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We believe we are on the cusp of a sustainability revolution that could have the scale of the industrial revolution and the speed of the digital revolution. Governments, companies and consumers are already making more decisions with sustainability in mind that have real consequences for industries and business models.
Investing that considers environmental, social and governance (ESG) factors is the fastest-growing area of asset management (Exhibit 8). Many portfolio managers have long incorporated these considerations as part of risk management and due diligence and have further strengthened their processes as more information becomes available. As markets reflect the growing difference between companies with superior ESG ratings and those with potentially riskier business practices, it will have implications across asset classes. For example, credit ratings that determine access to credit, for both companies and governments, may be impacted. Stocks of ESG leaders are already earning higher multiples, on average, than ESG laggards (Exhibit 9), which may prompt more capital to flow toward companies with better ESG practices and funds incorporating ESG considerations.
Exhibit 8: ESG equity inflows have outpaced non-ESG flows
Source: Morningstar, Goldman Sachs Global Investment Research. As of September 2021.
Exhibit 9: The multiple spread between ESG leaders/laggards is growing
Source: FactSet, Goldman Sachs Global Investment Research. Reflects 12m forward multiple of top quintile of companies in the GS SUSTAIN E&S headline rank vs that of the bottom quintile; Q5 is 5th quintile. As of September 2021.
Impact investing—investing in a company to both achieve financial returns and have a positive impact toward a specific goal—is increasingly expected by clients as the sector matures. Previously confined to private investing because of the difficulties in finding investments and measuring impact, public solutions are becoming more available as active managers find ways to meet these challenges. New products are not just at the fund level but at the security level. The green bond market is now over $1 trillion and we believe blue bonds targeting oceans are the next iteration.
Regulation that addresses greenwashing and considers ESG as part of fiduciary duty may help more capital flow to sustainable investing. In Europe, where interest in sustainability is high, new regulations now focus on standardizing terminology around ESG and sustainability, potentially making investment products more transparent and building confidence with investors.
In the US, the Department of Labor recently issued a proposed rule to make clear that plan fiduciaries may consider climate change and other ESG factors when making investment decisions and exercising shareholder rights, recognizing that ESG factors can be financially material; when they are, considering them is likely to lead to better long-term risk-adjusted returns.
In addition, important steps such as the development of the Sustainable Accounting Standards Board (SASB)’s framework are improving information quality and credibility in sustainable and ESG investing globally.
ESG Expands
We believe ESG considerations will matter more to investment success and alpha generation. Results continue to support the benefits of ESG for risk management and performance. A proprietary, fundamental active approach to ESG investing is critical because much of the data is still inconsistent and subjective.
We believe engagement is a key part of the process, both for gathering information and influencing change; scale ensures corporate access and a more powerful voice through both engagement and proxy voting.
ESG Customization
Investors have a wide variety of options to choose from including ESG enhanced strategies, which seek to outperform both standard indices and peer groups, thematic strategies that invest in environmental and social solution providers and impact strategies that seek to make an impact on specific goals. In addition, strategies can be customized, for example for the degree of carbon reduction vs. a stated benchmark or with a climate tilt.
Across all asset classes, many portfolios are not just making investments that consider ESG and sustainability but entire portfolios are also earning official classifications as ESG oriented funds under the European Union Sustainable Finance Disclosure Regulation (SFDR).
Fixed Income Strategies
In addition to active fixed income strategies that are incorporating ESG, there are several unique and relevant applications of ESG in the asset class. Considering ESG across sovereign bonds may be increasingly important, given the impact of ESG risks to economies. The large US mortgage-backed securities (MBS) sector also has potential to be used toward inclusive housing efforts. The development of the green bond and blue bond markets may add new ways for portfolios to directly invest in sustainable efforts. For US investors, municipal bonds tied to green infrastructure investments are an additional option.
Real Assets
Infrastructure, real estate and private investment may be critical to sustainability efforts. Beyond solar panels and power stations, battery storage is needed for energy generated from renewable sources, such as solar and wind. Additionally, innovation in agriculture is creating a need to finance new products and machinery that are making food production more efficient.
While much of the public dialogue on climate and the economy has focused on industries like transportation, packaging and food, more recently The World Economic Forum, for example, has called out real estate as the sector with the highest energy usage and most significant CO2 emissions. Therefore, real estate represents another potential opportunity for investors to help address climate change.
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