The Rise of ESG and Sustainable Investments

By Richard Nop

ESG stands for Environment, Social and Corporate Governance and they are a subset of sustainable investments. ESGs involves financing a business seeking to generate positive returns whilst also creating positive societal and environmental footprints.

What is the ESG investment current landscape like?

In Australia, exchange-traded funds (ETF) that invest in high sustainability ratings were one of the fastest growing ETFs on the ASX. Impact managed funds materialised in Australia and became immensely popular overseas as investors favoured financial entities focused on driving environmental and societal change. The twenty largest stocks on the Australian CleanTech Index have also outperformed the share market for seven years in a row.

In the U.S. markets, the quantity of sustainable open ended mutual funds and ETFs available to investors increased by 30 per cent from 2019. Sustainable funds have surpassed their conventional counterparts in 2020 and drew in record net flows of US$51.1 billion in 2020, more than twice the previous record set in 2019. These sustainable funds are reported to have lower ESG and carbon risk than the traditional fund.

Sustainable Funds Annual Flows and Assets

Source: Morningstar

Globally, renewable energy assets are moving towards AU$4 trillion and between January to November 2020, AU$370 million was invested into funds which supported sustainable businesses.

Factors contributing to the surging valuation of ESG stocks.

The gains in these stock prices were fuelled by booming interest in sustainable investing. This is demonstrated by the Deloitte Australian CleanTech Index, in which it has climbed a cumulative 117 per cent in the last five years.

A 2020 study written by Bradford Connell, published in the European Financial Management Journal, revealed that the lofty valuation of a company with high ESG ratings came at the expense of lower expected returns. When the investor’s preference gravitates towards non-pecuniary assets, it lowers the discount rate, thus decreasing the cost of capital. This resultantly increases the value of the company at the expense of lower expected returns. A report released by NYU Stern also echoed similar sentiments. It was revealed that companies focused on sustainable initiatives, appeared to have improved their financial performance.

ESG: The New Normal?

Last year was a time when environmental and societal issues were placed in the forefront. This propelled ESGs into the spotlight and caused investors to alter their financial preferences. The focus towards ESG investing involves shifting away from the traditional fundamentals of financial decision-making which prioritises risk and profitability. Present investors want to support sustainable businesses as climate change has become a pressing issue for most industries. This message was echoed at an annual general meeting (AGM) for Woodside and Santos where shareholders pushed for goals which aligned with the Paris Agreement.

Last year, Rio Tinto received massive public scrutiny pertaining to the blasting of an Aboriginal Heritage site in Western Australia (WA). Despite receiving permission from the State Government to go forth with its operation, Rio Tinto’s failure to recognise any ESG factors was publicly criticised and thus tarnished the company’s reputation. As investors preferences begin to shift, Paul Bartholomew, Platts APAC Head of Metal News and Insight, declared that there is now a growing urgency for companies to act sustainably and satisfy their stakeholders. China, Japan, South Korea, the United States and many other countries are also pursuing the goal of net zero carbon emissions. As countries progress towards this target, it can be inferred that ESG regulations will play a major role.

The Relationship Between ESG Investments and Other Financial Assets

A 2020 research looked into the relationship between ESG investments and its interaction with stocks, currencies and commodities. The study reveals that there is a significant and bidirectional causal relationship between ESGs, conventional and ethical equity portfolios. The causal evidence is strong in the short-term (2-4 days) and medium-term (32-64 days) and weak in the long-term (256-512 days). It was also observed that there is a significant causal association between ESG equity portfolios, currency and commodities. This correlation is strongest within the short-term interval, weaker in the medium-term interval and weakest in the long-term interval. Overall, what can be implied is that ESG portfolios may not provide exceptional diversification benefits in the short term for stocks, currency and commodities, however, will be effective in the long-term.

Risks

One of the biggest risks of ESG investing is the lack of widely recognised standards within the industry. This means that a company is able to rebrand itself as ESG despite not incorporating any sustainable factors into its business operations.

Conclusion

ESG investments have risen in popularity since its inception and following the pandemic. Sustainable investing possesses greater societal and environmental benefits and has profitable opportunities. Nevertheless, it is easy to succumb to the hype, and investors should not be ignorant of its risks.

Sources: AFR, Australian Mining, European Financial Management, Fitch Solutions, Forbes, International Journal of Finance and Economics, Morningstar, NYU Stern, Sydney Morning Herald, S&P Global Platts, The Motley Fool

Disclaimer
The authors of this publication are not qualified to provide financial or investment advice and as such the content provided should not be construed in this manner. All information is intended purely for educational purposes and is provided for the personal interest of UNIT members. The opinions expressed within the article do not reflect those of UNIT as an organisation, its partners or its sponsors.