Institutional investors are increasing taking environmental, social and governance (ESG) considerations into account when setting their strategies. Around a third of institutional investors and professionals now consider it to be a source of alpha generation and risk mitigation, according to research by RBC Global Global Asset Management.

“Clearly investors are giving greater weight to ESG criteria, not only in equities but increasingly across all asset classes,” says Kathryn Saklatvala, a director of bfinance and co-author of a separate study that found increasing sophistication in how policies are being applied. The universe of products and strategies is shifting away from negative screening towards bottom-up factor integration and active engagement.

It is not hard to see why. Although interest may initial be attracted to doing the right thing – especially for trustees of public institutions’ pension schemes – there is a growing body of research showing that returns are positively impacted by ESG considerations. 

Research from MSCI published in December found that ESG scores had positive correlations with size, quality and low volatility. Its results showed that integrating ESG criteria into passive strategies generally improved riskadjusted performance over the period 2007 to 2017 and titled the portfolio towards higher quality and lower volatility securities. 

When ESG was integrated into factor strategies, MSCI found that significant improvements in the ESG profile of these strategies was achieved with relatively modest impacts on target factor exposure (the degree of impact depending on the strategy). 

Investor appetite

Investors are taking note according to Hermes Investment Management, especially in the realm of infrastructure, which Peter Hofbauer, head of the asset class, describes as “inherently sustainable”. 

He says, for example, that his firm’s 2015 acquisition of a 40% stake in Associated British Ports (ABP) in conjunction with the Canada Public Pension Investment Board (CPPIB) was underpinned by “solid financial reasoning” but also “the beneficial holistic outcomes we expect to achieve over the life of our investments”. In addition, in the case of ABP, “investing in future decarbonisation trends such as renewable energy will hedge against the changing usage its ports will experience as old carbon-intensive energy imports decline”

There will certainly be a home for money seeking a home in emerging markets. McKinsey estimates that between 2015 and 2030 $89trn will be needed for sustainable infrastructure development and UNOPS is developing a business line to channel the money. 

“One of the major stumbling blocks for private sector investment is the short pipelines and slow pace of progress in developing bankable projects,” said UNOPS executive director Grete Faremo at a speech in early December. “We have taken the initiative to develop a seed capital approach to convert early stage or stranded projects into investable proposals.” 

Turning tide

The seemingly unassailable rise of ESG under the Obama-led international order faces a big challenge: Donald Trump. Globally, the last decades have seen increasingly tight environmental standards, subsidies for zero-emission cars, cooperation against money laundering, liberal trade deals and generous international aid. To have applied ESG principles back then would have put you on the correct side of history and rewarded you accordingly.

While the president-elect should be given the benefit of the doubt, his nomination of renowned climate change sceptic Scott Pruitt to head the EPA does not bode well. The COP21 Paris climate change agreement, which Trump described as “a bad deal for America”, is now almost certainly dead. Indeed, nonrenewable carbon stocks have seen a huge boost after the election.

The challenge now facing ESG is whether it can still add to returns, or even not harm them. It may be right to care about such issues regardless, but the movement will lose its ability to claim outperformance if investors lose out on an oil bonanza. ESG has had most resonance with trustees of defined benefit pension schemes which, in the UK at least, have an obligation to maximise returns for the beneficiaries. It will certainly make it more difficult for them to justify their investment strategies.