By Dhanada K Mishra*
In recent years, many investors have become increasingly anxious about the dangers of climate change, corporate greed causing environmental damage, and the slow pace of progressive corporate governance practices regarding issues such as flexible work arrangements, gender parity, and whistleblower protection.
Therefore, investors increasingly are aligning their financial portfolios with their values and beliefs by choosing ESG (Environmental, Social and Governance) investing. ESG investing considers a company’s environmental impact, social responsibility practices, and corporate governance policies when deciding whether it is worth investing one’s money. ESG investing does not offer a one-size-fits-all approach, and it is essential to understand the potential rewards, as well as risks.
Two recent events have highlighted the importance of understanding the world of ESG investing. Adani enterprise, a large Indian conglomerate, has lost over $100 billion of investors’ funds due to a history of bad ESG practices exposed by Hindenburg Research. Also, the Crypto Exchange FTX went bust as egregious corruption was exposed.
ESG and the RoR (Rate of Return) on Investment
ESG is a risk-mitigation strategy at its core. It helps the investor evaluate the material risks of a company’s future performance based on its environmental, social, and governance practices. For example, a company that doesn’t address its employees’ grievances may lead to a workers’ strike. Poor waste management practices could get a company fined or subject to strict government regulation, not to mention adverse environmental impacts and possible litigation.
A Gallup Poll of 953 US individual investors found most “prioritized the expected rate of return and risk for potential losses over environmental and other issues.” On the other hand, investor stances shifted in 2022 to one of “acceptance” (34% vs. 32% in 2021) and “compliance” (29% vs. 24% in 2021).
Economists distinguish between institutional investors and individual investors, or so-called “retail investors.” While retail investors tend to prioritize financial rewards, institutional investors take the ESG framework more seriously in their risk-mitigation strategy.
ESG investments can potentially exhibit superior risk-adjusted returns when compared to traditional investments.
A NYU Stern School study found that among investment studies focused on risk-adjusted attributes, 59% concluded that sustainable options performed as well or better than conventional approaches while only 14% saw a negative result. The study comprised of more than 1,000 research papers published between 2015 and 2020.
Evidence suggests that implementing ESG principles can have a positive impact on investment returns.
A study by Refinitiv and Probability & Partners found that companies with higher ESG scores had higher returns than those with lower scores. Additionally, a survey conducted by the Organization for Economic Co-operation and Development (OECD) secretariat, “ESG Investing: Practices, Progress and Challenges,” found that companies with higher ESG scores also had higher returns than those with lower scores.
ESG investments can potentially exhibit superior risk-adjusted returns when compared to traditional investments. However, the exact rate of return will depend on the specific ESG criteria used, the type of investments, and the markets in which the investments are being made.
Additionally, the effect of ESG investing on financial returns can vary depending on the type of investor and the time frame of the investment. [For a discussion about ESG criteria and scores see Dhanada K. Mishra’s article, “ESG—The Greening of Capitalism,” in the December/January issue of The Earth & I.]
Does there have to be a contradiction between the rate of return and ESG implementation? According to Svetlana Borovkova, “the investment community is split into two camps: One side believes ESG comes at a cost of financial returns, while the other thinks that good ESG performance promises better returns and lower risk in the future.”
ESG Implementation in a Competitive Environment
Implementing ESG initiatives in a competitive business environment requires a well-defined strategy and a strong commitment to its principles. Companies should start by thoroughly understanding their current ESG performance and their goals for the future. This includes setting specific targets for the reduction of their environmental footprint, increasing social responsibility, and improving corporate governance.
Once a company has identified its ESG goals, it should create a plan to achieve them. This plan needs to include a detailed approach to implementation and monitoring, as well as a timeline for achieving the desired results. Additionally, the company should ensure that its strategies and initiatives are in line with industry best practices and regulations and that they are communicated effectively to all stakeholders.
A company needs to ensure that the ESG initiatives are aligned with the company’s core values, vision, and mission.
The company should also ensure that its ESG initiatives are integrated into its overall corporate strategy. This includes ensuring that the initiatives are aligned with the company’s core values, vision, and mission. And finally, the company should ensure that its ESG initiatives are integrated into its operations, from production processes to customer service.
Regulatory Frameworks and Standards
In developed countries, a variety of ESG regulatory frameworks and standards have been established. These include the Basel III framework, which sets out regulations for international banking, as well as the International Financial Reporting Standards (IFRS), which are used by many countries as the basis for their accounting standards. In the US, the Securities and Exchange Commission (SEC) takes a principles-based, accounting-focused approach that applies equally to ESG disclosures. In Europe, a more prescriptive disclosure framework is popular, for example, the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).
Investment Results—With and Without ESG Considerations
Investments can yield different results depending on market conditions and timing. Investments in general, and ESG investments in particular, tend to provide higher returns over the long term. According to a study conducted by BlackRock, the average ten-year return of ESG-positive funds was 7.4%, compared to the benchmark index return of 6.2%. The study also found that ESG-positive funds in the US outperformed their benchmark index by 0.5%, while in Europe they outperformed by 1.1% because of strong corporate governance. Higher scoring firms in the Morgan Stanley Capital International (MSCI) ESG rating outperformed their peers by 1.5%.
“Investing in positive, solutions-oriented companies focused on sustainability is where the market is going and where investors will excel going forward.”
“By focusing on sustainability, we are able to potentially outperform the benchmark because the benchmark is comprised of the legacy economy, while sustainability-focused funds are looking forward to a new economy,” Peter Krull, CEO of Earth Equity Advisors, said, adding that “investing in positive, solutions-oriented companies focused on sustainability is where the market is going and where investors will excel going forward.”
‘Greenwashing’ and the Reality of ESG Implementation
Greenwashing is a serious problem that obscures the true extent of companies’ ESG implementation. Greenwashing means making exaggerated or false claims about sustainability performance to appear more socially and environmentally responsible or ethical. An egregious example is fossil fuel company claims about how environmentally benign they are.
Recently, it became known that research conducted as far back as the 1970s by some of the largest oil companies, such as Shell and Exxon, predicted global warming as a likely consequence of their business. They even put contingency plans in place to deal with sea level rise affecting their infrastructure.
Today, many companies are not actively working to reduce their environmental impact or improve their social practices but are instead investing in marketing and advertising campaigns to appear more socially and environmentally responsible. This makes it difficult for stakeholders, investors, and customers to accurately assess the true extent of a company's ESG implementation.
Benefits and Risks
One key benefit associated with incorporating an ESG approach into investment decisions is that it can reduce risk in a portfolio by avoiding companies whose business practices may be seen as unethical or environmentally harmful. For example, by choosing not to invest in fossil fuel stocks due to concerns over climate change impacts, investors would avoid any financial losses should oil prices decline due to market forces or policy changes. Such changes are increasingly likely because governments around the world are setting up carbon emissions reduction targets.
In addition, integrating environmental considerations, such as renewable energy sources, into investment strategies can also protect against future regulatory compliance costs caused by legislation designed to tackle global warming issues.
Universally accepted ESG scoring metrics are still evolving, and for the investor to understand, evaluate, and select the appropriate ESG methodology can also be risky.
On the other hand, some potential risks are associated with implementing an effective long-term strategy based on sustainable development goals (SDGs) principles. Many organizations have publicly committed themselves to achieve SDGs through various initiatives, such as reducing greenhouse gas emissions levels. But these commitments often rely upon external factors beyond the control of individual businesses, for example, government subsidies and tax breaks. If these external conditions fail to materialize within the time frame expected, certain investments could become “stranded assets,” losing significant value. In addition, universally accepted ESG scoring metrics are still evolving. For the investor to understand, evaluate, and select the appropriate ESG methodology can also be risky.
Unintended Consequences of the “Invisible Hand”
The Chicago School of Economics popularized the moral philosopher and economist Adam Smith, whose birth tricentenary falls in 2023. One of the school’s eminent faculty members was Nobel laureate Milton Friedman, who said: “In the economic market, people who intend to serve only their own private interests are led by an invisible hand to serve public interests that was no part of their intention to promote.”
However, the “invisible hand” is a much-misinterpreted concept that originated from Smith’s book, The Theory of Moral Sentiments. It was subsequently only once mentioned in a different context in his more famous book, The Wealth of Nations. This misinterpreted idea of Adam Smith seems to have brought forth a form of capitalism with unintended consequences on environmental, social, and governance fronts that need urgent redress.
The best tribute to the great thinker would be that ESG could become a framework to rein in the worst aspects of free-market economics and save the planet from a climate catastrophe waiting to happen.
*Dhanada K. Mishra has a PhD in Civil Engineering from the University of Michigan and is currently based in Hong Kong working for an ESG-focused prop-tech startup. He has a strong interest in issues around the environment, sustainability, and climate crisis.
