Environmental, social and governance (ESG) factors were once considered “nice to have” for investors who wanted to align their portfolios with their values. Today, we think incorporating them is essential for generating outperformance.
The importance of ESG today has a lot to do with changing preferences among consumers and employees, as well as increased scrutiny from governments and regulators. But there’s more to it than that. We think long-term economic viability and investment success increasingly depend on sustainable practices. We’ve seen the devastation that climate change can have on ecosystems and societies. We’ve seen what social and racial injustice can do to communities and the economies that support them. These are financially material issues, and we believe investors should be factoring them into their decisions.
A decade ago, it was common to assume one would have to sacrifice some return potential in exchange for having a social or environmental impact. But innovation, technological advances and an influx of capital into ESG strategies have since made it possible to do both.
Solar and offshore wind energy prices, for example, have declined sharply over the last decade, and investment in renewable energy has increased sharply; in 2018 it hit $280billion, which was triple the amount of investment in coal- and gas-fired energy generation that year. The Global Investment Research division of Goldman Sachs estimates that renewable power will be the largest area of spending in the energy industry in 2021, surpassing upstream oil and gas development for the first time.
And we believe such opportunities will increase. Consider for example, the innovation that has brought down the cost of long-term battery storage facilities for solar- and wind-generated electricity, making them increasingly viable investments, particularly for private capital.
That doesn’t mean every new technology amounts to an attractive investment opportunity. It is important to evaluate investment opportunities in terms of the risk/return attractiveness as well as their market maturity.
For example, green hydrogen fuel, a byproduct of water that is produced using renewable energy instead of fossil fuels with the potential to provide power for transportation and manufacturing, has a lot of promise but remains prohibitively expensive. It’s still important to take into account return expectations and risk.
But things change. Today, nascent technologies, including lab-grown meat produced from cells without the slaughter of animals and direct carbon capture methods that can pull carbon out of the air and sequester it in the ground, come with high costs and notable investment risk. But as more capital is invested in them, the cost curves may come down in much the way those of solar and wind power have.
Social considerations—the ‘S’ in ESG—are also materially important for investment outcomes today. There are several ways to design an investment program to help drive inclusive growth, and we think they start with the managers doing the investing.
Who are they hiring? How are they recruiting? What are they doing to retain diverse talent? We think it’s important to evaluate the diversity of each investment manager, as we believe diverse teams are more likely to avoid group think and make better decisions, which ultimately leads to better investment results.
When it comes to investing in private equity managers, it’s important to evaluate the products and services they provide to see whether they improve the lives of underserved populations by doing things like closing income gaps or improving racial and gender diversity.
The same goes for non-financial companies. One that can effectively serve traditionally underserved populations—perhaps by building software solutions to help millions of low-income Americans access and manage food stamps and find job opportunities—does good and may be more likely to do well.
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