Sustainability is attracting ever-greater public attention. The topic already ranks highly on the legislative agendas of most governments, especially since the groundbreaking agreement reached at the Paris climate talks last year. This growing public awareness of sustainability signals an important shift in global priorities. It is pushing consumers, governments and business leaders to pay more attention to environmental, social and governance issues than ever before. This shift will also have a fundamental impact on the way companies are run and perform.
The Volkswagon emissions scandal is just one example of how the management of social and environmental issues can have a deep, bottom-line impact for corporate performance. Although the extent of the financial and strategic ramifications on Volkswagen are still unfolding, the scandal has already led to a $25bn (£17.2bn) loss in market value, the prospect of over $90bn (£62bn) in US fines, and a corporate reputation in tatters. Such examples demonstrate clearly that a company’s management of key ESG topics can have a very direct impact on the firm’s competiveness and long-term profitability. It therefore comes as little surprise that more investors today than ever before are integrating key ESG metrics into their investment analyses.
This growing investor focus is perhaps most evident in the rapid growth in signatories to the United Nations-sponsored Principles of Responsible Investment (PRI). PRI signatories commit to “incorporate ESG issues into their decision-making and ownership practices and so better align their objectives with those of society at large.” Today, over 1,300 asset managers have become signatories, representing over $60tn (£41tn) in assets under management. These asset owners include heavyweight investors like Blackrock, PIMCO, KKR, Partners Group, and Goldman Sachs, suggesting that the integration of ESG analysis into the investment process has already entered the investment mainstream.
The growing interest in integrating ESG data into the investment process has historically been clumped – rather awkwardly – under the umbrella-term socially responsible investing (SRI). Due to its subjective focus on what is and what is not deemed ethical, the mainstream investment community has received this approach with a great deal of reservation. Early approaches simplistically screened out “sin sectors” such as alcohol, adult entertainment or tobacco – typically referred to as a negative screen. As a result, SRI returns usually underperformed the market due to the smaller opportunity set of investable stocks (given the negative screen).
This approach, however, can be completely turned on its head. Instead of crudely excluding certain sin sectors, the emphasis is on examining the ESG factors that directly affect a company’s long-term business strategy and profitability. As such, the approach is less about the subjective values of the investor, and more about evaluating a company’s exposure to the sector-specific ESG-related business risks and opportunities.
For example, anyone investing in cement, coal or oil companies would be remiss not to consider the potentially dramatic changes in asset value that could occur if a higher price for carbon were to internalise the environmental costs incurred during the production process. In the same way, if a reasonable price for intensive water use were to be introduced, the balance sheets of businesses that are particularly water-sensitive (ie food industries) would also be significantly affected. The prospect of such disruptive repricings can be compared to what happened in the financial crisis, when the true value of subprime mortgages was (only belatedly) recognised by the marketplace, leading to a sharp price correction and billions in losses.
In addition to better management of risks, new responsible investment strategies maintain that the proactive management of environmental and social themes can cut costs and enable access to new revenue streams. For instance, companies implementing policies directed at waste minimisation, resource productivity and energy efficiency can reduce their operating expenditures, and as such, enhance profitability. At the same time, firms that develop new products and services related to sustainability trends, such as electric cars, solar panels and energy efficient light bulbs, can benefit by tapping into new and potentially lucrative revenue sources. Toyota’s huge success with its Prius and Tesla’s growing prowess can largely be attributed to a growing consumer interest in environmentally friendly products.
A question of performance
A key question for many investors is whether the integration of sustainability issues can deliver acceptable returns over time. Recent academic work relying on long-term data conducted by Harvard researchers supports the view that a good performance on ESG issues is positively related to an outperformance of security prices. For their analysis, the Harvard researchers identified 90 companies that adopted environmental and social policies in the early 1990s. They then created a second sample of 90 comparable companies with almost identical size, capital structure, operating performance, and growth opportunities in the early 1990s, but without the environmental and social policies of the first batch.
The results of the study are compelling: the stock performance of the 90 sustainable companies between January 1993 and December 2010 returned over 2160%, versus just 1440% for the peer group. Moreover, the study found that the portfolio of sustainable firms exhibited significantly less volatile performance relative to the portfolio of unsustainable firms. Such results suggest that combining “ESG overlays” with a robust underlying investment process can indeed generate strong risk-adjusted financial returns.
In the final analysis, we at Julius Baer believe the way by which companies strategically manage the ESG issues that affect their businesses can be seen as a powerful determinant of the firm’s future ability to navigate change, to position itself competitively, and ultimately, to generate long-term financial returns.
To this end, our premise at Julius Baer is that, over time, the interests of shareholders will best be served by companies that maximise their risk-adjusted financial performance by strategically managing the impact their businesses have on the societies and natural environments in which they operate.