6 Trends in ESG Investing

Climate change, cybersecurity (including privacy), technological advancements and demographic changes were already altering the investment management landscape before COVID-19. In our view, the pandemic has helped hasten a shift toward sustainable investing. It has also elevated the social aspects of the environmental, social and governance (ESG) criteria that investment managers use to select—and exclude—potential investments.

COVID-19 not only altered the global economy but affected investment theory as well. Millennials poised for the “Great Wealth Transfer" are increasingly interested in responsible investing and believe economic theory should evolve past its sole focus of maximizing profits.

What’s good for the long-term viability of our economic system and society also has the potential to lead to positive investment outcomes. More investors are now measuring company performance beyond just profit and loss. It is no longer about what makes a good stock but what makes a good company.

Sustainable Investing Has Hit Record Highs

Investors are projected to purchase a record US$500 billion in green, social and sustainability bonds, with $54 billion invested in ESG bond funds in the first five months of 2021.¹

• First quarter broke records:

   Increased investor interest in ESG issues and sustainable investing drove sustainable funds to new highs in terms of flows, assets and product launches.

• Inflows increased in the first quarter:

  Sustainable fund inflows spiked in the first quarter, up 17% from the fourth quarter of 2020 to US$185.3 billion.²

• Europe dominated:

   Europe continued to dominate the space. The U.S. accounted for 12.7%, down slightly from the previous quarter. And flows in other parts of the world also grew—Canada, Australia and New Zealand, and Japan and the rest of Asia accounted for US$9.1 billion, combined.²

• Assets achieved new highs:

   Sustainable fund assets reached US$2.3 trillion by the second quarter of 2021, a 12% increase from the first quarter.²

What’s Driving ESG Investing Now?

We’ve identified six key trends. We believe successfully addressing these trends should not only contribute toward managing ESG-related risks and opportunities, but also help investment managers adjust to the shifting mindset toward sustainable investing.

1. Progress on SDGs = Progress on Human Rights

As the world simultaneously fights the pandemic and the negative effects of climate change, we believe investors will increasingly consider the environment, public health and the global economy intertwined.

Investors are looking to companies that are rethinking their resource consumption, supply chains, energy usage and manufacturing processes to eliminate waste, address modern-day slavery issues and generate renewable outputs.

While ESG issues, such as human rights, are often deemed risks, they also offer opportunities. In our “impact” investment screening process, we aim to find investment opportunities that help advance human rights, especially in emerging markets. These countries, where living standards are lower and socioeconomic inequalities typically significant, are more vulnerable to environmental damage and epidemics than the developed world.

Our investment teams have identified opportunities in long-term growth trends and improving corporate practices across emerging markets. Such businesses may contribute to progress in reaching the following U.N. Sustainable Development Goals (SDGs):

2. Digital Acceleration: Fasten Your Cybersecurity Seat Belt

We believe businesses exposed to the stay-at-home digital economy remain attractive investment opportunities. We expect software, data centers and cloud-based and 5G networking companies to continue thriving despite a pickup in demand for consumer goods cyclicals.

However, pandemic-led “digitized” companies will face heightened data privacy and security risks. This will accelerate the focus from data collection and mining (“know your customer”) to data security (“protect your customer”).

We expect cybersecurity and associated privacy issues to continue growing in importance for investors, as consumers and regulators grow wary of Big Tech watching us.

3. Climate Change and the Energy Sector: Innovate or Be Overlooked

We believe investors focused on decarbonizing their portfolios will redouble their efforts. Continued improvement in technological learning curves, toughened environmental regulations and shifts in investment mentalities will continue to support the transition to a lower-carbon economy. This shift can be achieved despite the cyclical recovery and improving consumer confidence that may support a rebound for the energy sector.

Investors can still use fossil fuel divestment to reduce climate change-related risks. This is especially true for assets deemed harmful to human health and the environment (e.g., coal, tar sands). But we believe investors will choose to focus their energy sector allocation rather than choose full-fledged divestment.

4. Balancing Clean Energy and ESG Risks

Global asset owners will need to strike a balance between accelerating the clean energy transition and managing increasing risks. Risks include human rights/labor violations and negative environmental consequences of using lower carbon enabling metals (e.g., copper, lithium, cobalt and nickel). Economic decarbonization is likely to continue driving growth for electric vehicles and renewable energy.

The production of minerals such as graphite, lithium and cobalt could increase by 500% by 2050, according to a World Bank Group report.³ Yet, concerns have surfaced about the negative impact of acquiring these materials.

For example, lithium, a key component in the lithium-ion battery, is water-intensive. Cobalt has been associated with child labor and human rights issues in the Democratic Republic of Congo. Moves to use less cobalt have led to using more nickel, which has been associated with negative environmental issues, including toxic byproducts.

In this context, we believe investors will focus on alternative supply sources for the minerals critical to building renewable infrastructure—without dialing back ESG risks.

5. ESG Regulation: The Europeans Are Coming! The Europeans Are Coming!

Investment managers with exposure to the European Union (EU) must comply with the new Sustainable Finance Disclosure Regulation (SFDR) and associated EU Taxonomy.⁴ These regulations will have a positive effect by making “greenwashing” more difficult. (Greenwashing is a tactic to make a company or industry appear more environmentally conscious than it actually is.)

Greater transparency and clarity will raise the barriers to entry, so it will be harder for investment managers to stick ESG labels on their investment products. Such cleanup (pun intended) may provide competitive advantages to investment managers with stronger ESG capabilities.

Will ESG regulations in Europe reverberate globally? It depends on the regional context and the policy priorities of respective countries. Addressing ESG puffery/deception in fund disclosures and promoting climate-conscious capital allocations is gaining consensus in the investor community.

For example, the U.S. Securities and Exchange Commission recently established a Climate and ESG Task Force, and Japan’s Financial Services Agency reviewed new rules for mutual funds to protect investors from possible ESG greenwashing.⁵ We believe the U.S., as well as some east Asian and Australasian markets, will look at western Europe for guidance on ESG investing best practices.

Overall, we believe investors will increasingly demand clear, verifiable evidence that ESG considerations are formally integrated into a manager’s investment process.

6. Crowded Trade: Is ESG in a Dotcom-ish Bubble?

In our view, ESG momentum will continue as trends become ingrained with economic realities. Digitalization and decarbonization are themes increasingly compared to the internet revolution.

Time horizon, turnover, risk appetite, sector allocation and investable universe are important characteristics when considering ESG allocations in a portfolio. Some strategies, by the nature of their design and investment objectives, might be forced out of the scope of “ESG love stories” and ESG regulations. This increases the risk of an overcrowded ESG trade (i.e., overpricing) as managers create similar products and own the same securities.

As ESG demand grows, investors should be mindful of the potential risks, as many of these investments are already overweight/over-represented sectors such as technology, renewable energy and health care.

While we believe many of these ESG-friendly investments have strong growth potential in the longer term, they warrant caution. Investment managers should be creative in unearthing rising stars (i.e., companies in earlier stages of change) at the onset of their ESG journeys or on the verge of improvement following business misconduct controversies.