In recent years, the Environmental, Social and Governance (ESG) criteria has gained momentum among investors. With the ESG-based investment market set to double in 2021 & an additional 17 percent of investors planning to move to ESG in 2022 or later, the potential is clear for the market to grow in the coming years. To better understand these trends and how ESG investments are expected to develop, we spoke to Niall O’Shea

 

Niall has over 20 years of experience in the forefront of Sustainable and Responsible Investment. He previously led the division for Responsible Investment at Royal London Asset ManagementCurrently he leads his own venture, Discern Sustainability, specialising in ESG expertise for the world’s leading investors, corporate social responsibility organizations and environmental consultancies.

 

Given these upbeat trends in the market, investors believe now ESG issues are potentially material, as evidence is finding that smart ESG approaches tend to be additive to investment returns. The creation of new funds, indices and structures has enabled asset owners to allocate to different flavours of ESG across asset classes. Niall also adds, “Policy has been highly supportive and is now producing regulation, such as the EU Sustainable Finance Reporting Directive (SFDR). The biggest theme of all that will continue to drive risk and opportunity are sustainability challenges we face, that have gone from being seen as ignorable externalities to boardroom priorities”. From a geographical standpoint, we learnt from Niall that Europe has had the biggest impact with ESG investments. Reports suggest that Europe continues to lead, forecasting between two-to-four times growth in AUM in broad ESG styles, by 2025. Estimates from the US for broad ESG approaches are around $18 trillion, growing very strongly but this size reflects more the innate size of its market. For the APAC region, Japan is still growing strongly but Asia is still slow on uptake, with Australia and New Zealand more Europe-like in their approach.

 

 

There has always been concerns related to inconsistencies around ESG data from private markets vs public assets. We got some interesting comments from Niall on the same – “The data sets, choices and metrics for public markets are far more advanced and there is a prize for those that can ‘crack’ the private markets conundrum; which is to the extent that such data exists at all, it is not freely shared or commoditized. For investors in real assets, for example, some vendors are using combinations of remote sensing, big data and AI to assess, for example, the optimal places to put wind farms or assessing the physical vulnerability to climate change under different modelling assumptions. Prominent benchmarks like GRESB (Global Real Estate Sustainability Benchmark) are generating data and learning experiences that will eventually permeate the wider market.” Speaking of benchmarking, new measurements for ESG accountability are being considered lately. According to Niall, benchmarking has its uses in providing a desired objectivity to measurement and the visibility of progress or lack of. “When we mention benchmarking, we should think too in terms of regulatory developments like the low-carbon and Paris-aligned benchmarks being developed by the EU as part of the wider drive to bring scrutiny to what is being claimed by investors and companies”, says Niall. He also states that keeping benchmarks lean and focussed rather than platinum-plated, and learning from unintended effects is important to their usefulness and credibility. The regulatory impact on ESG-based investments is something to take into account as well. From March 2020, in-scope investors marketing funds into Europe will have to embark on a disclosure regime that will result in them tying their funds to particular minimum definitions of ESG integration, or sustainability objectives being core purposes of those funds, if applicable. The EU Taxonomy is the de facto look-up for precisely what economic activities the EU regards as making a ‘substantial contribution’ to the bloc’s environmental sustainability objectives. In addition to these inputs, Niall also says, “Investors seeking to make any claims for a fund’s environmental sustainability will have to state to what extent and how the Taxonomy was used to calculate the percentage of underlying revenues and capex that is ‘inside’ the taxonomy i.e. green. The US SEC is taking a keen interest in the SFDR development. We are in the sunset of the free-for-all era with no standards or accountability. I welcome this, even if regulation will inevitably have some unintended effects or fall short of its objectives.”

 

 

Lately, there has also been consistent talk around an ESG Bubble forming and questions like – can ESG investments provide a win-win scenario where they can help save the planet while netting positive returns? To learn more about this, we got Niall to share his candid views –

“There is a strong body of empirical evidence that inflecting ESG in how investments are selected and managed in equities produces better and more resilient long-term risk adjusted returns. Roughly three quarters of the studies we found support that view, but based only on the asset class for which there is the deepest dataset – equities. For other asset classes like fixed income and infrastructure, there is at least no evidence for financial harm from such strategies but the jury remains out on out-performance while the dataset remains spotty. However, surveys of institutional investors repeatedly show sentiment ‘spreads’ from the experience of equities. It is generally accepted that a security or asset with good ESG performance is, all other things being equal, a better, safer investment-and it is hard to dissent from this intuitive case. With this said, I do not subscribe to the view that ESG axiomatically leads to outperformance. A good ESG strategy will make a sound investment approach better, but it will not rescue a poor one. There are no magic bullets in investment and those who present ESG shallowly as some sort of set-and-forget formula for success, whether out of naivety or opportunism do harm. Unfortunately, there is a risk of a bubble Fear-of-Missing-Out and the ESG arms race means that inevitably lots of sub-par strategies that wear the cloak of ESG will go on to underperform. Then, there are those who say with some justification that some popular ESG assets are being bid up wildly higher than what their fundamental valuation would support. The counter-argument is that those valuations merely reflect confidence in a world that is going to be transformed by the sustainability imperative in a way that markets have failed to price in. While there is a risk of a bubble, I am sanguine about the longer-term picture in that once some of this froth is driven out of the market and a correction takes place, the fundamental drivers I speak of will still be there, but stronger.” 

To conclude this insightful interview with Niall, we asked him – to what extent does he see ESG-focused companies lead the post-COVID economic recovery?“This is a popular talking point but I am somewhat agnostic. COVID revealed our vulnerability and perhaps a partial preview of much worse down the line with climate if we do not act, as well as highlighting social inequalities. But people have short memories and a desire to consume. I think the bigger theme here is the further dematerialisation of the working world and supply chains and the normalisation of the duality of life: physical presence giving way to digital and remote delivery where possible, and that these distinctions will be increasingly blurred. It is true that companies popular in ESG funds: tech, pharma, new energy, are expected to benefit”, says Niall

We sincerely thank Niall for his time and valuable inputs on this topic related to ESG investments. We are confident that our readers will benefit from his insights provided here.