For Individual Investors in the US

ESG Investing: The Upside

ESG Upside Featured Image
Marika P. Christopher

Marika P. Christopher

Senior Director, Product Strategy & ESG


Dec 15, 2021

Key takeaways:

Many investors gravitate toward environmental, social and governance (ESG) investing as a way to reduce their risk exposure. But are they aware of the potential upside opportunities? ESG Product Strategy and Development Director Marika Christopher discusses how new research has found compelling evidence that ESG factors appear to be positively correlated with financial performance.

Key Takeaways

  • The growing interest in ESG investing is expected to gain momentum in the years ahead, with a number of investors indicating a strong desire to invest in companies and/or strategies that support their values.
  • Many asset managers and investors focus on the ability of ESG investing to reduce exposure to companies with poor ESG credentials through negative screening. But focusing strictly on risk management means ESG’s potential to provide upside opportunity is often missed.
  • Recent research points to a positive relationship between a company’s ESG practices and its financial performance, with very few studies showing a negative relationship.

Over the past several years, asset managers and investors alike have seen a major uptick in the interest in sustainable or ESG investing. Asset flows into sustainable strategies have boomed around the globe as investors increasingly seek to reduce their exposure to companies that rate poorly on their environmental, social and governance activities. According to estimates by the Global Sustainable Investment Alliance, assets invested in ESG-related strategies reached a record $35 trillion in 2020,1 despite it being the height of the COVID pandemic.

And the trend looks poised to continue, especially when you consider the attitudes and preferences of younger investors. A 2017 Morgan Stanley study showed that millennials are nearly twice as likely as the overall investor population to invest in companies and funds that support their environmental or social values.2 Considering the fact that these investors are on track to inherit $30 trillion in wealth over the next 20 years, the further growth of ESG assets seems all but inevitable.

The interest is well founded: We’ve seen a number of companies with a record of environmental harms, poor working conditions and employee policies, and unethical management practices face extraordinary fines, immense public backlash, and even closure. These are certainly not the type of firms a prudent investment analyst would recommend holding over the long term.

While evaluating firms from an ESG perspective and reducing exposure to firms with poor ESG management makes sound investment sense for long-term investors, the magnifying glass is often too focused on reducing negative exposure and misses the potential for positive upside that ESG investing may provide. We are beginning to see the tides shift on this front, however. Investors and analysts alike have begun to explore the extent to which ESG credentials may impact corporate financial performance – and supportive evidence on this front is emerging across various research studies.

Linking ESG and Financial Performance

In February 2021, the NYU Stern Center for Sustainable Business, partnering with Rockefeller Asset Management, announced the findings from a new meta-study examining the relationship between organizations’ ESG-related activities and their financial performance in more than 1,000 research papers over the last five years.3 The authors surveyed over 1,000 peer-reviewed papers and 27 meta-reviews (based on ~1,400 underlying studies) published between 2015-2020.

The researchers divided the papers into two groups: Those focused on corporate financial results such as operating metrics or a company’s stock performance and those focused on investment performance, defined as “measures of alpha or metrics such as the Sharpe ratio on a portfolio of stocks.”

In addition to the six themes outlined above, the researchers found a positive relationship between ESG and financial performance in 58% of the corporate studies, with 13% showing neutral impact, 21% showing mixed results, and only 8% showing a negative relationship. In the investment-focused studies, 59% showed similar or better performance relative to conventional investment approaches while only 14% found negative results (see figure below).

Linking ESG and Financial Performance - Chart

Source: NYU Stern Center for Sustainable Business, February 2021.

While there are certainly still challenges associated with this type of research (including uniform definitions of ESG and sustainability factors and the extent to which the data is available, consistent, and transparent), NYU Stern Center’s recent findings offer evidence that ESG investing not only seeks to reduce downside risks, but also may provide an opportunity for potential upside performance – both in corporate earnings and investment returns.

Paying attention to environmental, social, and governance (ESG) concerns does not compromise returns – rather, the opposite.4

So how does integrating ESG factors into investment methodology provide for upside, positive potential? In a 2019 article, McKinsey & Company identified the following five ways in which a company’s ESG framework can create value, with examples for each:

  1. Top Line Growth: Sustainable products and/or practices to help attract additional consumers and gain better access to resources through improved community and government relations.
  2. Cost Reductions: Reduced water and energy consumption may help lower waste-disposal and other energy costs.
  3. Regulatory and Legal Interventions: ESG subsidies and government support may reduce the likelihood of fines and penalties.
  4. Productivity Uplift: Initiatives to improve employee morale and motivation to help drive productivity, talent, and innovation can drive productivity and talent retention metrics.
  5. Investment and Asset Optimization: Seeking to allocate capital for the long term (e.g., more sustainable equipment) while attempting to avoid investments that may not pay off due to long-term environmental issues.5

Based on the examples above, there appears to be investment value in forward-looking analyses that capture stakeholder interests, strategic plans such as carbon reduction and cost savings related to improved operational use of resources, and a focus on employee morale and mental health. This holds particularly true in the equities space, and we will continue to watch for similar evidence to emerge from the fixed income market, where upside potential is limited today. We expect to see greater positive opportunities from green bond6 issuance from governmental organizations, as well as stronger partnership between the private and public sectors to improve the long-term sustainability of communities around the globe. The excruciating cost of increased dramatic climate events should create more opportunity for those companies seeking to invest in long-term solutions.

In a world that is facing significant sustainability and social inequality issues, we believe the evaluation of how a company thinks about and incorporates ESG into its business practices over the long term will be one of the key investment tools to help reduce risk, as well as seek to deliver attractive risk-adjusted returns.

1“Global Sustainable Investment Review 2020.” Global Sustainable Investment Alliance (GSIA), July 2021.
2"How Younger Investors Could Reshape the World.” Morgan Stanley, 2017.
3“Determining the Financial Impact of ESG Investing.” NYU Stern Center for Sustainable Business, February 2021.
4“Five ways that ESG creates value.” McKinsey Quarterly, November 2019.
5Ibid.
6Green bonds are fixed-income financial instruments used to fund projects that have positive environmental and/or climate benefits.

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