Investors don’t need to make a special case for ESG, argue Jonathan Walker and Joe Krancki. Instead, it is a crucial factor to consider in the hunt for long-term value.
Investors do not have to regard themselves as especially green or progressive to care about environmental, social and governance (ESG) issues.
Investors often hold strong views on topics central to the ESG conversation, but even those that don’t should recognise something more fundamental: ESG has become a crucial driver of value creation.
To put that another way, ESG is nothing special. ESG encapsulates a set of factors that could create or damage future value. Evaluating those value drivers is simply what good investors do.
ESG should therefore be a core consideration in every investment decision.
If that sounds like over-reach, consider analysis of more than 2,000 studies of the impact of ESG on equity returns. Almost two-thirds of those studies found a clear correlation between a strong ESG performance and higher returns.1
Why should that be the case? Well, it’s because a focus on ESG can drive value creation in myriad ways.
Here are just six:
1. Enhanced risk management
Businesses with a mature approach to ESG recognise that while traditional financial analysis hasn’t focused on environmental and social considerations, these are increasingly financially material.
The World Economic Forum’s Global Risks Report 2023 suggests that in the next 10 years, 9 out of 10 of the most severe risks to global GDP are environmental or social in nature. These include everything from climate change risk and natural resource scarcity to the danger of a breakdown in societal cohesion.
ESG-aware organisations that identify and mitigate these risks have the potential to outperform those that don’t. We should not assume this is only relevant in certain sectors of the economy. A recent analysis of leading UK technology companies, for example, found that 7% of assets in certain businesses are already exposed to extreme weather events, and that this could rise to 14% by the century-end assuming no significant interventions on climate change.2
2. Greater cost reduction and efficiency
Investors sometimes worry that investment in ESG runs counter to the imperative for organisations to reduce cost and improve efficiency in response to current market volatility and uncertainty. But the two agendas do not have to be contradictory. ESG is often margin-accretive, particularly over longer-term periods.
Just ask the US conglomerate 3M. They introduced a “Pollution Prevention Pays” initiative back in 1975, and it is credited with saving 3M more than $2.4bn.3
More recently, Unilever’s “Sustainable Living Plan” has enabled the business to avoid more than €1bn of costs.4 Significant gains like these are available for businesses prepared to look past quarter-on-quarter cost comparisons.
3. Stronger reputation and brand management
As consumers, employers, employees, investors, suppliers and other stakeholders become more engaged on key ESG issues, an organisations’ position on these issues becomes critical to its brand value. The opportunity is to create a purpose for the business that aligns with societal expectations and drives brand value as management executes on that vision.
The risk is that poor ESG performance has the opposite effect. Accusations of greenwashing – companies attempting to overstate their ESG credentials – may be similarly damaging.
Contrast the positive brand value of companies with B Corp certification such as clothing retailer Patagonia and food producer Ben & Jerry’s with the problems experienced by companies such as Boohoo and Deliveroo. The former lost almost 80% of its market value amid concerns about its factory conditions, and the latter saw its IPO boycotted by investors worried about issues such as workers’ rights and corporate governance.5
4. Better access to capital
Businesses that hope to raise debt or equity will find it easier to do so if they perform well on key ESG issues. Investors and lenders are increasingly demanding about ESG criteria, particularly as many are now working hard to achieve their own sustainability and net zero ambitions. Some of those demands also consider the materiality of ESG. An example of this would be a credit rating agency downgrading a company because of the growing risk from the energy transition due to climate change and carbon and greenhouse gas emissions.
The collective flows of money through the fund management sector underscore what is at stake here. Data from Morningstar shows sustainable funds enjoyed inflows of £26bn during 2022 in the UK alone. Non-sustainable funds, by contrast, recorded outflows of around £50bn.6
5. More market opportunities
The shift to a more sustainable economy presents significant opportunities for many businesses and those that invest in them.
In the UK, the Climate Change Committee has suggested that the country will need to increase investment to £50bn a year between now and 2030, and then maintain investment at that level for the foreseeable future to meet its emissions goals.7
On top of this, the Green Finance Initiative has suggested there is a £56bn finance gap for UK nature-based solutions over the next 10 years.8
New ideas and solutions are going to be needed across every part of the economy. Accordingly, there will be many exciting and valuable opportunities for innovative companies across every industry and every sector, not just in energy.
6. Improved employee engagement and innovation
Last but not least, strong ESG performance will give companies an edge in a hugely competitive market for talent. Workers increasingly say they want to work at organisations whose values they share. That is particularly true of millennials and Gen Z, who will account for 72% of the global workforce by 2029.9
It is not surprising then to see a strong link between employee engagement and financial performance. Research in the US found that shareholder returns for companies regarded as the best to work for outperform their peers by between 2.8% and 3.8% a year.10
ESG also demands more progressive thinking about the make-up of the workforce, which has similarly been linked with increasing value. As one study found, companies with better-than-average total diversity deliver innovation revenues that are 19% higher and EBIT margins 9% points higher.11
Joe Krancki Investment Director |
Jonathan Walker, CFA Associate Director, Sustainable Investment |
1. Gunnar Friede et al., “ESG and financial performance: Aggregated evidence from more than 2000 empirical studies,” Journal of Sustainable Finance & Investment, Volume 5, Number 4, pp. 210–33; Deutsche Asset & Wealth Management Investment; McKinsey analysis
2. XDI Systems
3. 3M 2023 Global Impact Report
4. Unilever Sustainable Living Plan 2010 to 2020
5. Boohoo shares tumble on concerns over factory conditions (ft.com)
6.. 2022: Biggest Fund Outflows in a Decade | Morningstar
7. The Climate Change Committee’s (CCC) Sixth Carbon Budget Report www.theccc.org.uk/wp-content/uploads/2020/12/The-Sixth-Carbon-Budget-The-UKs-path-to-Net-Zero.pdf
8. Green Finance Institute (GFI): The Finance Gap for UK Nature https://www.greenfinanceinstitute.co.uk/wp-content/uploads/2021/10/The-Finance-Gap-for-UK-Nature-13102021.pdf
9. ESG as a Workforce Strategy (marshmclennan.com)
10. Edmans, Alex: The Link Between Job Satisfaction and Firm Value, With Implications for Corporate Social Responsibility
11. Harvard Business Review, “How and where diversity drives financial performance?”, 2018 (link)
