Sustainable investing: a private investor perspective

Three reasons to take another look at sustainable investing.

10 Sep 2020

Does sustainability matter for investors?

Sustainability matters for all investors. Whether you’re primarily focused on financial returns or seeking to drive sustainable outcomes, environmental, social, and governance (ESG) considerations can highlight recognizable risks and present new investment opportunities. In the wake of the COVID-19 crisis and as we face a more uncertain future than at any time in recent history, corporations, governments, and their stakeholders all acknowledge the interdependence of capital markets, economies, environmental constraints, social trends, and human behavior. The latter three issues now have an increasingly important impact on markets and investment dynamics.

Private investors have particular latitude in determining what they consider important, how they deploy their capital, and the accountability they expect from their investment partners and investee organizations. Many individuals are moving beyond the question of why they should invest sustainably, and are now focused on how to best incorporate sustainability considerations into their investments in ways that support their overall objectives.

For those on the fence, we spotlight three key reasons why all investors, particularly private investors, should consider sustainable investing (SI):

The time is now

While SI is not new, it’s still “new-to-me” for many investors. Growing acknowledgment of the interaction between social and environmental topics and corporate financial performance has strengthened the case for incorporating sustainability considerations into investment portfolios.The COVID-19 pandemic has elevated the importance of how companies operate and accelerated the increasing relevance of ESG considerations to investors.

A significant societal mind shift is driving change Two societal developments are contributing to the transformation of sustainable investing from a niche market into a mainstream investment strategy. First, social movements to address sustainability challenges are increasing in frequency. Efforts have most recently focused on climate change and racial inequalities, catalyzing changes in corporate behavior, government spending, and policy response. Second, financial market regulators have focused more and more on sustainable investing in recent years. In certain geographies, this has led to the development of new requirements intended to help investors navigate an investment landscape characterized by a lack of standardized definitions or taxonomy, by emphasizing transparency and comparability.

Much of the coordination of social movements takes place online and on social media platforms, highlighting the crucial role that global connectivity has played in elevating sustainability in recent years. Commitments such as the Paris Agreement¹ and frameworks like the UN Sustainable Development Goals, which both officially came into force in 2016, were not the first such attempts to galvanize international support for sustainability. But they were the first to truly unite almost all nations behind a common goal, and they rode a wave of popular media support for environmental causes driven by global influencers such as former US Vice-President Al Gore, former US President Barack Obama, and, more recently, youth activist Greta Thunberg.

Based on this increased transparency and connectivity, all investors private and institutional are, or should be, evaluating how ESG topics impact their portfolios. Investors can now more easily consider whether they want to be part of the solution, driving capital toward more diverse companies or industries developing strategies to address climate change and other sustainability challenges. Sustainable investments offer investors a range of solutions designed to capture ESG considerations intentionally and systematically, embedding them directly into their investment philosophy and approach.

Economic recovery spending to support sustainable investments

Governments across the globe have announced pandemic recovery spending plans of unprecedented scale that emphasize renewables infrastructure and green spending. A Bloomberg New Energy Finance report estimated that the world’s top 50 economies were putting USD 583bn into boosting green efforts. The EU Recovery Plan, aligned with the EU Green Deal, will allocate 30% of its announced EUR 1.8tr budget to climate-related investment over the coming seven years to reboot the economy. In the US, Democratic presidential nominee Joe Biden has outlined a USD 2tr climate spending plan to be implemented if he is elected in November.

While the implications of some of these announcements may already be, at least to a degree, priced into markets, we expect these overall spending plans to add further momentum to sustainable industries such as renewable energy and energy-efficiency technologies. Investors looking for how to position ahead of these developments should consider sustainable or impact solutions focused in these areas.

Forward-thinking investors increasingly focused on SI

Asset flows into sustainable investing funds have far outpaced asset flows into conventional funds in 2020 so far, despite the pandemic driven market volatility. Asset inflows in the first half of 2020 even matched total SI flows seen in the whole of 2019² As of June 2020, more than USD 1tr was invested in dedicated SI funds² a significant increase in just 18 months from around USD 600bn at the end of 2018.

In our view, this is not a bubble. Some of the largest and most sophisticated global investors already invest sustainably, including both the world’s largest sovereign wealth fund, Norway’s USD 1.2tr Government Pension Fund Global, and the world’s largest pool of retirement savings, Japan’s USD 1.4tr Government Pension Investment Fund. Hedge funds and private markets funds also recognize the performance potential of focusing on sustainability-related risks and opportunities, and are at various stages of incorporating ESG and impact considerations into their investment processes. And among UBS’s global family office clients, 73% report already investing at least some of their assets sustainably and more than a third (39%) expect to invest most of their assets sustainably in five years’ time.³

¹The Paris Agreement arose from the UNFCCC conference of the parties (COP 21) in Paris in 2015, and aims to unite all nations behind a common goal to limit global temperature rise this century below 2 degrees Celsius above pre-industrial levels.

² Morningstar

³UBS Global Family Office Report 2020

ESG topics matter

ESG factors have always influenced businesses and investors, but they were not necessarily obvious or given special consideration. Today, awareness of these topics and of their investment relevance has never been higher. Corporate incidents ranging from a wildfire-induced bankruptcy to data privacy issues and supply chain issues and, most recently, a global pandemic that exposed unethical corporate behavior (see Human rights case study below) have illustrated for investors the tangible impact of environmental or social risks on financial performance.

We see three main areas where ESG topics matter to investors:

Managing investment and portfolio risk
Participating in the upside potential of disruptive innovation
Engaging with the prevailing social and political agenda

Investing with a sustainability focus can help investors understand how their investments will be affected by a changing physical world and evolving social trends, identify investment opportunities in sustainable industries that are experiencing increased demand or in certain cases invest to catalyze needed positive change. There are numerous approaches to investing sustainably, and importantly they are not mutually exclusive.

Managing risk

Some ESG factors have direct, quantifiable impacts on a company’s business model and profitability. For example, additional capital expenditure may be needed in energy-intensive industries to replace manufacturing processes with more energy-efficient alternatives. Or in service-oriented industries, more stringent laws to protect employees in the aftermath of the pandemic could substantially increase workforce costs.

Other ESG factors may have an indirect influence on business models and competitive positioning. These may be more difficult to quantify, such as the value of a robust environmental management system that helps companies keep costs down and manage environmental risks, or the benefits of strong corporate governance. But over time these factors can affect the financial performance of companies, and the effects could materialize quite suddenly.

All investors need to explicitly consider material ESG factors in their decision-making. Numerous tools exist to help in making these evaluations, including ESG ratings that use standardized, rule-driven assessments to rank companies based on sustainability “performance” and research frameworks such as the Sustainability Accounting Standards Board (SASB) Materiality Map, which aims to help investors make better decisions by understanding the impact of ESG factors on a company’s revenue potential, profitability, and cost of capital. Some investors develop their own frameworks for evaluating ESG factors. Most important is that any framework takes into account both the financial and sustainability objectives of the investment approach. Simply attaching a “sustainable” label to an investment can help to match investments with investor preferences, but that is not in itself the ultimate goal of SI.

Participating in the upside potential of disruptive innovation The drivers of many long term investment themes are inextricably linked with sustainability. Population growth, aging, and urbanization are all trends that exacerbate sustainability challenges such as access to food, clean water, healthcare, and education, as well as the impact of the sheer number of people living on the planet and using up its finite natural resources. The scale of these challenges means that potential solutions can be commercially attractive while providing critical social or environmental benefit. These long-term sustainability or impact themes provide a roadmap for investors seeking to drive positive impact with their investment capital.

A few examples of key SI themes:

Transition to a low carbon economy, encompassing all the industries in the renewable energy and energy efficiency value chain. Many are technology-driven, seeking solutions that will disrupt the fossil fuel industry and enable a shift to a more efficient, less polluting, and less resource-intensive energy system.
Waste management, including reducing plastic packaging volumes which are expected to more than quadruple by 2050 (95% of the value of such plastic is lost after one use). Innovative waste reduction solutions can also increase businesses financial returns.
Shifting food consumption trends, such as alternative proteins snagging market share, and the modernization of the global food supply chain, a shift that has been accelerated by the risks of the global, just-in-time supply chains that were exposed in the coronavirus-triggered economic and travel lockdowns.

The prevailing social and political agenda

As we stated earlier, SI is not new. But investor adoption and assets under management have both grown strongly in recent years. Much of this growth has been organic, driven by demand and new business opportunity. Regulatory attention has been, to date, mainly focused on improving ESG-related disclosure among public companies. For example, Hong Kong’s Securities and Futures Commission has made it compulsory for public companies to report on ESG factors, and mainland China will introduce a similar requirement this year.

The introduction of regulation governing the investment industry’s approach to SI is a genuine milestone in mainstreaming SI. Peer pressure and the desire for a “social license to operate” can be powerful drivers, but embedding requirements in law makes even the most ardent skeptics pay attention. The EU aims to be a first mover in this respect, with comprehensive regulation encompassing the development, marketing, and advisory process surrounding sustainable investment products. This seems likely to influence regulatory developments in other regions, and in the absence of local standards or taxonomies, the EU version could become the default.

Returns and beyond

Sustainable investments can deliver comparable or better financial performance

Sustainable investing strategies at the index, fund, and instrument levels have demonstrated comparable or better financial performance in 2020 than conventional equivalents in a volatile market environment. Seventy-two percent of self-declared SI funds ranked in the top half of their Morningstar categories for the first half of the year. Similarly, MSCI “ESG Leaders” indexes across geographies outperformed conventional indexes, as did indexes focusing on a range of sustainable themes. For more details on the drivers of SI outperformance though the 2020 crisis, see Sustainable investing after COVID-19.

Empirical evidence from the performance of SI indexes over the past decades supports our view that SI approaches are well positioned to continue performing in line with conventional investments over the whole economic cycle, delivering comparable risk-adjusted returns in the future and, in some cases, potentially outperforming.

Different SI approaches and instruments have varying style, region, or market-cap biases that drive differences in performance across the economic cycle. This variation makes it possible to build a diversified portfolio of sustainable investments across asset classes, with the expectation that it should deliver risk-adjusted returns comparable to those of portfolios with conventional asset allocations.

In reality, there is likely as much variation within the group of funds labeled sustainable as there is between the group of funds labeled sustainable and the group of those that are not. This means that robust strategy selection is absolutely essential, even more so than when selecting conventional strategies, since not only must the fund approach be attractive from an investment perspective, but the promised sustainability profile, exposure, or impact must also be legitimate and credible. As the market for SI funds both in public and in private markets continues to expand, and as innovation continues to drive competitive financial returns along-side sustainability returns (more so than in the past), we anticipate an increase in attractive investment opportunities that will be interesting to all investors, whether motivated by sustainability or not.

Sustainability and impact benefits

Investors increasingly seek more than just financial performance, and they have differing levels of intent and motivation with regard to understanding and managing the impact of their investments on society and the environment. For example, some investors aim to mitigate risks through avoidance of certain exposures, others aim for greater understanding of the positive or negative impact of their investments, and still others intentionally seek to drive positive change with their capital and active involvement.

SI offers a range of solutions that can enable investors to achieve many of these sustainability or impact objectives, as well as the opportunity to access greater transparency on investments through sustainability reporting. In our view, these benefits should be appealing both to sustainability-focused investors and to returns-focused investors.

Investor takeaways

Investors increasingly show interest both in better understanding the positive and negative impacts of their investments on society and the environment, and in incorporating these considerations into how they construct and manage their portfolios.Sustainable investing offers solutions that are designed to address these motivations, and in so doing generate comparable or better long-term financial performance than conventional investments. Not all investors will choose to invest in dedicated sustainable investing strategies, but the expectations around sustainability considerations and transparency have increased and will only continue to do so.In our view, the quantity and quality of credible sustainable investing opportunities continue to grow substantially, with compelling options available for all investors, not just those who specifically target positive outcomes.There is still much work to be done to mainstream sustainable investing solutions, in areas ranging from stronger commitment to integration by asset managers, to improved corporate disclosure of ESG information (beyond policy and raw data), to greater standardization of sustainability and impact metrics.

The decision to invest sustainably starts and ends with each of us and what we hope to achieve with our capital, beyond financial returns. Sustainable investing offers the potential for positive social impact, in addition to competitive financial performance. Actual positive change requires engaged investors and forward-thinking company management teams that recognize the long-term benefits of addressing societal challenges through more responsible operations and/or sustainability focused products and services. As more and more investors recognize the interdependence of financial returns and social and environmental issues, we expect to see in-creased mobilization of capital with the expectation that it can deliver returns both for investors, and for society at large.