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Despite challenges in 2022 and the lack of clarity around definitions of what constitutes a sustainable investment, research shows that companies with good Environmental, Social, and Governance (ESG) credentials demonstrate strong financial performance.
More than 30% of professionally managed global investments now incorporate ESG factors at some level, and many investment managers integrate these considerations into every investment decision.
This represents a significant amount of financial influence. In a world where governments are turning inward, capital flows are increasingly outward-looking. These flows are starting to address cross-border challenges such as climate change, resource scarcity, biodiversity, and industry-specific issues like equality, labour conditions, and corporate governance.
Global Momentum in ESG Adoption
For example, many large institutional investors are transitioning their portfolios away from fossil fuels, with some having already made the transition completely. Retail and high-net-worth investors are also seeking ways to align their investments with a sustainable global economy. Over recent years, there has been an exponential increase in ESG-themed funds across both public and private markets.
Simultaneously, top-down regulatory initiatives and government policies, such as green stimulus packages, are driving meaningful change. One notable example is the Inflation Reduction Act in the US, which underscores this shift.
UNPRI Signatories Reflect Growing ESG Commitment
Ten years ago, there were 890 signatories to the United Nations-backed Principles for Responsible Investment (UNPRI), representing $24 trillion in assets. By the end of last year, that figure had grown exponentially to 3,826 signatories representing $121.3 trillion—comprising the majority of the world’s professionally managed investments.
This momentum is not solely driven by regulators or product providers. Asset owners are taking the lead, seeking to allocate capital to the right places while achieving good risk-adjusted returns.
Notable leadership comes from US state funds, such as those in New York, New Mexico, California, and Hawaii, as well as international players like Swedish state funds and Japan’s massive GPIF. These institutions increasingly require fossil-fuel-free portfolios, alignment with Sustainable Development Goals, and reductions in carbon intensity within equity portfolios.
Ireland, too, became the first country globally to divest public funds from the fossil fuel industry, reflecting how government policies are leveraging heightened investor awareness.
Pushback and Challenges
While the momentum for ESG investing is strong, it is not without opposition. For example, polarised views in the US have led to contrasting policies between states. Maine has ordered state funds to fully divest from fossil fuels, while Texas requires divestment from financial companies seen as "boycotting the fossil fuel industry."
Such cases, however, are exceptions. On balance, the business case for responsible investing is compelling, with moral, economic, and technological forces aligning.
The Evolving Mindset
Investment decision-makers have traditionally sought the best risk-adjusted returns. Now, younger decision-makers are also considering the future impact of their savings.
Corporate leaders increasingly understand that neglecting long-term impacts will lead to market punishment, while proactive steps will be rewarded.
The risks of inaction are stark: the World Health Organization projects that between 2030 and 2050, climate change will cause an additional 250,000 deaths annually. Climate inaction could also cost the global economy $178 trillion over the next 50 years, or a 7.6% cut to global GDP in 2070.
Notably, estimates from the World Bank show that taking action to combat climate change costs just 1% of global GDP, compared to a 5% annual reduction in GDP from inaction.
The Commercial Opportunity of Net-Zero
Former Bank of England Governor Mark Carney has described the transition to net-zero as "the greatest commercial opportunity of our age." Long-term investors increasingly recognise opportunities in companies addressing global resource challenges, which many analysts believe will drive secular outperformance.
This shifting mindset also reflects changes in fiduciary responsibility. It is now widely accepted that failing to consider ESG factors in portfolio construction may violate fiduciary duty, given the long-term societal and financial implications.
The investment management industry is responding, as evidenced by the Net Zero Asset Managers initiative. This group, comprising 291 asset managers with $66 trillion in assets under management, is committed to achieving net-zero emissions by 2050 or sooner.
ESG Underperformance in 2022: A Temporary Setback
Some commentators point to ESG underperformance in 2022, attributable to two key factors:
Traditional Energy Outperformance:Energy stocks, often excluded from ESG portfolios, performed exceptionally well amid a global energy crisis. Short-term tolerance for transitional energy sources like gas and nuclear has also increased.
Growth-to-Value Rotation:Technology stocks, which typically score highly on ESG criteria, underperformed during a market rotation from growth to value stocks.
Despite these challenges, ESG funds continued to attract investments, with $120 billion flowing into ESG funds in the first half of 2022. By contrast, broader market funds saw net outflows of $139 billion during the same period.
ESG's Impact on Corporate Behaviour
Asset managers considering ESG criteria gain a clearer picture of a company’s risk profile. Companies acting inappropriately face shareholder activism, regulatory sanctions, and divestment—leading to higher costs of capital.
Research from Sustainalytics shows that companies experiencing severe ESG incidents lose 6% of their market capitalization on average. Conversely, companies committed to science-based targets and transparency are more likely to attract investment.
Conclusion
While ESG investing faces challenges, it is clear that sustainability-focused funds generate returns for investors and help drive corporate accountability.
A meta-analysis by the Journal of Sustainable Finance and Investment found that approximately 90% of studies show a positive relationship between ESG and corporate financial performance. Furthermore, Morningstar research indicates that sustainable funds outperform traditional peers during periods of market volatility, reflecting the resilience of ESG-focused investments.
As regulations and transparency around ESG evolve, investors and asset managers alike will be better equipped to address global challenges while generating financial returns.