The Rise of Sustainable Investing

The seeds of sustainable investing were sown to serve as one of the means of risk mitigation, but it has evolved into an investment philosophy. In the top five global markets – the US, Europe, Japan, Canada, and Australia/New Zealand – the total Assets Under Management of sustainable funds grew 34% from 2016 to 2018 to reach $30.7 trillion, according to the Global Sustainable Investment Alliance.

World over, investors are now asking for options that are more socially and environmentally conscious in almost all types of instruments such as equities, bonds, pension funds, exchange-traded funds and hedge funds.

Sustainable investing, also known as socially responsible investing, incorporates Environmental, Social and Governance (ESG) factors in the financing decision criteria. Amongst the various methods to invest sustainably, the three most popular are – exclusion, integration, and impact.

The exclusion approach involves negative screening where investors avoid putting funds in firms engaged in activities/industries, like tobacco, alcohol, weapons, etc., that don’t align with their values. This is a subjective approach, and hence, varies significantly from one fund to the other. In the integration approach, both ESG and traditional financial factors are evaluated to analyse suitability, risk and value of the potential asset. The third approach, that is impact investing, is essentially financing assets that can generate measurable environmental or social return in addition to financial return, for example, investing in renewable energy, healthcare, education, and agriculture industries.

This current wave of sustainable investing has been driven by four major factors:

Firstly, governments globally are increasingly recognising the issues of climate change and inequality. In 2015, all member states of the United Nations adopted the agenda for sustainable development by 2030. Most nations have thus set specific targets towards a sustainable future and coming out with policies and regulations to achieve them. This presents immense growth opportunities for firms working in this space. It also increases the regulatory risk for businesses not operating responsibly.

Secondly, millennials have shown to display a greater affinity towards responsible investing than older generations. They are not only influencing the space as investors but also as fund managers, end-consumers, regulators, government officials, etc.

Thirdly, as the society becomes more conscious, preference for brands with stronger ESG practices is increasing, ultimately impacting reputation and market value.

Lastly, recent advancements in technology have enabled investors to incorporate ESG metrics into their strategies as the available tools to help assess and gather non-financial data in an easier manner.

Several large institutional investors, asset managers, and fund managers in the world are now doing sustainable investing. Some of the large pension funds such as Japan’s Government Pension Investment Fund, Norway’s Government Pension Fund Global, and the Dutch pension fund ABP have shown a strong ESG focus. One of Europe’s leading asset managers – Amundi – has committed to 100% application of ESG practices to its active open-ended funds by 2021. BlackRock has also set a goal to integrate ESG in all its active portfolio strategies by the end of 2020 and reduce exposure in the coal industry.

In India, the philosophy of sustainable investing is still at a nascent stage but is slowly picking up pace. In the middle of the Covid-19 pandemic, India saw a flow of ~$500m during January-March’2020 according to Morningstar. On the back of investor interest, several ESG dedicated mutual funds have been launched in India such as those by Quantum, the State Bank of India (SBI) and Axis Mutual Fund.

Impact investing has also seen a lot of interest in India with social and environmental needs brought to the surface by a rising population and government’s Intended Nationally Determined Contribution pledge for a greener economy. Many social entrepreneurs have entered industries such as clean energy, housing, microfinance, and agriculture – meriting a need for capital to boost their growth. To fund such ventures, several large impact investors such as the Aavishkar Group, Ankur Capital, Acumen, and Omidyar Network have emerged.

Another instrument that has gained momentum in the sustainability space is a Green Bond. It is a fixed-income instrument with proceeds earmarked to projects that generate positive environmental impact. As per the Climate Bonds Initiative, global green bonds and loans issuance increased by ~50% from 2018 to 2019 to reach ~$257bn. In India as well green bonds witnessed a lot of interest with a flow of $10bn in H1 2019, according to the Economic Survey 2019-20.

Some of the key issuers in India are the Indian Renewable Energy Development Agency, Indian Railway Finance Corporation, and SBI. In June 2020, Adani Green Energy announced plans to raise ~$12bn from green bonds in the next four to five years to invest in their renewable energy business.

There are several advantages to adopting a socially responsible investing approach. Companies with high ESG ratings are usually actively working on bringing innovative solutions in the sustainability space – providing a good opportunity for investors to gain from their growth. Further, due to consumer preferences and better risk management, most companies with high ESG score are shown to provide better returns than the others, even during an economic crisis such as the one our world is facing as a result of the current pandemic.

Avendus Capital’s ESG fund generated 6.2% alpha over Nifty 100 in Q1 2020. However, investing based on ESG also has some challenges. Unrefined strategies can limit portfolio diversification in terms of industries and market capitalization types – increasing the risk factor. Further, there is a lack of standardization in terms of definitions, parameters, and reporting frameworks of what constitutes sustainable activities. This has led to inconsistent reporting of risks and performance by companies and sometimes even Greenwashing, i.e. misleading claims on how a firm’s product is environment friendly.

With technology slowly helping resolve these challenges, sustainable investing is poised to be the new normal. While most of the current investments are exclusion-based, application of integration and impact strategies is likely to increase. Events such as the current coronavirus pandemic further highlight the need to build resilient businesses by increasing focus on people and planet in addition to profit. With the world shifting towards a low-carbon and socially mindful future, the capital needs to flow to the firms and assets positioned to best navigate this shift.