For a long time, investors eager to use their money to improve the world through socially and environmentally conscious investments worried that they would be sacrificing returns in the process. No longer. Investing that takes into account environmental, social and corporate governance (ESG) factors often equals or even outperforms investments that ignore these factors. Today more than $20 trillion, or a quarter of all professionally managed assets worldwide, follow ESG strategies. With younger people ascendant and especially concerned with climate change, that number is sure to grow.
Such investing, moreover, could be especially important in achieving a sustainable recovery after the pandemic and a better reality for current and future generations.
The question is whether it is wise for governments to also orient the investments of sovereign wealth funds (SWFs) and pension funds around ESG concerns, whether they be climate change, gender equality, labor conditions, or others. We decided to find out. In a recent study, we compared the actual performance of Chile’s two SWFs and five government-regulated pension funds against their conventional market benchmarks. We also created a counterfactual in which we replaced the funds’ benchmarks with their ESG counterparts. We found that over the period of our analysis (generally from 2013 to today) the SWFs and pension funds could have restricted their investments to those with good performance in environmental, social and corporate governance without sacrificing financial returns.
The Importance of Sovereign Wealth and Pension Fund Investing
This has important implications. To start with, governments have a particular interest in investments that align with their development priorities. Investing in firms that pursue unethical and unsustainable practices — for example, with high carbon emissions, corruption, or unfair labor practices — is always an option. But from a development point of view it makes little sense: The costs of those practices will be borne by society, and in the case of domestic investments, communities, employees, and perhaps the nation as a whole.
SWFs and pension funds also have long investment horizons during which ESG risks are more likely to materialize. Investing in oil or coal firms during the next six months may not be a problem. But investing in them over a period of 20 years or more is a different story. Countries will be changing their energy profiles in coming decades to more renewable sources, likely decreasing those oil and coal firms’ value. And with SWFs and pension funds controlling a large share of global assets, those funds are in a position to pressure firms to improve their ESG performance. That mean that even if takes time, they can lead the way, creating incentives for firms to behave in a more sustainable way.
The equal or better financial returns from ESG investing should be persuasive. When we examine one of Chile’s sovereign wealth funds, the Economic and Social Stabilization Fund (ESSF), for example, we find that from August 2013 to May 2020, the financial return of the counterfactual using ESG benchmarks delivered a cumulative return of 20.13%, compared to 19.82% for the actual return of the ESSF during that time period and 19.04% for the counterfactual using the current benchmarks. When we conduct a similar exercise for Chile’s five pension funds, constructing an ESG portfolio with the same asset allocation as the average allocation of each fund, we find that financial returns of the ESG portfolio were similarly superior. Interestingly, ESG investing substantially outperformed traditional indexes even during the coronavirus period. That is perhaps because firms that prioritize environmental and social factors as well as corporate governance are more experienced and better managed, allowing them to better steer their way through crisis.
All this is very good news. It means that there is no business or fiduciary case for failing to make investments more sustainable; that a country can invest its money in firms with good ratings in areas like climate change, human rights, gender equality, labor protection, forest conservation and a host of other ESG metrics without losing out financially.
A Crucial Time
The Covid-19 crisis has imposed unprecedented stress on the global health and economic system. But it also represents a significant wake-up call. While politicians previously procrastinated in finding solutions to major problems or made marginal changes, the pandemic represents a new reality. It comes as a surprise. But the problems related to climate change, unequal income distribution, social cohesion, gender gaps, and overall unfairness are no surprises. The financial system can make a difference. It can help, through sustainable investment, to create a better normal. The idea that there is a trade-off between such investment and financial returns is merely a poor excuse for avoiding the transformations that need to take place.
The trend towards incorporating ESG performance in investment decisions is part of broader re-definition of the role of firms, in which the maximization of shareholder value is no longer the sole objective, a trend that now accounts for a huge share of global assets. Gaining momentum in Latin America, it promises to make firms better governed and more environmentally and socially conscious. The fact that SWFs and pension funds can encourage that movement without sacrificing returns is only to be celebrated.
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