FA Magazine July/August 2022 | Page 63

this logic , we can expect higher returns over the long term for non-sustainable companies . As the adage goes , the greater the risk , the greater the reward , though a higher cost of capital is also to be expected for these less sustainable companies . The authors imply the risk premium is already in play today , it ’ s just that it ’ s being overshadowed by the higher demand of investors seeking sustainability .
• Because the higher long-term returns of non-sustainable companies come with increased risk ( and vice versa ), it ’ s reasonable to assume long-term risk-adjusted returns may be closer to those of ESG investments .
• If the authors are right , and there are , in fact , lower long-term expected returns from ESG portfolios , investors can compensate by using factors such as size , value , momentum and profitability in their portfolio choices .
• “ Brown ” companies face a higher cost of capital , so they will be able to invest less . Meanwhile , “ green ” companies with a lower cost of capital will be able to more easily expand their footprints . In other words , a higher cost of capital puts a company that is not sustainable at a competitive disadvantage .
• As critics of ESG investing have argued for some time , greenwashing is real . Research suggests that behemoth fund managers have exploited investor demand for ESG investing without delivering the goods . One study released in April 2021 (“ Do ESG Funds Make Stakeholder-Friendly Investments ?” by Aneesh Raghunandan and Shivaram Rajgopal ) suggests that these funds are not only more expensive , but that they regularly underperform non-sustainable funds over the same time periods by the same managers . Additionally , the companies making up these “ sustainable ” funds are actually less sustainable than the companies held by their nonsustainable fund counterparts ! This evidence supports the SEC ’ s April 2021 ESG Risk Alert , which cautioned investors not to over-rely on ESG ratings without further due diligence . The agency cited the ratings ’ lack of transparency and conflicting ratings criteria , while noting that some companies have gamed the system by self-reporting their data while some portfolio man-
Majorities Prioritize Alternative Energy Development And Back The U . S . In Taking Steps To Become Carbon Neutral
Percent of U . S . Adults Who Say ...
69 %
30 % u . s should prioritize developing alternative energy , such as wind and solar
u . s should prioritize expanding oil , coal and natural gas production
69 %
28 % favor the u . s . taking steps to become carbon neutral by 2050
oppose u . s . taking steps to become carbon neutral by 2050
31 %
67 % u . s . should phase out the use of fossil fuels completely
u . s . should use a mix of fossil fuels and renewables
Two-thirds want the U . S . to keep a mix of fossil fuels and renewable energy sources
note : respondents who did not give an answer are not shown . source : survey conducted january 24-30 , 2022 . “ americans largely favor u . s . taking steps to Become carbon neutral By 2050 ,” Pew research center . agers turn a blind eye in exchange for higher fees .
• While the study by Raghunandan and Rajgopal is disheartening , the evidence still suggests that overall , sustainable investing is working . In fact , the research reveals that sustainable companies enjoy lower systemic risk and have higher PE ratios , better cash flows , happier workforces , happier stakeholders and more transparent governance structures . They also generally make better long-term decisions . In the years 2018 to 2020 , sustainable investment increased to $ 12 trillion , while the carbon footprint of all major index companies declined by approximately 30 %. While we ’ re not suggesting there ’ s a direct causation , certainly the desire for more sustainability by investors ( and consumers ), has contributed to this trend . In other words , the tide has shifted in such a way that companies now know what investors and consumers seek — and are moving toward giving it to them .
• Engagement is also important . The evidence suggests that when companies engage with shareholders and managers to improve their sustainability metrics , they see an outsized performance return of 2.3 % in the year of engagement and a 7.1 % increase year over year ( according to a study called “ Active Ownership ,” by Elroy Dimson , Oğuzhan Karakaş and Xi Li that appeared in a 2015 issue of the Review of Financial Studies ). While this study is older , the conclusion is not surprising . It makes sense that companies will see improvements in their operating performance and profitability following such engagements since they will be able to attract positive press and social media attention . This in turn attracts more socially conscious investors and consumers .
What Does It Add Up To ?
Now that I have reviewed the research , my biggest takeaway is that ESG investing is working to change corporate behavior while at the same time providing returns that are comparable to those of other companies when risk-
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