Sustainability: ESG becoming mainstream

This article first appeared in Wealth, The Edge Malaysia Weekly, on December 28, 2020 - January 10, 2021.
Sustainability: ESG becoming mainstream
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One unwitting bright spot in the unprecedented volatility brought on by the coronavirus pandemic this year has been the performance of funds with environmental, social and governance (ESG) strategies.

The pandemic has spread with alarming speed, infecting millions and bringing economic activity to a near standstill. However, it has also strengthened the conviction of early adopters of sustainable portfolios that the value of an investment is no longer just about returns.

This has inadvertently cemented the significance of financial and non-financial risks in assessing resilience, and bolstered the views of industry experts that ESG strategies are bound to grow from strength to strength.

“2020 has actually been the year where ESG and sustainable finance were given a lot of focus, and fund managers expect the coming year to be just as good, if not better. Assets allocated into ESG investments have indeed accelerated this year, especially amid the Covid-19 pandemic,” says Lim Suet Ling, CEO of UOB Asset Management (Malaysia).

Sustainable funds will continue to gain the attention of asset managers and investors with the convergence of sustainability and megatrends in investing, she adds.

"Specific megatrends such as climate change and human capital management are also key drivers of ESG performance. These trends are picking up in pace and will be here for the long term." - Lim

Sustainable investment can be defined as a long-term-oriented investment approach that integrates ESG factors into the research, analysis and selection process of securities within an investment portfolio, says investment research firm Morningstar.

“Assets under management for sustainable funds have rapidly grown and we see investor interest in this space continuing [to push] this trend. Greater collaboration between stakeholders, as well as more resources flowing in to assess ESG investment opportunities will also contribute to their growth.

“As asset owners and managers increasingly gravitate towards these investments, the momentum is here to stay,” asserts Lim.

An analysis of active and passive strategies by Boston-headquartered research firm Opimas LLC shows that the value of global assets that rely on ESG data has almost doubled over four years, and more than tripled over eight years, to US$40.5 trillion (RM163.9 trillion) in 2020.

The research released in July shows that products not labelled as “ESG” or “sustainable” were also deliberated using sustainability data as a source of insight on portfolio companies.

Used as a yardstick to assess the inherent risks of investments, ESG factors have proved to be useful in identifying potential risks and opportunities beyond technical valuations that can be beneficial to financial performance.

"Our analysis suggests that investors have not lost their taste for ESG during this crisis. On the contrary, the recent ESG cumulative flows show the opposite and we can imagine that demand will continue to grow." - Laugel

According to Opimas, active strategies represent the majority of ESG-related assets under management, at 75% in the US and 82% in Europe in 2019 However, passive ESG strategies captured about 60% of new asset inflows in the US in 2019.

Meanwhile, sustainable funds in Asia saw a record high of US$8.7 billion during the third quarter, according to data from Morningstar Direct. This brings total ESG fund assets in the region to US$25.1 billion, which is 75% higher than in the second quarter.. These statistics are an indication that investors are increasingly outcome oriented. That is why Elodie Laugel, chief responsible investment officer of Amundi, believes that the financial aspect is no longer the ultimate goal for the new generation of investors.

“While it is difficult to predict the future outperformance of sustainable funds, what is clear is that ESG issues will continue to be a priority for investors. Effectively, our analysis suggests that investors have not lost their taste for ESG during this crisis. On the contrary, the recent ESG cumulative flows show the opposite and we can imagine that demand will continue to grow.”

Laugel says that sustainability awareness is increasing at all levels and expectations have changed. The French asset management firm managed more than €1.67 trillion (RM8.2 trillion) in assets as at Sept 30, across six main investment hubs — Boston, Dublin, London, Milan, Paris and Tokyo.

“There is a willingness to influence companies’ behaviour and avoid harmful practices. In this context, we can expect companies having an efficient ESG strategy to be preferred by investors and thus to outperform,” she adds.

"The year started off better, with the market saying ESG funds and indices performing better in 1Q during the Covid-19-related market downturn. Although in the last few months, ESG funds have sort of given back a little bit of their performance, it’s still a positive year to date." - Milon

BIMB Investment Management Bhd CEO Najmuddin Mohd Lutfi concurs. As social issues become the epicentre of the Covid-19 crisis, investors now understand that good ESG practices do not just encapsulate larger-than-life narratives like climate change.

“When we look back at 2020, it will be remembered as a turbulent year that will leave a very big legacy. The focus on people will be one of those things that will be materially important for investors.

“Most investors expect that the pandemic will accelerate an already growing trend towards ESG investments. What Covid-19 has done is to show acutely how a sustainability crisis can impact economies, businesses and society at large. It is an example of what could happen were we subjected to further sustainability shocks. That doesn’t have to be climate change,” says Najmuddin.

BIMB Investment is one of the few local fund houses that have integrated ESG criteria into their investment strategies and are working towards converting their existing portfolio of conventional funds into ESG-compliant ones.

Resilience amid turmoil

ESG risks are systemic risks, which are unlikely to slow down even after the pandemic ends, adds Najmuddin. “Investors are likely to continue sizing up companies with the best ESG credentials, as evidence points to them having proven resilient during the pandemic.

“Evidence shows that companies with good characteristics have more prudent management and demonstrate greater resilience in a crisis. Research also shows how the market discriminates between companies based on their attention to sustainability matters, both in crashes and recoveries, demonstrating why sustainability should be at the heart of active portfolio management.”

"What Covid-19 has done is to show acutely how a sustainability crisis can impact economies, businesses and society at large. It is an example of what could happen were we subjected to further sustainability shocks." - Najmuddin

At a minimum, it is a risk management tool, stresses UOB’s Lim, one that allows investors to limit their downside by identifying the companies at risk.

“If a company manages its material ESG risks, such as pollution for an industrial company, or data privacy for a tech company, better than their peers, studies show they have better profitability, lower cost of capital, and tend to do better in the long run.

“Performance can actually be cross-sectorial as well, as we see the materials and consumer discretionary sectors linking up with the manufacture of new electric vehicles in the market,” she says.

In Europe, regulators regard ESG considerations a part of institutional investors’ fiduciary duty, says Paul Milon, ESG specialist (Asia-Pacific) at BNP Paribas Asset Management.

The European sustainable fund market reached a milestone in the third quarter of 2020 with almost €882 billion of assets under management.

“The year started off better, with the market saying ESG funds and indices performing better in 1Q during the Covid-19-related market downturn. Although in the last few months, ESG funds have sort of given back a little bit of their performance, it’s still a positive year to date,” says Milon.

Nevertheless, investor interest has certainly been risen, he elaborates. “More investors want to allocate more of their money sustainably and invest with an ESG lens.”

It is undeniable that the downturn in the energy sector — oil prices tumbled after Saudi Arabia launched an aggressive price war against Russia in early March — played a role in the performance of ESG funds. This is because almost all ESG funds avoid or negatively screen against oil stocks, which means their performance has not been affected by the plummeting share prices.

Fossil energy slump aside, the economics of renewables is making it harder for oil to compete over time, Milon adds.

Net zero commitments from some of the world’s major economies is a testament to the fact that financial markets no longer exist in isolation from social or environmental challenges. This is reflected in the continued focus on sustainability that is coming through policy action.

These have an inherent material financial impact on investment portfolios as companies’ fortunes are intrinsically tied to their ability to navigate changes in the societies on which they rely, Milon emphasises.

Rising themes

In the last few months alone, three major Asian economies — China, Japan and South Korea — have made commitments to reach net-zero emissions. In October, Japan and South Korea pledged to reach net zero by 2050 and in late September, China committed to do the same by 2060.

Net zero means reaching a balance between the greenhouse gases released into the atmosphere and those extracted back — either by stimulating nature to absorb more or by building technology that does the job.

On the home front, Malaysia’s state-owned oil and gas producer Petroliam Nasional Bhd (Petronas) announced in November that it aims to become a net-zero emitter of greenhouse gases by 2050. It plans to do so by increasing its investments in renewable energy.

“For instance, our energy transition strategy has returned in excess of 130% year to date. Meanwhile, the MSCI AC World is [has returned] around 5% ,” points out Milon.

Financial regulators such as Bank Negara Malaysia and the Monetary Authority of Singapore are also doing their bit by consulting on incorporating climate-related scenarios in their future policies and to circumvent issues like greenwashing or ESG-washing from arising.

Apart from energy transition, advances in technology will also continue to drive the performance of sustainable funds, opines Lim. “Technology and data are definitely key areas that will drive ESG performance. There have often been concerns and scepticism over the different methodologies and ratings systems that ESG data providers can offer; there is no question that ESG data systems, as they become more robust, can better evaluate risks and opportunities not yet captured in existing financial valuation models.

“Specific megatrends such as climate change and human capital management are also key drivers of ESG performance. These trends are picking up in pace and will be here for the long term.

“Asset owners, including sovereign wealth funds, family offices and pension funds, are multi-generational and here for the long run. They will definitely be key in driving the greater adoption of these megatrends in ESG and sustainable investing as well,” says Lim.

Laugel adds that investors are now more outcome-oriented and favour ESG integration and sustainable themes over traditional strategies such as exclusion or the best-in-class approach.

“They seek materiality for their investments, meaning the recognition that those extra financial criteria have a material impact on either the growth perspectives or risk perspectives of the company,” says Laugel.

This demand can be translated by simple ESG products focusing on thematic sectors such as renewable energy or specific objectives such as the fight against climate change.

She adds that Covid-19 has increased the demand from the market to mobilise more private capital towards financing social projects as well. For example, social bonds — where the “use of proceeds” of fixed-income instruments are aimed at mitigating a specific social issue and/or at generating a positive social outcome — is a possible strategy to integrate social risks and to finance long-term inclusive growth, says Laugel.

Strategies like the “ESG improvers’ equities” approach can also make a difference, she points out. ESG improvers are companies that are demonstrating positive momentum in addressing ESG risks and opportunities.

“These companies are financially attractive but are also expected to improve their ESG or socially responsible investing score over a three-year horizon to the high end of the ESG score range,” says Laugel.

Moving forward, heightened regulations and awareness will improve the participation of retail investors, says Milon.

“The participation of retail investors, even those in the high-net-worth segment, is still relatively low. It is evident that the impact of Covid-19 is not enough. There needs to be more capacity building, education and awareness so that investors understand the importance of sustainable strategies.”