In an era where climate change debates heat the political sphere, many savvy business owners and investors are turning their focus toward a cooler, more sustainable future.
While addressing climate change is still politically controversial, for many, if not most business owners, it is a risk that must be addressed and managed. In fact, many businesses across a range of industries are doing exactly that. Their success in this effort has thus become of keen interest to investors in recent years, resulting in the rise of numerous strategies aimed at limiting carbon emissions or similar environmental goals.
The umbrella term for this kind of investing is environmental, social and governance (ESG) investing. Although that term can encompass a broad range of strategies with different goals and methodologies on how to achieve those goals, the focus is increasingly on companies that are environmentally sustainable and responsible.
There is often a perception among some that the sole reason investors invest in ESG is for ethical reasons. Of course, there is nothing wrong with ensuring that your investment portfolio reflects your values, if one chooses to do so.
However, while ESG investor interest in these companies may have been piqued for personal ethical convictions such avoiding investing in fossil fuel companies or polluters, it is often overlooked that many investors believe sustainable and ESG friendly companies are a wise investment decision.
In fact, there are sound economic and market reasons that support a focus on environmental sustainability. Many investors believe focusing on long-term sustainability and reducing fossil fuel usage is smart for business and the bottom line. Here are five reasons a focus on climate may make sense for companies — and investors.
Risk mitigation. It is important to emphasize that the impact of climate change is ultimately a potential business risk. For example, insurance companies incur higher liabilities from climate-related disasters, and many businesses may face supply chain disruptions from extreme weather events.1 Companies with an effective climate strategy and high ESG scores can help mitigate those risks. Moreover, highly ranked ESG companies with comprehensive risk management practices may be less likely to face reputational risks and legal liabilities from poor environmental practices. Avoiding those risks may impact the bottom line in the short term monetarily and in the long term reputationally.
Operational Efficiency and Cost Savings. Many companies that adapt to the new climate reality by becoming more sustainable and reducing their fossil fuel usage typically work to achieve that through innovative technologies and operational efficiencies. That, in turn, could potentially lead to significant cost savings – and higher profit margins-- that may translate into stronger returns for investors.
Resilience to Regulatory Changes. Although environmental regulations concerning climate continue to be controversial in many places, we are generally seeing a trend towards more stringent regulations and carbon pricing mechanisms globally. Climate-efficient companies with robust sustainability frameworks appear to be better positioned to adapt to these changes without incurring significant compliance costs. This, too, may translate into more stable earnings and lower risk premiums, which makes them more attractive to investors.
Access to Capital and Favorable Financing Terms. Companies with high ESG scores often enjoy better access to capital and more favorable financing terms, as banks and other financial institutions are offering loans, such as green bonds, which typically have lower interest rates for companies that meet specific environmental criteria. This access to cheaper capital can fuel growth and innovation, driving long-term value creation, which again, makes them appealing for long-term investors.
Enhanced Competitive Advantage and Market Opportunities. Whether it means expanding into new markets for green products and services, tapping into consumer demand for sustainable goods, or leveraging government incentives for clean technology, climate-efficient companies are positioned to capitalize on new opportunities related to the transition towards a sustainable economy. This competitive edge may lead to increased market share and a boost to revenues.
Despite assertions from many that ESG strategies underperform, some studies indicate the opposite. For example, a report by Manulife shows ESG indexes outperforming their non-ESG counterparts, and greater resilience during periods of market volatility..2 That makes intuitive sense since climate-focused companies tend to operate more efficiently, with a focus on risk mitigation. Still, it should be noted that all investing carries risks, including ESG and such strategies could see periods of underperformance.
Over the long term, however, many believe the case for investing in climate focused companies with high ESG scores is strong. Such companies are more likely to adopt sustainable business practices that ensure their viability and success, building business models that can deliver consistent returns to investors over the long term. ESG investing is sometimes viewed as a tactical 'satellite' position alongside core equity holdings; however, the long-term nature of sustainability and the increasingly effective response by a range of businesses to adapt to that challenge underscores the strong case for including it in the core of your portfolio.
1 https://www.bankrate.com/insurance/homeowners-insurance/natural-disaster-costs/#billion-dollar-disasters
2 5 benefits of ESG investing (manulifeim.com.hk) https://www.manulifeim.com.hk/en/insights/5-benefits-of-esg-investing.html