The traditional belief that Environmental, Social and Governance (ESG) funds miss out on lucrative returns compared to their mainstream comparators has been debunked over the last few years. This outperformance was under relatively benign economic conditions.

The 2007 GFC removed any focus on ESG or sustainability from all but the deepest green corporates and investors – sustainability was about meeting the next payroll. Since 2007 ESG approaches adopted by corporates have deepened – ESG strategy is now much more about identification of longer term exogenous risks, adjusting strategies and driving competitive advantage and opportunity.

When done well this approach controls costs, manages risks and engages staff. ESG investing is also maturing – the use of ‘ethical screens’1 is still in place, however ESG integration is increasing in uptake and quality across the Australian investment landscape.

Graph showing leaders and laggards in esg

ESG fund performance

The economic downturn caused by COVID-19 was therefore seen by many as a significant test of this maturity: would the ESG/sustainability market fold again as it did in 2007? Mounting evidence from Schroders, AXA Investment Managers’ and MSCI shows that this has not been the case. ESG funds have consistently outperformed non ESG or ‘traditional’ funds.

ESG index comparison for Q1

ESG index comparison for Q1

ESG index comparison YTD

ESG index comparison YTD

Not only have MSCI’s ESG indexes outperformed the benchmark MSCI ACWI index2, AXA Investment Managers show that “companies with the highest ESG ratings have proven more resilient in the coronavirus market crash”3. Companies who are considered ESG leaders have outperformed the ESG laggards by 16.8% in Q1 20204. Schroders research shows that ESG indices outperform mainstream indices with the FTSE 100 – ESG Leaders index returning -27.3% in the period compared with -33.7% for the FTSE 100 index5.

Graph comparing FTSE 100 and ESG Leaders Index performance

Additionally, we’re seeing a significant increase in the level of interest and demand for ESG services from the private equity sector at the deal stage, as well as increased focus on ESG strategies applied across the portfolio as they look to drive performance and value.

We are currently in a transition for ESG. Moving between a period of greenwashing, where issues are “nice to have” until the next economic downturn – to action and a period of true ESG value, where climate and environmental services are seen as the only assets of true fundamental value.

As environmental and climate boundaries continue to be reached or exceeded, and social inequality keeps rising, the repercussions on society and the economy will not cease to magnify. Through this lens the disruptive impact of COVID-19 can be seen as a taste of things to come. Understanding, valuing and acting on ESG will be critical for corporates and investors to succeed.

Why has ESG outperformed during COVID-19?

  1. Sectoral exposure and avoidance of fossil fuels
    Responsible investment strategies such as integration of ESG considerations typically result in the screening of fossil fuel investments. Subsequently, ESG screened funds are less exposed to the oil and gas markets, which have been volatile during initial stages of COVID-19
  2. Experience in exogenous risk management:
    Organisations who are performing well on ESG factors, and subsequently Investment managers practicing responsible investment strategies, are used to dealing with exogenous risks to their business. Identifying, measuring, monitoring, and managing exogenous risks and opportunities is the foundation of ESG-aligned business strategy
  3. Efficiency and a longer term perspective
    Traditionally ESG-focused businesses have concentrated on minimising the impact of their organisation’s operations on the environment, reducing the required inputs to processes and subsequently the costs associated with these efficiencies. As ESG-focused businesses mature and naturally look to the longer term, they’re increasingly seeing the reciprocal benefits of a well-managed and positive relationship between consideration of ESG factors and their balance sheet – reflected in their superior market valuation during COVID-19.

Consumer expectations

Annually we’ve heard through investor channels such as the Responsible Investment Association of Australasia: From Values to Riches 2020 Report6 that 9/10 of Australians expect that financial institutions invest responsibly across the board. This holds true for super funds as much as banks with 86 percent of Australians expecting their super to be invested ethically or responsibly. Following events like the bushfires of the 2019/20 Australian summer and COVID-19, fund members are also increasingly demanding their super fund considers ESG and climate factors, with four in five Australians feeling that environmental issues are important when deciding where they invest their money. Renewable energy, energy efficiency, sustainable water systems, and healthy river and ocean ecosystems rank within the top of consumer environmental concerns6. This consumer sentiment has led fund members to move their super towards ethical options such as Australian Ethical Super at unprecedented rates. KPMG’s Super Insights Report7,8 over the past few years has highlighted the consistent high performance of Australian Ethical Super’s new member inflow, with the bushfire events sparking an average movement of 1000 new members per month9.

Climate risk is the first of many financial sector critical ESG risks

The bushfires of the 2019/20 Australian summer showed the importance of investors incorporating risks such as climate into their view of the future and associated investment strategies. The Task Force for Climate Related Disclosures (TCFD) was created post-GFC to deal with the unidentified, systemic and catastrophic risks posed to the global financial markets by climate-related factors. The TCFD’s recommendations released in 2017 provides a clear framework for considering climate-related risks and opportunities, and integrating them into investment strategies.

Key investment and regulatory bodies are also getting behind this. In 2019, the United Nations Principles of Responsible Investment (PRI) announced that it would require all signatories to report against TCFD from 2020 onward10. In an open letter in February 2020, the Australian Prudential Regulation Authority (APRA) declared that it intends to develop a climate change financial risk prudential practice guide11. The guide will be aligned with the TCFD, designed to assist entities in complying with existing prudential requirements, including governance, strategy, risk management, metrics and disclosures.

Broad uptake of the TCFD recommendations and the clear and logical links made between climate performance and future resilience and operation of the global financial systems have opened the pathway to understanding and valuing other ESG risks – we expect to see similar approaches adopted to ESG issues such as biodiversity and social inequality moving forward.

ESG policies and portfolio construction

Coronavirus has shown that super funds and asset managers need to consider risk beyond just climate, and more broadly recognise ESG-related risks and opportunities. Issues including natural capital and inequitable social structures also threaten the long-term performance of economies, and by implication investors’ portfolios12 .

The Sustainable Development Goals (SDGs) are increasingly being used as a framework to consider ESG risks. In June 2020, the PRI published Investing with SDG Outcomes: A five-part framework, which guides investors to “shape the real-world outcomes” using the SDGs, as it prepares to introduce mandatory outcomes-based reporting for the first time, from 202113.

According to the PRI focusing on investment outcomes can help investors:

  • identify opportunities in business models, supply chains and products/services;
  • prepare for legal and regulatory developments;
  • protect their reputation and licence-to-operate;
  • meet commitments to clients and beneficiaries – and communicate progress;
  • consider materiality over longer time horizons, to include transition risks, tail risks, financial system risks etc.; and
  • minimise the negative outcomes and increase the positive outcomes of investments13.

Closer to home bodies such as the Australia Sustainable Finance Initiative (ASFI) are working to develop frameworks to enable the Australian financial sector to embed SDGs and the Paris Agreement into the investment decision.

Investment Governance and ESG

The Superannuation Industry (Supervision Act) (SIS) requires a super fund trustee, when formulating an investment strategy, to give regard to the risk and the likely return from the investments, diversification, liquidity, valuation and other relevant factors. We note that APRA outlines in the Prudential Practice Guide – SPG 530 – Investment Governance, that additional factors (such as ESG) can be incorporated into this process where there is no conflict with the requirements in the SIS Act, including the requirement to act in the best interests of the beneficiaries.

As we have previously noted, the traditional belief that ESG funds miss out on lucrative returns compared to their mainstream comparators has been debunked over the last few years, and it is our view that a strong investment governance framework that incorporates and integrates ESG factors into a super fund’s investment processes across the investment portfolio will in the long term protect and add value to members’ retirement account balances.

Super funds need to consider how they integrate ESG into their investment decision framework, including:

  • the design of investment portfolios,
  • the structure of investment mandates,
  • their commitments to and performance of ESG due diligence as part of the broader investment due diligence,
  • the engage with and monitoring of asset managers’ performance, and
  • the aggregation of investment risk and performance for reporting to members and stakeholders.

Finally, asset managers need to consider how they can clearly link the value of their businesses’ performance to ESG factors – making a competitive argument for their prudent management of these issues and successful investment mandates.