Reconciling Returns and Impact: An Evidence-Based Approach to ESG Investing

Introduction

- Emerging “sustainable capitalism” trend

Over the past years, responsible investing has become increasingly popular due to the rise of ESG. It is an attractive proposition that investors no longer have to compromise between good returns and a beneficial impact on society. However, some of its critics argue that this win-win situation only works in ESG investing.

The Complex Link Between ESG Factors and Corporate Financial Performance

- Most studies show a positive relationship between ESG and CFP (Friede, Busch & Bassen)

A comprehensive analysis by Friede, Busch and Bassen in 2015 encompassing more than 2000 empirical studies indicated that most indicate a positive relationship between ESG criteria and corporate financial performance.

Nevertheless, Aw, LaPerla, & Sivin (2017) argue that integrating ESG factors into investment strategies can produce varied results depending on the industry sector, selected ESG metrics or period under scrutiny. Human capital is a significant material factor for ESG (Bernstein & Beeferman).

According to Bernstein and Beeferman’s findings of 2015, human capital metrics are crucial determinants of company financial performance, hence critical drivers of companies’ social responsibility varying across economic sectors.

However, a nuanced approach is required now.

This means we should avoid treating the proposed rationale for any form of sustainable finance as overly simplistic but rather adopt an evidence-based approach towards understanding what motivates such institutions from their social and business perspectives.

Enhancing ESG Integration for Impact

Incorporate materiality analysis and impact assessment

To effectively align investments with both financial return objectives and social purpose goals, it is necessary for the process of integrating materiality analysis in ESG to scrutinise sectors for financially significant ESG factors and a rigorous impact assessment that shows on-the-ground social and environmental realities.

Move beyond risk mitigation to proactively drive sustainability innovation

Investors should not only view ESG factors narrowly as risk-mitigating strategies but instead direct them towards scaling up sustainability-oriented innovations that would stimulate systemic change.  

Focus on systemic transformations rather than incremental change

Therefore, sectors such as renewables, sustainable agriculture, and microfinance, among others, can be funded more heavily to make industries, in this case, environmentally and socially responsible, which amounts to systemic transformation instead of piecemeal improvements.

Evidence for ESG Investing Outcomes

Mixed results for ESG integration affecting bond returns (Gerard)

According to Gerard’s 2018 literature review, it is difficult to analyse how fixed-income returns are affected by different types of ESG factors since there is a mix of findings concerning the influence of these issues on bond performance.

Success depends on the quality of the investment process (Fulton et al.).  

In addition, Fulton et al. (2012) also explain that if successfully implemented, mutual funds focusing primarily on environmental aspects can generate above-average risk-adjusted returns, indicating that outcomes hinge upon investment process quality.

Extending ESG considerations to broader societal issues (Robinson et al.)

Moreover, Robinson et al. reveal how ESG criteria can impact systemic societal issues, including obesity or nutrition.

Conclusion

- Some evidence suggests alignment between financial returns and ESG is possible

Some empirical literature supports the possibility of a relationship between the two, although there are still gaps in our understanding and essential opportunities for future research.

Materiality and impact rigour are essential but require nuanced integration.

Nonetheless, it is subject to the proper identification of material ESG criteria and robust impact evaluation.

This way, ESG investing is rethought to go beyond the returns versus impact fallacy.

Suppose we consider this new approach to ESG investing and use relevant evidence. In that case, we can stop thinking about a false “either-or” between financial returns and purpose and instead think about models that play a part in creating long-term sustainable value.