Last Updated on Thursday, 17 March, 2022 at 8:32 am by Andre Camilleri
Maryna Chernenko is managing director of UFG Capital, a Cyprus-based alternative investment fund manager (AIFM) company that provides private and institutional investors with management services through investment funds.
ESG investing has become a key trend in the financial industry in the last few years. Simply put, it is a sustainable form of investing that considers factors related to the environment, society and governance to evaluate both the overall impact and financial returns.
The main purpose of investments is to generate income, but if we talk about ESG investment, it means that we should give a special priority to securities of the enterprises that contribute to the development of society. In fact, it creates a new company selection standard or criterion for investments when we pay attention not only to such classic indicators as risk and profitability but ecological influence and contribution to the community.
Research confirms ESG’s potential
According to a PwC report surveying 325 investors globally, 80% of the respondents stated that ESG is an important factor in their financial decision-making. In contrast, 50% expressed their willingness to divest businesses that are unwilling to take sufficient action on sustainability-related problems. At the same time, BNP Paribas’ study revealed that 22% of the polled investors integrate ESG into at least 75% of their portfolios, which is expected to further increase in the coming years.
The rising popularity of ESG investments is not without reason. Last year, Deloitte Global and Forbes Insights surveyed 350 business executives. Based on the results of the study, the majority of the respondents stated that ESG had a positive impact on their companies’ revenue growth (59%) and profitability (51%). In addition to the financial factors, 48% and 37% indicated increased customer satisfaction and measurable positive impact on the environment, respectively.
Indeed so, among other benefits, socially responsible investing improves business financials and often leads to outperformance. According to a Morgan Stanley report, ESG equity funds in the US outperformed their traditional peer funds by a median total return of 4.3 percentage points, while the same difference was 0.9 percentage points for sustainable bond funds in 2020. Furthermore, a 2015 meta-study by Friede, Busch and Bassen aggregated evidence from over 2,000 academic reports to find that over 90% of the analyzed research showed that ESG either had a neutral or positive impact on financial returns.
We shouldn’t forget about the risks
It’s clear that ESG has become an important trend in the financial world. However, while sustainable investing has many benefits, we shouldn’t forget about the potential downsides and risks involved.
Since data collection and analysis are crucial for measuring ESG performance, investors need a standard way to determine a company’s sustainability and ethical impact.
Unfortunately, even with the popularity of ESG investing, the sector lacks this universal measuring tool. As a result, you have to consider a massive number of factors, from the firm’s CO2 emissions and potential disposal of hazardous waste to employee diversity policies and local community donations, which makes the process increasingly complex.
With a near-infinite list of social, environmental and governance issues, ESG makes room for quite some subjectivity. For example, as stakeholders have different priorities in the field of sustainable investments, companies have to tailor their business processes to fit the needs of profit-seeking shareholders, employees searching for a firm that aligns with the values, and consumers who want to have a clean conscience when they use a product or a service.
In this scenario, it’s hard to determine which group needs to prioritise when evaluating ESG investment performance. At the same time, it’s also difficult for businesses to pick the factors they should put first. Should they turn greater focus on social issues or their impact on the environment? Or should they prioritise governance-related factors? In any case, leaving out an important ESG element increases the enterprises’ backdoor risks.
Furthermore, the process of changing standards can cause several problems regarding the communication between funds and their clients. For instance, the sudden shift of a number of ETFs to ESG indices at the beginning of the year, and by that excluding companies from the ETFs, caught some European investors off-guard or even “upset” them. Such alterations as changing the index influence profitability and the number of companies available for investments. Moreover, one more problem appears when a fund changes investment policy unilaterally: the growth of discontent among clients which results in customer loss. It happens because sometimes issuers do not know their shareholders, so they have no opportunity to warn them about investment policy changes.
It’s important to mention regulation as well, which adds another layer of complexity to the process. While multiple jurisdictions – including the EU, the UK and Canada – have already regulated ESG (or are planning to do so in the near future), the laws and rules around this field vary a lot.
Brexit is an excellent example here. Soon after the United Kingdom quit the European Union, regulators in the country announced that they started developing their own disclosure requirements for sustainable investments instead of utilising the new EU rules. While the FCA’s proposed framework will include five labels for categorising sustainable credentials, there are only three categories in the EU law.
While this gives a chance for UK regulators to create something new that may solve some of the inefficiencies of the EU ESG framework, it makes sustainable investments more complex. And such divergence doesn’t just lead to confusion when it comes to interpreting data but also increases the costs for shareholders.
ESG: a promising trend that still needs some work
Regarding what we discussed in this article, it is easy to figure out that even such a good intention to improve public responsibility and build a sustainable future can come with downsides.
Due to the lack of universal regulation (in fact, it is a little similar to the crypto market’s regulatory state) and a standard way to measure performance, investors face increased risks, especially when it comes to evaluating ESG stocks. At the same time, businesses have to consider numerous factors to fulfil the needs of different stakeholders.
However, while this instrument is not perfect, we must finalise it and carefully implement it, taking into account all the risks and consequences of such an innovation.