What Forbes says about why ESG investing makes sense
Koch: Ties between ESG criteria and long-term corporate performance have been an area of academic and investor interest since the beginning of the socially responsible investing movement in the 1970s. In 2015, DWS conducted a meta-study along with the University of Hamburg that examined approximately 2,200 academic studies that had looked at the relationship between ESG and financial performance.
The results of the study show that the business case for ESG investing is empirically very well founded. Roughly 90% of studies find a nonnegative relation between ESG and financial performance and the large majority of studies exhibit positive findings that appear stable over time. Not surprisingly out of E (Environmental), S (Social), and G (Governance), the G factor displays the strongest correlation, followed by the E and then the S factors. In addition to positively impacting fund performance, ESG can uncover non-financial risks that may become costly for companies in the future, in effect turning them into financial risks – for example, a firm can experience an unforeseen environmental crisis caused by poor production processes and magnified by weak disaster management procedures.
We can see these effects in the past performance of ESG indices. In particular, we can observe outperformance in emerging markets stocks due to the weaker corporate governance of many emerging markets issuers vs. their peers in developed markets. Avoiding these issuers may pay off. For example, the MSCI ESG Leaders EM index has outperformed the regular MSCI EM index in the last 1, 3 and 5 years, with the 5 year outperformance being 2.43% per annum (at just 13 bps higher volatility).
Lastly, ESG may also uncover long-term systemic risks which traditional risk metrics may not consider, such as risks that may be associated with climate change. Over the past few years, we have seen hurricanes, flooding and forest fires intensify in strength and frequency. These events can lead to costly interruptions of the value chain of companies or make some of their factories and other facilities worthless.
Skroupa: What impact will climate change have on investors’ portfolios and what should investors be doing to protect against this?
Koch: Globalization has led to a situation where many companies headquartered in developed markets have significant portions of their operations conducted in locations vulnerable to environmental risks. These risks are highest near the equator and, in particular, in South-East Asia. The effects of changing climate will lead to major costs by disrupting the companies’ value chains: rising sea levels, flooding from extreme rainfall, tropical storms, extreme heat, and wildfires can all lead to interruptions of sourcing inputs, production and marketing of the companies’ goods and services.
In addition to damages, lost revenues and additional direct costs, there will be longer-term financial implications for companies associate with the transition to a low(er)-carbon economy over the next decades, associated with tighter carbon emissions regulations. These factors may lead to lower demand for oil and gas and higher refinancing costs for corporate issuers due to fossil fuel-divestments which we have seen from leading institutional investors around the world.
The good news is, by acting now, investors can take steps to protect their portfolios against climate change-related risks. First, they need to identify companies that are not prepared for a transition to a lower carbon economy. Then, they should know where the vital components of the value chain of companies they invest in are located – not only where the headquarters is or where their shares are traded, but where a company’s manufacturing facilities and other operations are located. Location matters! Overall, investors should avoid or underweight companies with elevated climate-related risk.
We partner with climate specialist Four Twenty Seven, who help us to assess climate-related risks. They have developed a framework to measure the risk to over 2,000 companies globally, assessing their supply chain, markets and the 1 million facilities they own and operate (each with their own specific location-based risks).
By systematically using this data, combined with inputs from another vendor for transition risk, DWS has developed a smart-beta framework that can be applied to a broad variety of investment universes. This approach is available to investors, ranging from European stocks (where the risk is the lowest), US stocks (with an average risk) to emerging markets stocks (where the risk is the highest).
Christopher P. Skroupa is the founder and CEO of Skytop Strategies