Fixed Income Boutique

ESG's return proposition continues to have merit


Recently, ESG investing has caught flak as powerful voices1 claim that ESG makes an unattractive value proposition to investors. Supposedly, this is because green assets will always tend to underperform brown assets since good ESG performers benefit from lower costs of capital which, by definition, results in lower returns to investors in the future. As if this wasn’t already bad news enough for ESG, these critics reduce ESG's return potential to being entirely dependent on the whims of consumer sentiment which changes with climate change news.

However, none of these views withstand a hard look at reality.

Reality check

First of all, expected returns do not equal realized returns which reveals that the above argument only holds in perfect markets with perfect information. The reality is that we are operating in imperfect markets with incomplete information which creates numerous possibilities for above-market returns via ESG investing. However, these can only be uncovered and harvested by active investment management as opposed to a mechanical replication of the market by a static approach. In addition, if ESG's return potential really is at the mercy of investor sentiment that changes with the tune of current climate change news, then active management can make a difference by over- and underweighting ESG names at the right times.

Catching rising ESG stars

More importantly, ESG has a transitional aspect that must be taken into account. Companies progress on ESG at different speeds which harbors significant return potential for those who are able to identify companies on a promising ESG trajectory. Once good ESG management becomes apparent, companies start attracting capital which lowers their cost of capital and drives up their bond and share prices with sizeable capital gains for investors who caught the signs of good ESG management early enough. Bad ESG performers will be left by the wayside and will end up underperforming ESG leaders.

Good companies will always attract investors

The above mentioned critics make it seem like a lower cost of capital by virtue of good ESG management is bad news for investors. This sounds like investors would be better off investing in brown assets as the potential for financial reward is much higher. This view is oblivious to the fact that long-term capital commitments are not captivated solely by the magnitude of absolute returns but rather by the quality of these returns. Higher expected returns based on higher cost of capital goes hand in hand with higher risks since there is a relationship between higher yields and higher volatility. Ultimately, investors do care about how they are compensated for each unit of risk they are taking on.  And let's not forget that lowering your cost of capital by attracting a high volume of investments is a good thing. Failing to do so could make it unsustainable for a company to continue operating. Conversely, high-yield, high-risk companies could run the risk of bankruptcy and by shunning them, investors avoid getting stuck in redundant companies in the medium term.  Plus, there are companies out there that keep on getting better at what they do, like Amazon and Apple for example. Ultimately, good (ESG) companies will always attract investors - because of a lower cost of capital and despite higher share prices.

Investors' motivations have changed

Finally, I am convinced that investment management is in the midst of a powerful transformation which will empower ethical investing at the expense of coldblooded, profit-maximizing capitalism. Investors no longer just want returns at any price. Already today, investment management is being shaped by a new generation of investors who want to future-proof our world and these investors will judge the quality of an investment through an ESG lens. Therefore, making an investment will no longer be a binary decision based on the prospect of absolute returns. It will be a much more nuanced process taking into account ethics, risk and returns for the sake of a better future.  

1. Financial Times, ESG's lower (expected) returns