ESG excellence doesn’t yet pay off for companies, but public policy can help change that

WITH the ESG label slapped on an endless array of financial products, and the tools for quantifying sustainability risks in financial markets limited at best, it’s no wonder ESG (environmental, social and corporate governance) investing has suffered heightened scrutiny recently. The real question is whether the industry confronts that scrutiny head-on – because the future of ESG investing depends on it.

It’s hard to deny that momentum behind sustainability is growing across every corner of financial markets, especially among the investment community. The structural shift towards a more sustainable society, however, is by many measures still in its infancy. Companies, consumers, and investors are still finding their feet in that transition, learning new ways to better quantify ESG risks, adapt and grow more resilient in confronting them.

ESG investing is here to stay, but the real work is just beginning. With this in mind, we reflect on the main findings of our research and some lessons for the next phase of ESG.

Renewable energy makes economic sense

The cost of sustainable energy generation is lower than coal and natural gas. There is no longer any need for financial compromises.

Higher commodity, labour and transportation costs have impacted energy generation, but solar and onshore wind plants are still the cheapest sources of newly built generation. This is a key conclusion from our analysis on greenflation – an issue exacerbated by the Ukraine war. Higher demand for sustainable energy could push prices higher for metals heavily used in green technologies, such as lithium. But we find that overall commodity prices have reflected mostly global growth and broader supply shortages.

We’ve also found that some consumers are willing to pay more for more sustainable products, although that attitude will be tested as inflation hits their pockets. Higher energy costs are already challenging voters’ preferences for carbon taxes and other measures, potentially delaying the carbon transition.

Little reward for ESG outperformance

Absent regulation, markets have generally done a poor job pricing social and environmental externality.

As investors continue integrating ESG into their investment processes, we would expect at least some discrimination between sustainability and asset performance. Often, however, the opposite is true.

For instance, the global food industry is responsible for 30 to 40 per cent of greenhouse emissions. Encouragingly, we found some companies have indeed been able to lower emissions substantially. But there is little evidence that companies that are polluting less are rewarded with better equity returns.

The evidence is slightly better for energy producers. When ESG ratings improve, so does equity outperformance. But the correlation does not hold for downgrades. Importantly, companies with lower carbon intensity (defined as emissions per unit of sale) tend to benefit from lower credit costs. But the difference with the laggards is minimal.

Similar results hold for other ESG issues besides the environment, and across industries.

This begs important questions about incentives: Why would a company be willing to incur the costs of reducing emissions if there are no tangible benefits?

Public policy is crucial

We have found 2 clear exceptions where ESG awareness makes a difference – both cases in which public policy plays a critical role.

Our study of the tobacco industry highlights the lack of a correlation between the public health costs of cigarette consumption and credit spreads – until the United States administration announced much tougher policies against nicotine consumption. Stringent regulation meant that US companies underperformed as markets priced in a more challenging long-term revenue stream.

We found much the same in our analysis of US utilities. After emissions regulations of greater stringency were implemented, the market selected winners and losers based on their current carbon footprints – not only their ambitions to reduce.

While further investigation is needed, policy nudges seem an important factor driving markets to realise the long-term potential financial costs arising from unsustainable practices.

Corporate governance has major impact

Another important finding is the strong correlation between governance — especially corporate board diversity and executive pay — and superior environmental outcomes.

We’ve found that greater female representation on executive boards (especially if at least one-third of the board is female) is correlated with better sustainability practices, as well as superior equity performance versus industry peers. This is the most powerful connection we have found between ESG indicators and asset performance.

Likewise, companies that disclose linking chief executive pay to ESG indicators have reduced carbon emissions compared to peers. These are very encouraging results and could offer another pathway for companies towards encouraging the transition to a low-carbon economy: focus on the right governance incentives and the results will follow.

Clearer standards and more consistency needed

There is still substantial work to be done in defining measures of ESG factors that are more accurate. Ratings that attempt to combine many aspects largely miss the point. ESG rating methodologies, scopes, and weights vary drastically, are inconsistent and biased.

At the other end of the spectrum, it is hard for asset managers, let alone for individual investors, to pore over hundreds of indicators across dozens of ESG categories. We hope that relatively straight-forward measures such as our WEDG diversity indicator (racial composition gap between executives and overall workers), scope 3 carbon emission intensities, or the percentage of women at board level add value to investment decision-making.

At a minimum, ESG factors should be easily measurable and widely understood; that should be the guiding principle of ESG investing 2.0. If regulators and the industry do not press on this topic, ESG investing risks further scrutiny and, potentially, being relegated to the dustbin of fads past.

The writer is head of ESG macro strategy at NatWest Markets.