ESG and Impact Investing – The Next Big Thing?

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Over the most part of a decade, ESG and impact investing have become key terms for both investors and fund managers, leading a new path to how companies are being researched whilst also having influences on fixed income investments.

In this article, I will attempt to explain why ESG investing is, and will continue to become a major consideration for investment management firms and some potential barriers along the way. 

What actually is ESG and impact investing?

ESG considerations and impact investing actually offer two very different approaches within the investment process. They both come under a branch of socially responsible investing initiatives and can be defined as the following:

Impact investing can be thought of to be more aligned with investor values – reflecting what the asset owner’s themselves value non-financially. For example, the objective of the investment is to achieve a specific benefit to wider society and the environment. Examples would include green bonds, social impact bonds, or community investing products [1]. 

On the other hand, ESG considerations refers to environmental, social and governance – three key factors in measuring the sustainability and ethical impact that a company makes. Within each of these divisions, there are wider in-depth considerations. For example, social factors would measure whether e.g. a company has good labour management and supply chain standards. ESG factors are therefore not a product on their own, rather the consideration of the aforementioned factors are utilised alongside the traditional investment decision-making process.

One way to measure a company’s ESG credentials is through the MSCI ESG rating – used by leading fund managers, which give company ratings between AAA to CCC [2]. Other ESG rating systems include Morningstar’s Sustainability Ratings as well as the Social Equality Score to name a few [3].

Overall, an intuitive way to distinguish between ESG and impact investing, is that ESG considerations generally aim to produce greater in depth understanding of a specific company and whether it is attractive over time. Furthermore, it should be noted that ESG and impact investing are amongst other factors such as screened and thematic investing.

For the remainder of the article. I will refer primarily to ESG factors as a broad term.

Brief History:

Historically, ESG factors have been involved since the 1960s, where simple stock screening used to be applied e.g. exclusion of a tobacco company from a portfolio due to its externalities [4]. However, its significant growth really took place in 2006, whereby the launch of the principles for responsible investing included ESG considerations within the investment process. 

Why has the growth occurred?

One major explanation for the growth in sustainable investing initiatives is that the world and the demographics of it, is changing. For example, we are seeing greater global challenges e.g. rising sea levels, global warming, flood risks etc. This has shifted the movement away from pure financial gain that traditional investment approaches offer. Furthermore, with a new generation of technology enabled individuals who are asking more of their investments, this is further driving the shift. This is best illustrated by Morgan Stanley’s 2015 study that showed 84% of millennial investors being interested in sustainable investing [5].

This is crucial evidence as US millennials alone are projected to have a wealth transfer of roughly $59 trillion from 2007 to 2061 [6].

If we also apply some economic intuition, it is the idea of negative externalities whereby the costs are not accounted for in prices – we ultimately suffer from unsustainable impacts made by firms. This can be seen in practice, as high net worth individuals and investors across the spectrum are making moves towards ESG – understanding its long-term importance [7].

Therefore, this has led to a significant rise in the number of investment management firms integrating ESG into portfolios, which grew at an average rate of 17% from 2014 to 2017 [8].

Graphically, the trend can also be seen that more investment firms are becoming signatories of the PRI, gradually expanding the assets under management that aim to consider ESG factors. 

Graph 1: Increase in Assets, Signatories and Asset Owners since APR 06.

Source: MSCI

Too fast too soon?

As with almost every significant trend, there is an issue of over-exaggeration of the real potential of ESG and impact investing in the short term.

The big profitability that ESG brings to investment firms is the lure of more assets under management (AuM), and this can be seen as an issue if ESG factors are emphasised without solid proof – i.e. “green washing”.

This has been seen to occur from both the perspective of asset managers as well as the individual companies that are being analysed. One example is Anheuser-Busch InBev, which has previously claimed that its products are made 100% from renewable energy but it turns out that only the Budweiser brand fits this claim (Corona, Bud Light etc. cannot make the same claim) [9].

BlackRock is another example that illustrates how long term this trend actually is, whereby Larry Fink (CEO) stated the commitment towards renewable energy but the firm still holds over $2trn of fossil fuel investments [10].

Therefore, ESG and impact investing will likely encounter green washing issues through outs its expansion. Furthermore, it can be said that more independent third-party rating agencies will be required in order to give fair scores especially between those of smaller firms in comparison to large corporates.

Overall, sustainable investing looks to be the major addition within the investment process for almost all fund managers in order to adapt to changing investor preferences and global issues. It seems that it will see the most growth in the US and Asia as opposed to Europe as the sustainable investing market only accounts for 21.6% (US) and 4.2% (Asia) as opposed to Europe’s 52.6% as of 2016 [11]. There is further evidence to suggest this, as AuM is set to continue rapid expansion, especially across the US as AuM is expected to rise from $84.9trn (2016) to $145.4trn by 2025 [12].