ESG InvestingDec 4 2020

Meeting the demand for ESG

Search supported by
Meeting the demand for ESG
Pexels/Min An

Interest in responsible investment is reaching new heights, with the impact of Covid-19 providing a real catalyst for change.

As this demand grows, the financial industry, and society as a whole, wants to know how to practice responsible investing – and what results investors can expect from it. 

EY and Royal London wanted to contribute to this debate by reviewing existing empirical evidence of how responsible investing affects returns.

Applying ESG principles can deliver financial benefits, both in corporate performance and in reducing volatility

A number of hypotheses were set out to measure how using environmental, social and governance principles could impact investment performance.

More than 300 academic and other published papers were then reviewed to determine if the hypotheses were supported by evidence.

Our analysis shows that applying ESG principles can deliver financial benefits, both in corporate performance and in reducing volatility. This is a significant finding and is backed up by the resilience of sustainable companies in the face of challenge, not least now with Covid-19.

Key points

  • It is illuminating to look at the impact of ESG principles on investment performance
  • The Mifid II principle is affecting how advisers talk to clients about ESG
  • Companies with higher ESG ratings have lower share price volatility

Furthermore, this comes at a moment when demand for responsible investing is being pushed to new levels by the social and environmental ripple effects of the pandemic, and when regulatory changes such as the amendments to Mifid II are adding to the significant momentum.

Together, we expect the three key drivers of evidence, demand and regulation will rapidly accelerate the investment industry’s adoption of sustainable practices in a post-Covid world. Developing responsible investment capabilities is no longer an option: it is a necessity.

Regulation – a clear direction of travel

In recent years we have seen an enormous number of ESG-related initiatives worldwide and these have given a real boost to responsible investing. While many of these are focused on climate change, many other sustainability or stewardship regulations have also been introduced.

For financial advisers, perhaps the most significant change is a proposed amendment to Article 25 of Mifid II. This will require companies to take sustainability risks and clients’ sustainability preferences into account.

For asset managers, proposed reforms to Ucits and alternative investment fund managers mean incorporating the consideration of sustainability risks into governance structures and operating models.

The Pensions Regulator has taken several actions for workplace pension schemes. These include telling trustees that weighing ESG risks is consistent with maximising financial returns, and requiring the trustees of local authority, defined benefit and defined contribution funds to disclose their approach to ESG factors. These are just a few of many changes that the industry will need to deal with in the coming months.

The evidence on performance is growing

The idea that a company’s adoption of ESG principles could positively affect its performance has been discussed for some time. We believe our review of the empirical evidence can add real weight to this debate.

As part of this review we developed a series of hypotheses expressing specific ways in which ESG principles affect investment performance.

These include reduced risks, alongside lower volatility and costs of capital. We then tested these hypotheses against the findings of more than 300 studies, meta-studies and literature reviews with the findings outlined below.

You will see that our findings support or partially support eight of our hypotheses, including several sub-hypotheses. The most persuasive findings relate to corporate financial performance.

A variety of studies see neutral or positive evidence that companies that have pursued substantial environmental and social policies since the 1990s perform better than lower credentialled peers on accounting measures, such as return on equity and return on assets, and in terms of stock market performance over time.

In addition, companies with higher ESG ratings exhibit lower share price volatility than peers with lower ratings. Good ESG performers generally have better risk management processes and governance procedures that mean they are less exposed to idiosyncratic risk incidents.

We also found positive evidence relating to the performance. Studies of comparative investment performance found that portfolios that have exposure to companies with strong ESG scores perform better than those that do not.

However, this research is typically based on a relatively short timeframe, given that integrated ESG funds have only become a staple of responsible investing in recent years.

Studies including longer established ethical funds showed mixed results. In part, this reflects the ‘negative exclusions’ that have often been applied by ethical funds in sectors such as alcohol, tobacco and gaming. This reflects the inherent limitations of comparing historical data around ESG performance.

The power of positive investor sentiment

We have seen a huge surge in demand among investors for responsible investment.

Morningstar data shows that $21bn (£15.7bn) of new assets were invested in mutual funds or exchange-traded funds based on ESG themes during 2019 – nearly four times the previous record set in 2018.

This has been accelerated by the Covid-19 pandemic, which has brought increased focus on corporate behaviour – investors, especially younger people, are increasingly looking to invest in line with their values.

As a result, companies are under increasing pressure to demonstrate their responsible investment credentials.

We believe that responsible investment will become increasingly important as time goes on, and financial advisers and asset managers must continue evolving how they operate to meet this demand.

There are four key attributes that asset managers and financial advisers alike can use to develop strong responsible investing capabilities. This includes organisations with limited resources, and those that have taken few steps so far to implement ESG principles. Those attributes are:

• Listening and engagement: Listening to the end investor can help businesses gather more insight and data on consumer sentiment and trends. EY’s Future Consumer Index shows that enhancing environmental and social impacts is one of the leading factors that make consumers willing to share their personal data.

• Leadership and purpose: It is important for businesses to lead by example and demonstrate the values consumers seek. The impact of Covid-19 makes it even more important for companies to incorporate ESG principles into their own operations and conduct, not just their investment decisions or advice.

• Consistency and communication: Using internally consistent sets of ESG definitions and assumptions, aligned to global regulatory standards, will help to build a robust ESG framework, make performance comparisons and build trust and transparency with staff, investors and stakeholders.

• Training and culture: Training, education, leadership and culture are all essential to fully implementing ESG frameworks, and to increasing awareness of the benefits of responsible investing.

We expect regulatory change, evidence of no detriment to returns and fast-growing demand to drive sustained growth in responsible investing.

Meeting those needs will generate powerful revenue growth for financial advisers and asset managers. Those that fail to keep up risk being left stranded as the whole industry shifts onto a more sustainable footing.

Lorna Blyth is head of investment solutions at Royal London Intermediary and Gareth Mee is a partner – sustainable finance consulting at EY