Retail investors are just one stakeholder group accelerating the rise of sustainable investing. And, we will talk about them and other key drivers in this article.

GSIA: The Global Sustainable Investment Alliance, a collaboration of membership-based sustainable investment organizations around the world, aims to deepen the impact and visibility of sustainable investment organizations at the global level. 

UN PRI: The UN PRI organisation is the world’s leading proponent of responsible investment. It helps the investor community to understand the investment implications of environmental, social and governance (ESG) factors and supports its international network of investor signatories in incorporating these factors into their investment and ownership decisions.

CFA Institute: The CFA Institute is a membership-based organisation for the investment profession. It promotes the highest standards of ethics, education and professional excellence in the investment profession for the ultimate benefit of society.

IA: The Investment Association is the trade body and industry voice for the UK’s leading investment managers.

Pensions Climate Risk Industry Group: The group, established in 2020, has recently produced draft, non-statutory guidance on assessing, managing and reporting climate-related risks in line with the Taskforce on Climate-Related Financial Disclosures.

Moral considerations increasingly compete with the desire to maximise financial gains: In a recent study amongst 23,000 retail investors worldwide, 77% of those surveyed said they wouldn’t invest against their personal beliefs, while 23% of people stated they would do so for greater returns.

A changing mindset amongst retail and institutional investors, businesses, governments and gradually across all of society has been the main factor for the rising popularity of sustainable investing. But how did we get here?

Following, we have a closer look at the key drivers:

Acting upon their social or moral considerations – for example concerns over climate change, workers’ rights or racial diversity – private investors have started to allocate their money to companies applying ESG criteria and as such adopting more sustainable business models.

In particular the “Millennials” generation, those born between 1980 and 2000, are playing a significant part in the growth of ESG investing, with a staggering 95% of Millennials expressing interest in sustainable investing in a KPMG survey and 67% saying they already own sustainable assets. The research also found that Millennials are twice as likely to want to invest their pension responsibly compared to older generations. Also, 89% of those surveyed expect their financial professional to explore a company’s ESG factors before recommending an investment opportunity.

The difference in investment attitude between millennial investors and their parents, in particular against the backdrop of a $30 trillion intergenerational wealth transfer currently taking place, will put pressure on wealth managers and financial advisors to expand their offer of ESG investments if they want to retain their millennial clients.

Looking at the high net-worth individuals (HNW) end of the private investor spectrum, family offices have equally discovered sustainable investing. While impact investing isn’t new to the very wealthy, this often happens outside of the family office business, and a 2019 survey of 121 of the world’s largest single family offices, each worth an average $1.6 billion, shows that there’s still much room to increase sustainable investments: The average family office portfolio allocates 19% to sustainability while 57% of family offices currently allocate less than 10%. These numbers are set to change: 32% of those family offices surveyed said they plan for their portfolios to be sustainable within the next five years.

Institutional investors such as pension funds, mutual funds, money managers, insurance companies, banks, hedge funds and private equity firms, are, in the first instance, acting on behalf of private investors and with demand for sustainable assets growing fast, institutional investors are gearing up to ‘hunt down’ ESG-compliant investment opportunities for their clients by further improving screening methods and data collection and upskilling their staff on ESG – a Franklin Templeton study found in 2019 that 80% of institutional investors are in the process of allocating more resources to improve their ESG knowledge and capabilities in this area.

At the same time, there’s more to it than institutional investment firms simply following through with what their private clients demand. Many of their boards have been voicing their own views on how sustainability matters, publicly acknowledging in the past few years that it’s imperative for corporates to have a positive impact on society, which goes well beyond trying to maximise the financial gains for shareholders. In a recent global KPMG survey, 84% of over 150 institutional investors stated that maximising shareholder returns can no longer be the primary goal of companies, while 86% said they would accept a lower return if it meant investing in a company that addresses sustainability considerations.

Action speaks louder than words: 85% of CFA Institute members now (in 2020) take E, S, and G factors into consideration in their investing, up from 73% in 2017. 63% use companies’ ESG ratings as a part of their investment selection process and 40% of investment professionals incorporate climate risk into their analysis. Also, about one-third of the CFA institute members have dedicated ESG specialists, and a third have portfolio managers conducting ESG analysis.

Prominent examples of institutional investors calling for a shift in the public and corporate mindset include Black Rock CEO Larry Fink, who announced in January 2020 in his annual letter to clients and corporate CEOs that his firm, which has almost $7 trillion assets under management (AUM), would make sustainability integral to its portfolio construction and risk management, exit investments that present a high sustainability-related risk and launch new investment products that screen fossil fuels. Likewise, the Net Zero Asset Managers initiative, a group of 30 international asset managers totalling $9 trillion in AUM, has set itself the goal of achieving net zero carbon emissions across their portfolios by 2050 with interim 2030 targets.

Most importantly, pension funds holding an estimated $20 trillion in assets, the single largest asset pool in the world, have finally thrown their financial power behind the transition to a sustainable global economy, which will no doubt boost the sustainable investing market.

Faced with rapidly aging populations and solvency issues, many pension funds have been slow to adopt ESG investment practices, however, while only 55% of European pension schemes said in 2019 that they consider ESG risks as part of their investment decisions, this number shot to 89% in 2020, a Mercer study shows. And leading the way, in June 2020, the Universities Superannuation Scheme, the UK’s largest pension scheme, announced that over the next two years it will be divesting from companies involved in tobacco manufacturing, coal mining and weapons manufacturers, where this makes up more than 25% of their revenues. This amounts to a reported £1.6bn in assets and is perhaps the largest recent example of the changing approach to sustainable investing in pensions.

While regulatory changes, such as the European Union’s IORP II and the Action Plan on Sustainable Finance, and industry groups like the Pensions Climate Risk Industry Group, have contributed to this shift, 51% (compared to just 29% in 2019) said in the same survey they were driven by the potential impact on investment returns, emphasising the fact that the reality of the catastrophic consequences of climate change on the planet as a whole and specifically on businesses is sinking in.

Investor coalitions, above all the UNPRI, have contributed significantly to the rise of sustainable investing. The UN’s six Principles for Responsible Investment (UNPRI), launched in April 2006 at the New York Stock Exchange, are a voluntary set of investment principles, developed for investors by investors, offering a menu of possible actions for incorporating ESG issues into investment practice. UNPRI signatories commit to the following:

• Principle 1:We will incorporate ESG issues into investment analysis and decision-making processes
• Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices
• Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest
• Principle 4:We will promote acceptance and implementation of the Principles within the investment industry.
• Principle 5: We will work together to enhance our effectiveness in implementing the Principles
• Principle 6:We will each report on our activities and progress towards implementing the Principles.

By the end of March 2020, the UNPRI had 3,030 signatories, representing collective assets under management (AUM) of $103.4 trillion.

Equally influential, but following a slightly different route than the UNPRI, has been the investor coalition Climate Action 100+. Launched in December 2017, the initiative aims to ensure the world’s largest corporate greenhouse gas (GHG) emitters – identified via the MSCI All Country World Index and using CDP modelled and reported data – take necessary action on climate change; ultimately turning non-sustainable assets into sustainable assets.

The initial 100 so called ‘focus companies’ are responsible for up to two-thirds of annual industrial carbon dioxide emissions, according to CDP. In July 2018, an additional 61 companies were added to the focus list.

In signing up to Climate Action 100+, more than 540 investors, responsible for over $52 trillion in assets under management – representing over 50% of all global assets under management – have committed to engage with at least one of the 167 focus companies to seek commitments on the initiative’s key asks: 

• Implement a strong governance framework on climate change;
• Take action to reduce greenhouse gas emissions across the value chain and;
• Provide enhanced corporate disclosure.

Regulations have been another major driver of the rise of sustainable investing: The UN PRI found that for the world’s 50 largest economies there had been over 730 hard and soft-law policy revisions across some 500 policy instruments in 2019, which all support, encourage or require investors to consider long-term value drivers, including ESG factors.

The most significant of these policies aim to improve the understanding of what exactly constitutes an ESG-compliant company and to establish international, if not global ESG standards to allow for a better comparison of corporate ESG-performance. Game-changing new policies include:

• EU Ecolabel for Retail Financial Products: The Ecolabel, one measure of the Sustainable Finance Action Plan, aims to offer clear guidance on the financial products retail investors can invest in if they wish to support environmentally sustainable projects and activities – in line with the EU Taxonomy Regulation.The planned introduction of this label seeks to solve the biggest challenge that investors face:  disparate ESG standards, which make it difficult, if not impossible, to effectively compare the ESG credentials of companies that report under competing ESG standards. Furthermore, the label should help to eliminate “greenwashing”, whereby companies only disclose data that paints them in an environmentally good light.
• Non-Financial Reporting Directive (NFRD): As part of the European Green Deal,the European Commission committed to complete a review of its NFRD in the fourth quarter of 2020, which since has been moved to the first quarter of 2021 due to the COVID-19 pandemic. The EU introduced the directive to help investors, consumers, policy makers and other stakeholders to evaluate the non-financial performance of large companies and encourages these companies to develop a responsible approach to business. It requires the disclosure of non-financial information, such as reports on the policies businesses implement in relation to environmental protection, and diversity information to be published in the annual reports of large public-interest companies with more than 500 employees, from 2018 onwards.
• EU Taxonomy: The EU Taxonomy is one of the most significant developments in sustainable finance and will be a key policy, if not the most wide-ranging policy for investors and issuers. While its focus is on helping companies to access green financing to improve their environmental performance, the performance thresholds the taxonomy introduces can help any business to identify which of its activities are already environmentally friendly. Under the EU Taxonomy, environmentally sustainable activities must:
  1. Make a substantive contribution to one of six environmental objectives or be enabling transitional activities. The six environmental objectives are: climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, protection and restoration of biodiversity and ecosystems
  2. Do “no significant harm” to the other five environmental objectives, where relevant;
  3. Meet minimum safeguards, including OECD Guidelines on Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.

Financial market participants and companies will be required to complete their first set of taxonomy disclosures, covering activities that substantially contribute to climate change mitigation and adaptation, by 31 December 2021.

In addition to mandatory government policies, non-legally binding ESG principles and standards have been drawn up such as the six Principles for Responsible Investment (PRI), which have become the common reference point for investors considering ESG issues. In implementing them, the now over 3000 signatories representing well over $45 trillion in capital, commit to developing a more sustainable global financial system. 

The Paris Agreement in December 2015 finally propelled the threat of a global temperature rise and climate change as a result into the mainstream media. It also sharply brought into focus the potential financial consequences of climate risk. Estimates valuing the global financial assets at risk from climate change, often referred to as “stranded assets”, range from $2.5 trillion to $4.2 trillion.

In response to these staggering numbers, insurers, pension funds, banks and other asset owners have started to put in place tools, analytics and processes to properly assess climate risks in their investment portfolios and to scrutinise the inherent climate risk in potential new investments. Conducting climate risk assessments, however, is a highly complex task due to the many facets of climate risk, which entail:  

• Physical risks: damage to land, buildings or infrastructure due to physical effects of climate changed such heat waves, droughts, storms and rising sea levels
• Secondary risks: knock-on effects of physical risks, such as falling crop yields, resource shortages or supply chain disruptions
• Policy risks: financial impairment arising from local, national or international policy responses to climate change, such as carbon pricing, emission caps or subsidy withdrawal
• Liability risks: financial liabilities resulting from secondary risks
• Transition risks: financial losses arising from disorderly or volatile adjustments to the value of listed and unlisted securities, assets and liabilities in response to other climate-related risks
• Reputational risks: risks affecting businesses that either engage in activities that its stakeholders consider to exacerbate climate change or risks affecting the environmental “laggards” amongst businesses leading to customers switching to products of “green pioneers”.

With banks, insurers and pension funds divesting from assets with high climate risks as a result of their climate risk assessments and seeking sustainable assets for their freed-up capital further drives demand in the sustainable investment market.

To meet demand from private investors looking to align their savings with their values, funds management firms are churning out a record number of new ESG funds: in Europe alone, more than 100 new sustainable funds came to market in the fourth quarter of 2020, lifting the total number of new sustainable investment opportunities within a year to a record 333 funds - a steep rise from the 265 sustainable funds that came to market in 2019.

Equally, sovereign debt investors have found the offer of green, social and sustainability bonds to more than double within the last five years: In the first half of 2020, green bonds issuance reached $91.6 billion. While this marked a 26% dip compared to H1 2019 due to the impact of the COVID-19 pandemic, this six month period still delivered a new market milestone for the green bonds market: With over 85 market entrants from 24 countries the total number of green bonds issuers jumped over the 1,000 mark to 1,056 issuers.

Social bonds needed some time to gain traction and – until 2020 – had been overshadowed by the green bonds market. Yet, when the COVID-19 pandemic hit nations around the globe the social bonds market soared on the back of sovereigns, multilaterals and banks raising capital for COVID-19 relief: By October 2020, total social bond issuance reached roughly $80 billion, nearly three times the amount sold in 2019. Finally, sustainability bonds – where proceeds are applied to finance or re-finance a combination of green and social projects – saw an almost threefold increase in volume to $46 billion in 2019.

And there’s more to come: Government policies and changing corporate behaviour will lead to a “flood of green (and social) infrastructure projects in the next few years to the tune of several trillion dollars”, which in turn will increase the supply of sustainable assets and further whet sustainable investors’ appetite. Estimates predict that the climate solutions market could double from $1 trillion a year now to $2 trillion a year by 2025, including innovations in renewables, electric vehicles, batteries, biofuels and circular economy.

Corporate clients who would like to discuss this topic further should contact:

Varun Sarda, Head of ESG Advisory

Notes

[1] Numbers that are changing the world (PDF)