As more companies report data about sustainability, investors are starting to integrate this information into their investment decisions.
Businesses have learned that sustainable business practices can be beneficial to financial performance. Whether it’s shifting to renewable energy sources, conserving energy and water, or investing in new technologies that allow them to become more efficient, companies are finding that sustainability can make a difference to the bottom line.
Investors have taken notice and are increasingly looking at sustainability as a way to enhance portfolio returns and reduce risk. Just as valuation, market cap, momentum, and volatility have become cornerstones of factor-based investing, sustainability is fast becoming another factor to consider. Making this possible is an uptick in sustainability-related data.
Evolution of transparency
Decades ago, sustainable investing was limited. It usually meant screening out individual companies based on investor values. Investors who didn’t want to support tobacco or weapons would simply avoid investing in those industries. This often meant eliminating high-performing companies without replacing that portfolio performance.
Today, sustainable investing includes many more options. Investors can put their money in funds that focus on themes such as clean water or renewable energy. They can also incorporate sustainability factors in a fundamental analysis. The market for sustainable investing has grown accordingly. The Global Sustainable Investment Alliance estimates that ESG assets totaled $30.7trillion in 2018.
Linking sustainability to returns
Improved data availability has made sustainable investing more sophisticated and, as a result, allowed investors to make more informed decisions, with the potential to improve returns. A recent study with the University of Hamburg found that there is a strong positive correlation between ESG and financial performance across equities, fixed income and real estate. Another study by the University of Cambridge and several asset managers found that ignoring climate change and its associated risks could have a significant and detrimental effect on investment performance. Future climate change risks could lead to losses of 23% for fixed income portfolios and up to 45% losses for equity portfolios.
Integrating ESG into investing
Given the growing evidence that sustainability impacts returns, investors are looking for ways to insulate their portfolios from risks associated with climate change, accounting fraud, data privacy violations, and other sustainability-related factors.
A common way to do this is by over-weighting companies with ESG ratings and under-weighting or excluding those with poor ratings. Some investors are excluding high carbon-emitting companies, or those that have vast fossil fuel reserves on the balance sheet. Investors are applying ESG principles to domestic and some foreign equities plus corporate investment-grade credit
There is still plenty of room for growth and improvement when it comes to data, but more transparency is coming. European companies are further ahead when it comes to reporting about sustainability. U.S. companies that are disclosing climate-related risks aren’t necessarily doing so in consistent ways or may not give granular data. For instance, some don’t reveal the percentage of revenues earned from customers in a hurricane zone or the physical location of every warehouse or office.
This is a theme that can be expected to continue for the long-term. Climate change, as one of the most important ESG risks, will play a larger role in investing in the near- and far-term. Investors and companies all have a critical role to play in making markets and the economy more sustainable.
The association between ESG variables, financial performance and viability over the long-term mean that investors should view it as a core risk factor. By pushing for data on sustainability to be more readily available, consistently reported and transparent, investors can ensure that sustainability is an integral part of their investment decision-making process. For more information about how data on sustainability is affecting investment decisions, download PDF of the report.
1. Global Sustainable Investment Alliance, 2018 Global Sustainable Investment Review
2. DWS, ESG & Corporate Financial Performance: Mapping the global landscape, 2015
3. University of Cambridge Institute For Sustainability Leadership, Unhedgeable risk: How climate change sentiment impacts investment, 2015