Portfolio Decarbonization Coalition, a United Nations–sponsored group of 27 mostly European institutional investors and asset managers controlling $3.2 trillion in assets, has committed $600 billion to fund green projects and investments.
- A 2016 study of institutional investors by ShareAction found that 95% of those who responded plan to engage with the companies in which they invest about the issues covered by the SDGs.
- Issuance of green bonds in 2016 was $81 billion, nearly double the 2015 mark.
- In 2017, the Global Impact Investing Network (GIIN) reported that about 60 percent of the 208 “impact investing organizations” taking part in their survey actively track the financial performance of their investments with respect to SDGs—or plan to do so soon.
Yet, for more companies to adopt a change in policy and strategy, they may need to be confident in investors’ ability to accurately price these long-term risks and opportunities. Market participants, including regulators and policy makers, are now in pursuit of a “lingua franca”—a common terminology and standards for identifying sector-specific ESG factors and measuring the capital differential of more sustainable enterprises.
Developing internationally accepted principles and key performance indicators regarding transparency, governance, and environmental impact would be an important enabler for higher levels of investment in areas such as clean energy and other sustainable infrastructure. Allowing investors to speak the same language when evaluating investments would let them better assess the relative merits of one project or asset against another.
What is ESG?
Once part of a simpler measure of a company’s corporate social responsibility, ESG criteria have expanded beyond charitable and community activities to encompass every aspect of a business—including items such as environmental impact, the governance systems that oversee those impacts, the willingness to develop human capital, and a company’s behavior as a corporate citizen.
For instance, increased scrutiny is forcing change on companies in the “G,” or governance silo, such as promoting transparency, elevating efforts in diversifying corporate leadership and board of directors membership, and solidifying existential risks like business continuity plans and cybersecurity safeguards.
Why do these issues matter?
In a Wake Forest University study of more than 2,000 companies from 1998-2011, researchers found that “firms with more diverse boards (gender, race, age, tenure, and expertise) are more risk-averse … exhibiting lower volatilities of stock returns than those with less diverse boards.”
In the global efforts for the pursuit of sustainability, finding these commonalities is essential.
Demographic Changes Driving ESG
Demographic changes in the investment community are fostering this increased interest in ESG. For instance, the youngest millennials, now entering adulthood, have consistently shown a commitment to the environment and a willingness to put their money where their convictions lie.
A global survey conducted by the research firm Nielsen in 2015 showed that almost three-quarters of millennials are willing to pay more for sustainable products and services. Factors influencing their purchases include whether a product is made from fresh, natural, or organic ingredients, and a company’s environmental friendliness or commitment to social values. A 2015 Morgan Stanley study showed that millennials are twice as likely as other generations to invest in companies and funds that target specific social/environmental outcomes and are just as likely to divest because of objectionable corporate activity.
The growth in the power of female investors, who now control more than half of all wealth in the U.S. and a rising percentage around the globe, has also contributed to the growth of the adoption of sustainability and ESG. In surveys, women have consistently shown more concern about weather volatility and greater support for social justice policies and helping communities thrive—all elements of ESG. In fact, female investors are nearly twice as likely as male investors to consider both the rate of return and the positive impact made by a company when making an investment, according to the Morgan Stanley study.
Financial innovation in the indices space has transferred this traditional decision-making authority. With clear trends of passive investing in equities growing exponentially in recent years—our research shows total net assets of index equity funds increased to $1.79 trillion in 2015 from $281 billion in 2002—access to thematic investing is now widely available to most retail investors.
These newly empowered groups are pushing for change politically and in the marketplace, which in turn influences the actions of asset managers. According to a State Street study, half of retail investors want their financial advisors to communicate more about ESG investing so they can align their investments with their personal values. In April, UBS announced it would be teaching sustainable investing to its 7,000 financial advisors and rolling out a new range of impact investment products as it attempts to position itself as the greenest bank in the market.
Filling Demand With Supply
In this light, investment managers large and small have taken steps to accommodate the growing demand for sustainable and impact investments. In addition to PIMCO’s “sustainability initiative,” BlackRock—the world’s largest asset manager with more than $5 trillion under management—now offers “Investor Strategies for Incorporating ESG Considerations,” and Northern Trust has been actively promoting its tools for conscience-driven investing across all its global offices.
This comes amid a boom in markets for sustainable assets. Sustainable investing in the U.S. grew 33% from 2014-2016, and sales of long- and short-term “green” municipal bonds reached $1.5 billion in the first quarter of 2017—up 42% from a year earlier—even as overall municipal bond issuance declined 11%.
Then there’s China.
Facing the prospect of more than 1 million deaths a year from pollution-related illnesses thanks to its heavy reliance on coal for power generation, the world’s second-largest economy has committed to begin a transformative spending initiative on renewable energy sources, the production of low-emission vehicles, and the construction of new transportation and water infrastructure. Already this year, China has issued green bonds at a rate that puts it on track to double its 2016 total, with prospects for doubling that number again a year from now.
These actions not only help the Chinese government address humanitarian stress, but also open its doors to the global capital flows in search of a home for sustainable assets.
View From the C-Suite
While market demand continues to increase for tools, standards, and data, many companies are woefully behind the curve in providing useful ESG metrics, in part because of the mistaken belief that investors don’t allocate funds based on ESG performance. MIT Sloan Management Review’s “Investing For A Sustainable Future” showed that very few companies prioritize the communication of sustainability performance, even as evidence mounts that sustainability-related activities are material to the financial success of a company over time. In short, “investors care more about sustainability issues than many executives believe,” the review concluded.
Part of the problem transcends a company’s willingness to engage with investors on a deeper level regarding ESG. Even those managements that are eager to share more and invest resources to capture data may be struggling to figure out ESG without any agreed-upon standards.
However, companies that are on the forefront of understanding the impact of ESG are recognizing that these criteria should be considered not only in the context of mitigating risks and responding to stakeholder pressures, but also as new strategic directions to remain competitive, foster innovation, and create new commercial growth opportunities.
In fact, a recent collaborative study from Harvard Business School, KKS Advisors, and The Generation Foundation shows that when companies adhere to an ESG framework and at the same time develop an authentic purpose, they actually become more appealing to their key stakeholders, including customers, employees, and investors—thus driving innovation and creating value and a competitive edge. No surprise that The Economist, in a 2013 survey, found that 70% of senior executives worldwide believe a sustainability strategy is necessary in order to create long-term growth.
Of course, those companies that fully embrace and practice an ESG culture benefit from having the tone set from the very top. Allianz SE is consistently recognized as one of the most sustainable companies in the insurance industry by the Dow Jones Sustainability Index (a product of S&P Global). CEO Oliver Bäte said in September that his company is “very proud of this result. We started with the integration of ESG factors into our business early on and have continuously improved. We also set ambitious goals for the coming years and would like to contribute to the achievement of the Sustainable Development Goals.”
Industry giants like Starbucks, Apple, and Walmart are making long-term, board-level commitments and adapting their business models to develop differentiated products, enter new markets, ensure sustainability of their supply chains, attract and retain millennial talent, and enhance their relationships with regulators and local governments.
Data is beginning to support this belief that having a long-term mindset can pay financial benefits. According to a study by McKinsey Global Institute and FCLT Global, the results showed that from 2001–2014, companies focused on the long term had a higher amount of market capitalization growth. They also outperformed the competitor set by 47% when it came to revenue growth and by 36% in earnings growth.
Still, with all this progress, there remain remarkably few standards, available data, and useful tools by which investors can effectively price financial instruments based on their level of greenness or how sound a company’s social policies and governance practices are. This has prevented, for example, the social finance sector from achieving its untapped potential.
To be sustainable and prosperous, to embrace a standardized ESG framework, and to push publicly traded companies to disclose in greater detail ESG-related risks and return value to shareholders are the challenges and rewards facing corporations, the investment industry, and investors. As each challenge is completed and each reward achieved, creating a sustainable, more inclusive, less volatile global economy will become more of a reality.