A few years ago, the world of sustainable investment exploded; I couldn’t open a newspaper without seeing an article referencing the importance of ESG (Environmental, Social and Governance) and every fund manager’s presentation suddenly included slides on how they consider ESG factors in their investment decisions.
Roll forward to today and the narrative looks quite different. Suddenly the media coverage surrounding responsible investment has taken an unfavourable stance (a quick search for ESG news and the first headline I come across is ‘ESG exodus’) and ‘ESG funds’ have experienced outflows in the billions over the past two years.
So, what has caused this shift in sentiment in a relatively short space of time? Perhaps the stellar performance of the (traditional) energy sector in 2022 was enough to convince investors that oil trumps renewable energy. Perhaps the anti-ESG regulation in the United States is scaring investors. Perhaps investors are feeling overwhelmed by the amount of information out there and the ever-increasing reporting burden. It’s difficult to know, but one thing is certain: the issues that responsible investment seeks to solve are certainly still prominent – it’s hard to ignore climate change when you’re sunbathing in the UK in early October!
Putting morality and ‘feel good’ aspects aside, responsible investment can be alpha generative. A strong investment process considers the full spectrum of strengths and the potential risks of an investment, and ESG factor analysis is simply another lens through which one can analyse an investment. For example, an ESG-integrated process will identify that a company is not disposing of waste efficiently (environmental risk that could lead to reputational damage) or has a strong culture that leads to happier employees (social opportunity).
Companies are increasingly redirecting capital expenditure (CapEx) into pro-ESG areas like renewable energy, electric vehicles (EV), employee mental health etc. Taking the example of EV’s, it is expected that automakers will spend around $1.2 trillion through to 2030 switching their product lines towards EVs1. Taking a backwards looking example, in 2022, global investment in the low-carbon energy transition equalled $1.1 trillion2 – a significant amount of capital in a single year. In turn, companies that have successfully reduced emissions faster than peers over the last five years have outperformed those in the worst quintile of emissions management by c.3% per annum3, demonstrating that this CapEx spending is additive to returns. When selecting the long-term winners, it’s difficult to ignore these trends.
‘Long term’ is a phrase that is misrepresented a lot in the investment world. There is no hard definition for the phrase and every fund manager I’ve met has told me that they are a ‘long-term investor’. Responsible investing is genuinely a long-term game because it’s going to take years for many of these themes to play out, such as the renewable energy transition or addressing the male-to-female ratio on Boards. It is likely that there will be some short-term volatility and the gains will not be linear, but over the longer term these themes will likely be beneficial. The recent rise in the oil price saw some investors dampening their focus on environmental factors and increasing the carbon footprint of their portfolios in order to chase short term performance. Now it’s worth noting that as a firm, Momentum is not opposed to owning carbon-intense portfolios but it’s important that fund managers stick to their convictions, consistently follow a robust process, and our preference is that firms are engaging with companies to improve.
The final point that I will make to demonstrate why responsible investment is additive to returns is regulation. Yes, there are ‘red states’ in the United States (US) that are pushing anti-ESG policies, and the UK has backtracked on various green policies recently, but there is global regulation coming and even in the US we are seeing pro-ESG policies such as the SEC’s sustainable disclosure regulation, rolled out in 2022. More broadly we are seeing an increasing number of guidelines, regulation and best practice initiatives being introduced in the UK, Europe, Asia and even in some Emerging Markets. When these policies are brought in, investors will want to own companies on the ‘right’ side of this change because there is a risk in holding those that have to spend huge amounts in a short time period in order to catch up.
All in all, investors do not have to give up returns in order to invest responsibly and in fact there is evidence that investing responsibly and integrating ESG factors is additive to returns. However, not all responsible investment strategies are created equal and alongside many other factors, one has to assess a fund manager’s ability to implement a responsible investment strategy effectively.
Sources: 1 Reuters.com: Automakers to double spending on EVs, batteries to $1.2 trillion by 2030. 2Bloomberg L.P. Global Low-Carbon Energy Technology Investment Surges Past $1 Trillion for the First Time. . 3Schroders: Funding the future, investing in climate action.