It is an age-old question for investors: will I have to sacrifice returns if I want my investments to align with my ethics? The answer used to be unclear. Things, however, are changing. Nowadays the answer will invariably be ‘no’, or at the very least ‘it depends’.
Enough evidence is emerging for us to be confident firms that adopt sustainable business practices perform better over the long run, and this is in turn rewarded by financial markets. According to researchers at the University of Hamburg and Deutsche Asset and Wealth Management, a positive relationship between ESG ratings and corporate performance was found in close to half of over 1,800 academic studies published since 1970, with a negative correlation being found just 10 per cent of the time.
Similar findings have been found for other asset classes. For instance, a 2016 study by Barclays analysts found a “small but steady” performance advantage by imposing either a positive or negative tilt to different ESG factors on a portfolio of US investment grade corporate bonds.
Our own shorter-term analysis also supports these conclusions. Recent performance of the global equity market when split into stratified thirds based on Aviva Investors’ inhouse ESG metric rank shows the gap in performance has been consistent and of notable magnitude.
As financial markets have begun to realise the potential costs associated with evolving risks like climate change, ESG approaches to managing risks and opportunities are becoming an integral part of holistic financial analysis. Our research suggests material ESG metrics have provided significant return differentiation recently, which tells us increasing ESG awareness is already impacting valuations. There is also a growing body of evidence suggesting highly-rated firms have a lower cost of capital – meaning that firms who score well on ESG metrics can borrow money at more favourable rates of interest.
Furthermore, since the evidence suggests companies can create value by improving their ESG scores, it makes sense to engage with them to help improve their approach. For example, BP shareholders recently voted overwhelmingly in favour of a motion pushing it to set out a business strategy aligned to the Paris Agreement’s goal to combat global warming. The resolution, which we co-sponsored, requires the company to evaluate whether each new fossil fuel project is consistent with the Paris Agreement. We believe this strategy will put BP in a better position to protect long-term returns.
For individual investors it can be hard to navigate the complex vetting process of determining which products and investment managers to choose. Beyond simple ethical funds that screen out ethically-questionable activities, looking for managers with a strong heritage and evidenced commitment to affecting change across the industry is a good marker. For instance, last year we voted on 54,335 resolutions at 4,713 shareholders meetings. More specifically, we engaged 1,954 companies as part of our stewardship responsibilities and voted against 27 per cent of management resolutions including 49 per cent of pay proposals.
Also, for too long finance has lacked a set of publicly available standards to allow consumers to ensure their savings are invested responsibly. But this is about to change: the British Standards Institute (BSI) is developing a kitemark that can be used by asset managers that meet voluntary standards on responsible investment. Think of it as ‘Fairtrade for finance’.
If real change is to be achieved, then capital markets will need to change themselves as company boardrooms and most financial analysts are preoccupied with quarterly results. As a result, more weight is attached to the short-term costs or benefits of an initiative than the long-term ones, whereas many ESG considerations are only likely to play out over the long term.
However, we expect pension funds and individual plan holders to exert more pressure. Within our workplace pensions business, we are already seeing individual investors ask more questions around how their money is managed.
It is becoming extremely difficult to argue against incorporating some level of ESG analysis into investment decisions. While investors need to be wary of overpaying for assets based on ESG criteria alone, there is every reason to believe investing responsibly, far from leading to returns being sacrificed, will pay off.