Investors worldwide are increasingly seeking investment opportunities that promise to bring environmental and social benefits, in addition to market rates of return. If this trend continues, with the advancement of environmental or social objectives enhancing an investment’s value, it will strengthen the commitment to sustainability that is already gaining momentum among businesses around the world.
Last year, one out of every six dollars of assets under professional management in the US – a total of $6.6trn – was allocated toward some form of sustainable investment, especially public equities.
Some 1,260 companies, managing $45trn worth of assets, are signatories of the UN’s Principles for Responsible Investment, which recognise environmental, social, and governance (ESG) factors – and thus the long-term health and stability of companies and markets – as critical to investors. One signatory, CalPERS, one of the world’s largest institutional investors, has gone a step further; it will require all of its investment managers to identify and integrate ESG factors into their decisions – a bold move that could transform capital markets.
$6.6trn
Was invested in sustainable options in the US last year
The number of companies issuing sustainability reports has grown from fewer than 30 in the early 1990s to more than 7,000 in 2014. And, in a recent Morgan Stanley survey, 71 percent of respondents stated that they are interested in sustainable investing.
Changing perceptions
To be sure, a major barrier to incorporating ESG criteria into investment decisions remains: many investors – including 54 percent of the respondents in the Morgan Stanley survey – believe that doing so could lower the financial rate of return. But there is mounting evidence that this is not the case, with several recent studies indicating that sustainable investments do as well as – or even outperform – traditional investments.
A seminal 2012 study that analysed two groups of companies – similar in terms of industry, size, financial performance and growth prospects – found that those in the high sustainability group had superior share-price performance. And a new study by Morgan Stanley’s Institute for Sustainable Investing, which analysed the performance of 10,228 open-ended mutual funds and 2,874 separately managed accounts in the US, found that sustainable investments usually met – and often exceeded – the median returns of comparable traditional investments for the periods examined.
Many ESG factors come into play when evaluating sustainable investment options. For example, the Generation Foundation – the think tank of Generation Investment Management (on whose advisory board I serve) – identifies 17 environmental factors, 16 social factors, and 12 governance factors relevant to sustainability.
The challenge is to distinguish between the ESG factors that have a material influence on company performance and those that do not. But the data that companies currently report is inadequate to enable investors to make this distinction. The non-profit Sustainability Accounting Standards Board (SASB) is attempting to change that by developing material sustainability accounting standards for 80 industries, consistent with the US Securities and Exchange Commission’s compliance regulations. More than 2,800 participants – including companies with market capitalisation totalling $11trn and investors with $23.4trn in assets under management – have been involved in the SASB process. Using the SASB’s proposed standards for 45 industries, as well as other metrics, a new study – the most definitive so far – has found that companies that perform well on material sustainability factors tend to have better operational performance, are less risky investments, and earn significantly higher shareholder returns than companies that perform poorly.
Similarly, a new framework recently proposed by Morgan Stanley for valuations of companies in 29 industries includes ESG factors that pose material risks or opportunities. Whereas a company is traditionally valued based exclusively on how it deploys financial capital to generate returns, the new framework incorporates how it deploys natural, human, and social capital, as well as the transparency of its governance practices. This new approach to company valuation reflects the view that the most successful companies will be those that deploy all four kinds of capital responsibly.
Practical benefits
Material ESG factors can affect a company’s financial performance and shareholder returns through several channels. For example, more efficient energy and resource use can lower costs; better management of human talent can boost productivity; stricter safety, health, and environmental rules can reduce the risk of serious accidents; and new green or fairtrade products that appeal to consumers can increase revenues.
Consider investments that improve the energy efficiency of data centres, which use 10-20 times more energy than average commercial buildings, and thus are responsible for considerable greenhouse gas emissions. Decisions about data centre specifications are important for managing costs, obtaining a reliable supply of energy and water, and lowering reputational risks, particularly given the increasing global regulatory focus on climate change. Google’s construction of data centres that use 50 percent of the energy of an average data centre has brought it considerable savings.
Similar success stories have played out across sectors. Since 2011, the US chemical company DuPont has invested $879m in research and development of products with quantifiable environmental benefits. It has recorded $2bn in annual revenue from products that reduce greenhouse-gas emissions, and an additional $11.8bn in revenue from renewable resources like wind and solar power.
Likewise, the multinational consumer goods company Procter and Gamble reported $52bn in sales of “sustainable innovation products” from 2007 to 2012. That is roughly 11 percent of the company’s total sales over that period.
There are reasons to believe that investing in sustainability can increase shareholder value. In fact, if a company is to fulfil its responsibility to its investors, it has no choice but to go beyond financial returns to incorporate ESG factors that have an impact on performance over time. This is the kind of incentive that could propel the world to a sustainable future.
Laura Tyson is Professor of Economics at the University of California
© Project Syndicate 2015