Do well by doing good — The investment case for sustainability

ESG issues manifest themselves in a company’s financial performance in three ways: blow ups, the slow burn, and structural shifts.

However, the more interesting question is not whether these issues have financial implications for shareholders but how. At its simplest, integrating ESG analysis into investment decisions provides a more holistic view of a company’s quality and resilience, helping shareholders to spot underappreciated risks and take advantage of new drivers for growth. ESG issues manifest themselves in a company’s financial performance in three ways: blow ups, the slow burn, and in structural shifts.

Blow ups arise as a function of poor ESG practices that lead to catastrophic and costly failures. Organisations that have a short-term outlook, who cut corners, or conduct themselves unethically are at risk. The timing of blow ups is unpredictable but poor management of ESG risks increases the likelihood and consequences of these events.

ESG issues manifest themselves in a company’s financial performance in three ways: blow ups, the slow burn, and in structural shifts

Examples of blow ups are many and include the Boohoo slave labour scandal earlier this year. In early July, Boohoo had more than £1bn wiped off its value in one day and over 30% in a week after an undercover reporter found staff at factories were being paid significantly less than the minimum wage. However, this was not the first-time questions had been raised about Boohoo’s labour practices or the working conditions of factories in Leicester.

Perhaps the costliest blow up in history was the BP Deepwater Horizon disaster, which caused an estimated 4.2 million barrels of oil to spill into the Gulf of Mexico and killed 11 people. BP has been charged US$53.8 billion over the past decade destroying about one-fifth of their earnings.

While the scale and timing of the disaster were unpredictable, that it would most likely be BP was not. BP had incurred many more regulatory penalties than peers and had a string of disasters — all before announcing a significant cost cutting program. As safety expert Nancy Leevson put it, BP were “an accident waiting to happen”.

While not as dramatic, an equally important benefit of ESG analysis is the slow burn effects that flow from good sustainability performance. A 2014 meta-analysis found that 80% of studies had found good sustainability performance positively impacted stock prices. Research by academic and commercial organisations in Altiorem’s library have found similar results. For managed funds too, the Responsible Investment Association of Australasia, has consistently shown superior average returns for sustainability focused funds.

One example of this is how employee engagement and well-being improve overall long-term performance, as illustrated by the correlation between Glassdoor’s 100 best places to work and stock prices. 78% of the top 40 companies outperformed the S&P 500 over the last five years.

Structural shifts are perhaps the greatest long-term driver of returns from sustainability

While avoiding disasters can help prevent losses and superior ESG performance can aid the long-term compounding of returns for shareholders, structural shifts are perhaps the greatest long-term driver of returns from sustainability.

For the first time the World Economic Forum Risk Report 2020, had environmental concerns take up all the top long-term risks by likelihood (see Figure below). Over 200 of the world’s largest firms estimated that climate change would cost them a combined total of US$1 trillion if the world does not act to prevent the worst impacts. At the same time, there is broad recognition among these firms that there are significant economic opportunities, provided the right strategies are put in place.

Top 5 Global Risks in Terms of Likelihood World Economic Forum The Global Risks Report 2020

The best example of these structural shifts playing out in markets is the fundamental change within the energy sector. The dramatic fall in the cost of clean energy technologies means that in a growing number of countries it is cheaper to build new renewables than to keep existing fossil fuel assets running. These changes not only destroy demand for new fossil projects, it means that even operating assets risk becoming stranded, leaving companies with hefty remediation liabilities. Markets are already pricing this in, with investments in the S&P Global Oil Index resulting in 10 year returns of -6.16% per year. Recognising these risks, over 100 globally significant financial institutions have divested from thermal coal.

While zombie assets and companies are a threat to shareholder returns, the converse is also true as companies who are leading the transition offer future growth. There is a reason that Unilever’s sustainable living brands grow 69% faster than the rest of their portfolio. Although, even with companies selling sustainable products and services, risks of blow ups and the effects of the slow burn remain. The insights may be powerful, but there is no free lunch.

ESG issues make a difference to investment risk and return, that much is clear. Capturing those opportunities can be difficult as the disclosure from companies and market noise obscure the long-term benefits, however, hardworking investors can benefit greatly by incorporating these issues into their investment analysis. No company or investor is immune from these trends.

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About the authors

Georgina Murray is currently the Direct Marketing Manager at UNICEF Australia and has an interest in responsible investment.

Pablo Berrutti is Altiorem’s founder, he has deep investment and financial services experience including responsible investment, risk management, marketing, communications and strategy. He is currently a senior investment specialist for Stewart Investors Sustainable Funds Group and was formally the Head of Responsible Investment, Asia Pacific for Australia’s second largest fund manager.

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