OPINION: The NZ Super Fund looks at what priority fund managers should give ESG.
The pros and cons of ESG and long-term investment goals.
In 1970, economist Milton Friedman wrote an article titled 'The social responsibility of business is to increase its profits', and arguments over what businesses owe society have ebbed and flowed ever since.
Questioning what, if any, priority fund managers should give to environmental, social, and governance (ESG) factors in deciding where to invest is just one example of that.
Opponents of socially responsible investment practices sometimes argue that portfolios with better ESG performance will be less diversified, and that arbitrarily eliminating a class of investment opportunities means also eliminating some lucrative returns.
Or that environmental and social action comes at a cost, so firms that take these actions will see worse financial performance.
However, the data does not support these suppositions. On the contrary, it seems companies doing the right thing generally outperform.
Various theories have been put forward to explain this. The first is that companies with poor ESG performance are likely to face greater regulatory, litigation and social license to operate risks, which can materially harm their performance and thereby introduce undesirable financial risk in an investor’s portfolio. Another is that companies doing good are able to inspire greater loyalty from their employees and customers.
The evidence that ESG-enhanced indices have tended to either match or beat the performance of standard market indices is mounting.
To take one example, a report from NYU looked over a thousand academic studies and thirteen meta-analyses including data from 1976 to 2020.
For studies focused on corporate financial performance (for example operating metrics such as return on equity (ROE) and return on assets (ROA) or stock performance for a company or group of companies) 58% displayed a positive relationship between ESG focus and financial performance, while only 8% showed a negative relationship.
For investment studies, which typically focused on risk-adjusted attributes such as alpha or the Sharpe ratio on a portfolio of stocks, 59% showed similar or better performance than conventional investment approaches, while only 14% found negative outcomes.
Studies looking purely at the relationship between low carbon strategies and financial performance recorded similar or better results.
Not content to rely on others’ findings, we commissioned our own back-tests, which found that ESG indices provided greater returns and lower volatility.
The world is facing pressing environmental and social challenges. To name just two, climate change and biodiversity are threatening significant impacts on the performance of the economy as a whole. Swiss Re Institute has estimated that the impacts of rising temperatures could reduce global GDP by as much as 18% by 2050, compared with a world without climate change.
According to the World Economic Forum, $44 trillion of economic value generation – over half the world’s total GDP – is moderately or highly dependent on either the direct extraction of natural resources or the provision of ecosystem services such as healthy soils, clean water, pollination and a stable climate.
As nature loses its capacity to provide such services, these industries could be significantly disrupted.
NZ Super Fund's Lucas Kengmana.
So from a purely self-interested perspective, an investor with exposure to the performance of the economy as a whole is likely to see some benefits from helping to drive a world that avoids the worst impacts of climate change and biodiversity losses. And of course, our stakeholders (the New Zealand public) are likely to be much better off.
Regarding environmental, social, and governance issues as important criteria in our investment decisions is nothing new for the NZ Super Fund. By law, the people overseeing the Fund (the Guardians of New Zealand Superannuation) must manage and administer the Fund in a way that avoids prejudicing New Zealand’s reputation as a responsible member of the world community.
Investors can influence environmental and social outcomes through scaling up investments in companies that are having outsized impacts, using their influence as shareholders to encourage companies to improve the way they do business, and selling out of companies with poor ESG conduct. These practices are already generating real change – for example, the NZ Super Fund has been able to reduce the emissions intensity of its portfolio by 49% relative to the market as a whole.
Some would argue that establishing complete confidence in the link between ESG performance and financial performance requires long time series so we should wait until we can definitively prove that ESG enhanced strategies outperform before we shift to them.
But this could mean another 20 years of missed opportunities.
Knowing what we do about the economic costs of ESG risks like climate change, and given the shift in stakeholder expectations regarding unacceptable business practices such as slavery and bribery, we owe it to our investors and the global community to act now.
Lucas Kengmana is a senior investment strategist with the NZ Super Fund.
This content was supplied free to NBR.
