This article was originally published in the AFR.
Funds labelled as ESG or sustainable have faced headwinds over the past 18 to 24 months. Performance concerns, volatility in fossil fuel prices, the politicisation of ESG in the United States and the uncertainty around the energy transition have all added to challenges for the sector.
But despite all this, sustainability remains firmly entrenched in government policy and regulation, in corporate sustainability comments, and shareholder demands. Legislation is pushing for more, not less, sustainable solutions.
Recalibration of ESG investing has been an excellent exercise in weeding out the greenwashers, bandwagon participants and naysayers.
Have environmental, social and governance funds had their day? No. Is the sector maturing, recalibrating, and setting itself up for success? Absolutely. The underlying trends driving sustainable investing are going only one way.
Climate change, inequality, geopolitics, food and energy security are all real-world issues that have tragic, real-world consequences. If not addressed, they can and will continue to affect financial markets.
The ESG acronym shot to prominence 10 years ago, but according to data provider FactSet, companies citing "ESG" on earnings calls in the last quarter of 2023 reached their lowest number since 2020.
Some academics are calling for the term to be removed completely, not because it's no longer an important consideration in investment decision-making, but because it has become so polarising and, according to Morningstar, flows out of sustainable funds have been significant.
In a recent note, UBS pointed out that the headlong rush into ESG without robust and transparent processes in place, particularly in the event of a potential market downturn, risked damaging the enthusiasm for the asset class overall, and the constant promise that ESG would always do two things: save the world, and always outperform. Of course, neither is true.
Ultimately, ESG investing should be considered the same way as any other investment strategy, by looking at its place in an overall investment thesis rather than in isolation.
Incorporating non-financial factors into long-term investment decision-making is good investing, not just ESG investing. This logic is seen with asset prices all the time. Would you buy a house in the Northern Rivers region of NSW without considering flood risk? Why, then, would you invest in a company without considering any material climate or social risks that may affect returns?
ESG integration into the stock selection process is far more intertwined with asset price valuation than many investors realise. It's all about the choices that companies make, how they think about the implications of those decisions, and how it might affect the long-term health of the company.
The pioneering approach to investing sustainably centred on large exclusion lists, which took the view that not allocating capital to companies that did not share the same values as the investor would ultimately lead to an increase in the cost of capital, and a lower share price. But this hasn't necessarily played out. In fact, selling to an investor whose primary focus is to maximise returns ultimately may have led to the opposite outcome.
By their very nature as another constraint to the portfolio construction process, exclusionary strategies can affect performance versus a traditional benchmark.
Investing for a sustainable future has evolved to be far more than just exclusions, although this strategy does still play a role in terms of values alignment. Exclusions also remove the ability for investors to engage and influence behaviour. We saw this recently with the actions of Australian superannuation fund HESTA against Woodside.
Allocating capital to strategies that are focused on impactful outcomes is far more tangible in terms of outcomes, relative to exclusionary only funds. To make the global economy more inclusive and sustainable, a blend of approaches - public, private and everything in between - is required.
Considering the implications of non-financial factors in investment decision-making, whether it be environmental factors, social or governance issues, patents, trademarks, government policy or legislation, is just good investing.
The polarisation of the ESG acronym may see a pullback in ESG-labelled strategies and more of a focus on solutions and outcomes. This is a good thing. Increasingly, some of the most successful investment managers are not labelled as ESG per se but have the best and most robust processes around integrating ESG factors.
The bottom-up pressure on companies is also not going away. Legislation and disclosure requirements are only going to get more intense, and as Australian Securities and Investments Commission chairman Joe Longo said recently, it is clear that ESG issues are driving the most significant changes to financial reporting and disclosure standards in a generation.
On March 27, Australia's new climate-related financial disclosure regime was tabled in the House of Representatives, with proposed climate-related financial disclosures coming into force on January 1, 2025.
Recalibration has been an excellent exercise in weeding out the greenwashers, bandwagon participants, and naysayers. With enhanced reporting and regulatory frameworks, less greenwashing, and a move towards incorporating non-financial factors into all investment decision-making, it will lead to better outcomes for people, the economy and investors.
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