Investing has become more than just a way to earn profits in the recent past. The rise of ESG funding has made it quite clear.
Though what meets the eye is rarely all that there is: ESG funding has been the topic of a lot of heated debates in the recent past. This article puts forward all the different aspects of it, and ends with trying to answer a question which everyone is asking:
What is the future of ESG funding?
What is ESG Funding?
Let’s start off with the most pertinent question, what is ESG Funding?
Well, If you are someone who has been following the financial sector even remotely, there is a high probability that you must have heard of this term.
ESG funding (Environmental, Social, and Corporate Governance) refers to the three central factors in measuring the sustainability and societal impact of an investment in a company or business.
These criteria help to better determine the future financial performance of companies.
With more and more companies and investors becoming conscious of investing to have a better impact on society, rather than just for earning profit, these funds have become the perfect source for them to show that they care about the world
But the concept of ESG investing is not new. The idea had been around as long as there has been an idea of investing, though the official use of the term was first done around a decade and a half ago.
When did it start?
It all started way back in 2004 when the former UN Secretary General Kofi Annan wrote to the major CEOs of financial institutions, to invite them to participate in a joint initiative under the auspices of the UN Global Compact, The International Finance Corporation (IFC) and the Swiss Government.
The goal was to find ways to integrate Environmental, Social and Corporate Governance issues into the capital markets.
A year later, a report entitled “Who Cares Wins,” by Ivo Knoepfel made the case that including environmental, social and governance factors in capital markets makes business sense and leads to sustainable markets and better societal outcomes.
At the same time, the Freshfield Report further made the point that ESG issues are relevant for financial valuation.
The Growth story:
As per a report by CNBC, 87% of millennials and 64% of women have stated that ESG issues have had an impact on their investment decision, and this has been heard and understood well by global investors.
Picture: The largest ESG fund in the world, the MFS value fund, had 11.66% of its portfolio in oil related securities in 2010, over the course of 10 years, that decreased to 2.45%.
Though “impact investing” as it is also called, has been in the limelight for almost a decade, the main focus had been on the “E” or the Environmental effects of investing, in 2020, though, things changed.
With the pandemic taking a toll on people’s work lives all over the world, there has been a growing focus on the “social” side as well.
With the Black Lives Matter movement and the case of Breonna Taylor coming to the limelight, there has been a further focus on doing away with racial discrimination in the workplace. Those companies who have been able to make sure of that, have been awarded handsomely.
The result is there for all to see.
These will make the relevance of these funds quite clear
- The share of global investors who have applied ESG funding to at least a quarter of their total investments has gone from 48% in 2017 to 75% in 2019, according to a statistic by Deloitte.
- The interest in sustainable investing among the general population of investors has grown from 71% in 2015 to 85% in 2019.
- The Global sustainable fund flows all over the world in the first quarter of 2020 has been $45.6 billion as per a report.
- Both the number of ESG funds, and their assets, have doubled over the course of the past three years as per a report by morningstar.
That’s not all, Larry Fink, CEO of BlackRock, the World’s largest asset manager, in a letter given to his employees has stated clearly that, he believes, “sustainability is the new standard” and will work on making sustainability the new criteria in all of BlackRock’s workings.
So, has everyone become nice?
So, all of a sudden, have all the shrewd investors and fund managers become so nice and un-selfish that they are striving only towards fulfilling a social cause?
Though that would be a huge step towards a perfect world, the reality is that investors are also gaining financially by investing into these securities.
Many of the ESG funds have been outperforming the S&P 500 comprehensively all throughout the year. The top-performing ESG fund, i.e, the Brown Advisory Sustainable Growth Fund gained a whopping 20.1 % in the year.
The growth has a lot to do with the fact that these ESG funds have been investing in tech companies.
As per a report by the Wall Street Journal, most commonly held stocks by sustainable equity funds are Microsoft, Alphabet, Visa, Apple and Cisco, and these are the stocks which have risen exponentially during the pandemic.
What’s the Problem then?
It’s true that all seems okay with ESG funds. It helps investors get their money and makes sure that the social objective also gets fulfilled. It’s a win-win, right?
Well, hate to break it to you again, but this is not a perfect world, far from it.
The Sustainability Conundrum published in the Journal of Portfolio Management in March 2020 noted that
“sustainability or ESG is a very broad term that is interpreted in many diverse ways by many different investors. This leads to problems in definitions and wide dispersions in ratings of the same companies.”
The main issue with ESG investing is that there is no standard basis which defines what to include and what to exclude in the funds. These leads to not only disparities in ratings but a distorted vision of what ESG funds really stand for.
Inclusion of Tech Stocks
One glaring example of this is the inclusion of tech stocks in ESG funds. Though tech companies like Microsoft, Alphabet and Amazon have taken concrete steps towards increasing environmental sustainability, (the E component), almost all of the big players have been involved in some or the other issue, be it data privacy for Facebook or the third party dealings with Amazon.
But the fact of the matter is that no one can question their inclusion as there is no metric set for the same.
Another criticism of these funds pointed out by experts is that there is no way to determine whether the company which has promised about their ESG policies have been following up to their promises by their actions or not.
A paper from Soohun Kim and Aaron Yoon found that there are no improvements in a portfolio’s ESG scores and the signatories become less likely to vote on environmental issues after they have signed on ESG policies.
A perfect example of this was the Volkswagen Emission Scandal of 2015
After a thorough examination of its vehicles, The Volkswagen Company admitted that “cheat devices” were present in over 11 million vehicles which lowered down the car’s emissions when a car was going through emission tests, and hence the ratings showed that the emission levels were under control, when in reality they overshot by a huge margin.
What’s to come for ESG funds?
As per a report, the number of investors who are investing in ESG funds is going to grow to about 50% by 2025, or increase from about $10 trillion in 2018 to more than $30 trillion by 2025
Though ESG funds do seem like a thing for the future but the fact of the matter remains that they will have to increase their transparency about their working.
In recent times, the US government has limited the extent to which ESG funds can be a part of 401(k) plans of the people.
Organisations such as United Nations and European Commission have been working on promoting common standards for ESG ratings, which could be a very big and meaningful step towards the future of these funds.
As with anything, trying to fathom the future of ESG funds is a very uphill task as there are a lot of variables involved. But one thing is for certain, that until and unless there is some clarity and transparency about the workings of these securities, with a common measuring scale, a very promising concept might just go out with a disappointing end.