Overcoming the challenges of sustainable investing (08/2023)
Sustainable investing has come a long way and is now mainstream. Whatever your motivation for change, its clear there is an increased interest in sustainable investment – at times led by clients, led by firms themselves, and sometimes in response to regulation. This report provides an overview of concepts to shed light on both the progress and challenges with respect to the current state of ESG investing.
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Forms of sustainable finance have grown rapidly in recent years, as a growing number of institutional investors and funds incorporate various Environmental, Social and Governance (ESG) investing approaches. While the mainstreaming of forms of sustainable finance is a welcome development, the terminology and practices associated with ESG investing vary considerably.
Most investors agree that they feel it was important that they engage with companies they consider responsible. Whereas only a minority are not interested in investing sustainably at all. This forms the catalyst for change. Institutional investors recognize environmental, social, and governance factors as drivers of value. The key to investing effectively is to integrate these factors across the investment process. Assess your current approach to sustainable investment. Are you taking the opportunity to explore your values and whether they could align with the investment objectives?
The techniques used in sustainable investing have advanced as well. While early ethics-based approaches such as negative screening remain relevant today, other strategies have since developed. These newer strategies typically put less emphasis on ethical concerns and are designed instead to achieve a conventional investment aim: maximizing risk-adjusted returns. Many institutional investors, particularly in Europe and North America, have now adopted approaches that consider ESG factors in portfolio selection and management. Others have held back, however. One common reason is that they believe sustainable investing ordinarily produces lower returns than conventional strategies, despite research findings to the contrary.
In late 2020, the Forum for Sustainable and Responsible Investment stated that US sustainable investing assets had topped $17trn, or some 33% of all US financial assets under professional management. Unfortunately, such figures are a case of overstatement and under delivery.
Much of what is liberally classified as “sustainable investment” lacks substance. Simple screens and the token consideration of ESG factors in the investment process generate few, if any, real-world benefits for people and planet. Much of the $17trn in sustainable investing is in fact a security-level activity. That may lead to the refusal to purchase certain securities, due to involvement in a controversial activity, or a sustainable factor may increase or decrease a price target by a few percentage points. However, the solution to the predicament of overstatement and under delivery lies not in improving such single security selection – it sits squarely with asset allocation.
Sustainable factors often do not enter the asset allocation debate. When they do, they are typically considered at the end of the process and treated as a constraint
Moreover, returns have shown mixed results over the past decade, raising questions as to the true extent to which ESG drives performance. This lack of comparability of ESG metrics, ratings, and investing approaches makes it difficult for investors to draw the line between managing material ESG risks within their investment mandates and pursuing ESG outcomes that might require a trade-off in financial performance. Despite these shortcomings, ESG scoring and reporting has the potential to unlock a significant amount of information on the management and resilience of companies when pursuing long-term value creation.
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