ESG investing: It’s here, are you ready?

Bank of America Merrill Lynch (BAML) has recently published perhaps the most comprehensive analysis yet of the performance and future impact of ESG investment strategies on companies and markets – and its findings are startling. 

So startling, in fact, that in places the tone of the report is one of surprise; one suspects that BAML came to the subject with a degree of skepticism but, after conducting the analysis, it has been converted to the ESG cause. The conclusion is stark: ESG investment strategies not only outperform on shareholder value, but also provide a highly accurate prediction of success. 

Companies with a high ESG score are: 

• Less likely to go bankrupt over the next five years
• Less likely to have large price declines
• Less likely to have earnings declines or increased EPS volatility
• More likely, if small cap, to become high-quality stocks in future
• More likely to see extreme inflows over the next few decades
• Delivering three-year returns significantly better than their peers.

‘ESG is a better signal of earnings risk than any other metric we have found,’ the authors conclude. 

Furthermore, the authors say a wall of new investment money governed by ESG factors is going to materialize over the next 20-30 years. ‘We conservatively estimate that inflows [to US exchanges] into ESG-type strategies over the next few decades could be roughly equivalent to the size of the S&P 500 today,’ they write.

Significantly, one of the major drivers for ESG uptake comes from supranational institutions. The EU’s non-financial reporting directive, one of the most binding pieces of European corporate legislation to date, should result in approximately 6,000 companies in EU member states publishing ESG disclosures. Meanwhile, the United Nations Sustainable Stock Exchange Initiative has signed up 78 partner exchanges since launch in 2015, including the MENA exchanges of Bahrain, Egypt, Jordan, Kuwait, Morocco and Qatar and the Dubai Financial Market in the UAE. 

And it is not only investors and supranationals that care about ESG. Index compilers are increasingly adjusting index constituents by their ESG scores – on both an inclusion and an exclusion basis. Regulators are increasingly adopting an ESG lens when examining firms and framing legislation. Markets, too, are increasingly prone to support members that are serious about ESG. 

Put together, these developments comprise a ‘super-trend’, an unstoppable and massive shift in investment approach that is going to impact every market, every company and every asset manager for many years. And if the super-trend identified by BAML is true, companies around the world will have to adapt and transform their business models and corporate practices to adopt ESG principles, or risk disappearing. 

The BAML report gives strong indications of why the super-trend will materialize: when investors see clues to future outperformance, they want to replicate this factor across their portfolios to generate extra returns – and also to guard against missing out. As the evidence mounts that strong ESG is an indicator of outperformance, so portfolios will be constructed using this evidence. 

ESG in the Gulf

For Gulf companies, this is an important consideration. While ESG may be a minor concern for local investors today, that will change, and the BAML report shows that it is already a major issue for international funds – both passive and active. Gulf Cooperation Council (GCC) firms that can demonstrate a commitment to ESG will win more attention from international investors. 

The largest sectors of regional markets – real estate and banking – are particularly suited to ESG investment. Regional banks will need to learn fast about how their international peers have tackled issues such as the environmental impact of their lending, their policies on customers in distress, and the governance and risk management of their business. Real estate firms have an environmental impact through their day-to-day business. They will need to present their business models through an ESG filter to satisfy the growing number of investors insisting on good ESG scores before committing their investment. 

And this accelerating global exposure of regional business is matched by their increasingly global activities. Headlines in recent days have demonstrated the increasing pace of international involvement in the GCC economy: Baker Hughes, a subsidiary of GE, acquired a 5 percent stake in the Abu Dhabi National Oil Company’s drilling business for $550 mn; in banking, the Saudi British Bank, 40 percent owned by HSBC, merged with Alawwal Bank, creating the third-largest bank in Saudi Arabia; and Oman has announced a major privatization of its electricity generation industry. 

As the GCC’s markets become more international and the region’s listed firms become more familiar to international investors, valuation and reputation will increasingly be ESG-driven. Environmental, social and governance issues will appear higher and higher on the list of boardroom concerns. Executive teams and boards will have to frame their strategic plans with a view to delivering ESG outcomes, and IR teams would be wise to begin drafting an ESG report, if they are not already doing so. 

IR professionals can play a valuable role in helping management to understand the issue, and advising management and boards on how to make the most of the opportunity it presents. The point is that ESG factors are not a ‘nice to have’: they are increasingly forming a central plank of investment strategy. For that reason alone, regional firms will not be able to avoid the issue for much longer. 

After all, when a global institution like BAML is convinced of the future importance of ESG and sees it as an accurate guide to future performance, no one can ignore it for much longer.

Oliver Schutzmann is CEO of Iridium Advisors