How can institutional investors benefit from (ESG), environmental social governance - Impact investing

By Shyla Awasthi

BS, Business Administration - University of California, Berkeley

The ESG investments behind "Impact Investing."

Before we can explore how institutional investors can benefit from (ESG) environmental social governance investing, let’s first define what ESG is. ESG stands for environmental, social, and governance. ESG investing is about influencing positive changes in society by being a better investor. This type of ethical investing strategy helps people align investment choices with personal values (Napoletano, 2024). Environmental factors look at what kind of impact a company has on the environment, including the carbon footprint, use of toxic chemicals in manufacturing, and its sustainability priorities throughout its supply chain. Social factors include how the company improves its social impact within in the company and outside. This includes everything from LGBTQ+ equality to racial diversity and inclusion programs. Governance factors include how the company’s board and management drive positive change from diversity in leadership to issues surrounding executive pay. ESG is important because companies that put work to pursue ESG goals become well-run and successful companies and are good stocks to own for investors (Napoletano, 2024). Whether or not the ESG goals are being met are a good indication of the strength and sustainability of a company.

Are Institutional Investors interested in (ESG) Impact investing?

A 2024 Morgan Stanley survey found that 77% of global investors are interested in sustainable investing (Yasar, 2024). Many investors are very concerned about environmental and social problems, such as climate change, gender and racial inequality, data security and privacy. Investors want to make sure that they don’t invest in firms that exacerbate or contribute to these problems. Rather, they want to invest in companies that are leading positive ESG movements. A recent survey by Stanford researchers reveals how institutional investors prioritize ESG factors in investment decisions, highlighting a shift from the broad ESG framework to a narrower focus on governance and climate-related risks (Gelfand, 2024). Governance factors, like board oversight and ownership structure, rank the highest, followed by climate concerns, specifically carbon emissions and climate change. Social factors, including workplace diversity and pay equity, are deprioritized, with exceptions like data privacy gaining attention in Europe.

Is ESG investing seen as significant or important?

The growing significance of ESG issues to investors can be seen in the recent 2020 EY Climate Change and Sustainability Services (CCaSS) Institutional Investor survey. The survey found that, of the 98% of investors surveyed who assess ESG, 72% carry out a structured review of ESG performance, compared with just 32% in the previous survey conducted two years earlier. Moreover, many of those who currently use an informal approach of analyzing a company’s ESG rating, plan to move to a more rigorous process (39%) (Bell, 2021). Despite varying regional ESG mandates, most investors assess ESG performance relatively within industries rather than using absolute benchmarks, allowing them to avoid poor performers without excluding entire sectors. This targeted approach underscores the evolving nature of ESG investing, focusing on factors that drive financial performance and risk management (Gelfand,2024).

Benefits of ESG Investing

One key benefit of ESG investing is improved risk management. Investors primarily view ESG as a tool to mitigate risks, such as tail risks that could severely impact portfolio performance, rather than a means to exceptionally achieve large returns (Gelfand, 2024). 54% of companies include ESG in risk inventory reporting, and for good reason (Nathan, 2024). From environmental regulations to shifting consumer demands, companies that prioritize ESG are better equipped to manage whatever comes their way. By integrating ESG criteria into an investment strategy, investors choose to work with companies that champion clean energy and responsible resource use, not those harming the environment through things like deforestation or relying heavily on fossil fuels (Nathan, 2024). This lets investors align their money with the company’s values, which reduces the risks associated with the investment.

ESG investments can enhance portfolio performance.

Another benefit of ESG investing to investors is enhanced portfolio performance. Research by the NYI Stern Center for Sustainable Business and Rockefeller Asset Management found a positive relationship between ESG and financial performance in 58% of corporations. Among the many ESG benefits for companies, ESG investments have proven to outperform non-ESG investments in the long term (Nathan, 2024). These findings are further supported by McKinsey & Company, who claim that a strong ESG proposition correlates with higher equity returns as well as a reduction in downside risk (Henisz et al., 2019). It’s also been noted that companies with sustainability strategies usually achieve enhanced operational efficiency, increased cost savings, lower employee turnover, retained talent, and reduced compliance costs (Nathan, 2024). A 2015 report by Oxford University and Arabesque Partners finds that it is in the best economic interest for corporate managers and investors to implement sustainability considerations into their decision-making processes. Specifically, good ESG quality can help a company to develop a competitive advantage, which can then drive better performance. For example, Coca-Cola successfully improved their ESG quality and produced superior performance as a direct result when the company reduced the water intensity of their production process by 20% over the last decade. This increase in performance is beneficial for investors who will receive a higher return on investment. Additionally, Marks and Spencer reaped similar benefits when they introduced ‘Plan A’ to source responsibly, decrease waste, and help communities, leading the firm to save $200 million annually (RBC Wealth Management, 2018).

How exactly does ESG investing benefit society as a whole?

ESG investing can also be a way for investors to make a positive impact on the environment. Growing media and public pressure are pushing businesses to become more sustainable. For example, more companies are investing in green bonds. Green bonds aim to fund projects which deliver positive environmental goals such as reducing carbon emissions, improving air quality, and promoting sustainable resources and clean transportation (Nathan, 2024). Another example

is sourcing materials from suppliers who reflect a similar commitment to environmental responsibility. For example, choosing a supplier who uses recycled materials in their packaging over a supplier who uses plastic. Prioritizing ESG in investments can also influence businesses to undertake initiatives to reduce their carbon footprint by increasing energy efficiency and sourcing renewable energy. This can lead to significant emissions reductions at the corporate level. A survey by PwC survey found that 46% of customers are purchasing more sustainable products or those that have a reduced impact on the climate. These consumers are willing to pay up to 9.7% extra for brands that align with their values and are more loyal to organizations that treat people well. Today's socially conscious consumers want to know what the businesses they support is doing for the greater good (Yasar, 2024). This reflects a shift in customer buying

behavior that investors can take advantage of.

ESG offers institutional investors portfolio diversification

ESG investing can also benefit investors by diversifying their portfolio, ultimately leading to higher returns. A challenge that institutional investors often struggle with when integrating ESG standards into their strategies is determining how to implement these principles without sacrificing diversification. According to an MSCI report, one way to do so is by increasing the weights of companies with strong ESG profiles while minimizing exclusions to a core group of objectionable stocks (RBC Wealth Management, 2018). Overall, institutional investors can benefit from ESG investing through reduced risks, higher returns on their investments and contribute to making the world more sustainable.