Written By: Stephen Hearle
So far, ESG investing has been dominated by the environment. But with social issues increasingly prominent, Stephen Hearle of Nordea Asset Management considers whether investors should take a second look at the S in ESG
In recent years, institutional investors have shown a keen and growing interest in environmental, social and governance (ESG) issues. Many institutions now integrate ESG screening into their investment processes. Meanwhile, concepts such as sustainable investment, green bonds and the United Nations’ 2030 Sustainable Development Goals (SDGs) have moved into the investment mainstream. Over the past year, inflows into ESG-focused funds grew dramatically even as other funds recorded significant outflows.¹
So far, however, much of the focus has been on the E in ESG, with environmental concerns very much to the fore. That’s entirely understandable. Climate change is the biggest challenge we face as a species. And investors can combine altruism with self-interest in funding companies and projects that are working to mitigate the harm we do to our environment.
As a result, the environmental trend has become one of the most important themes in investing. Witness the sustained outperformance of environmentally-focused funds² and the high demand for green bonds – demand that is being answered with increased issuance from governments and companies alike.³ As governments, corporations and individuals have begun to wake up to the climate crisis, investors who were swift to back this trend have prospered – and are well placed to benefit in the decades ahead.
But the environment is only one aspect of ESG. If we look at the UN’s 17 SDGs, no fewer than 11 are related to social concerns. Today, as the world struggles with the Covid-19 crisis, the S in ESG has come into sharp focus. In the years ahead, it looks set to become the next theme investors will turn their attention to. And as with any long-term investment trend, the greatest opportunities are available to those who get in early.
The Covid catalyst
There’s no doubt that the Covid-19 pandemic has catalysed interest in the social aspect of ESG. As the world has struggled to stem the spread of the virus, the importance of our healthcare and education systems has never been clearer. And many social divisions have been sharply exposed by the unequal way in which the burden of Covid has been spread.
At the same time, the pandemic has cast a harsh light on the practices of many companies. As firms struggle to deal with the economic consequences of Covid, they are having to reconsider how they treat their employees, their customers, their supply chains and society at large. In some countries, government support for struggling businesses during the pandemic has only increased the scrutiny that these companies are under.
Meanwhile, the global protests that we witnessed last year have underscored the urgent need for social justice – and for countries and companies alike to combat prejudice, foster diversity and promote equal opportunity.
A shift driven by stakeholders
The shift in perceptions of social issues is being shaped by stakeholders – whether they are employees, shareholders or ordinary members of the public. Thanks to the rise of social media and the ease of communication in our digital age, companies can be held to account as never before.
Retail investors are increasingly conscious of where their savings are going, and this is particularly true of the younger investors in Generation Z. So there is growing pressure on institutional investors to evaluate the performance of companies on social issues as well as in the environmental and corporate-governance spheres.
Regulators and ESG ratings agencies are taking note, too. A problem in the past has been that the S in ESG is less easily defined than the E and G aspects. This has led to some notable discrepancies in the ratings provided by agencies. But with the growing focus on social issues in the wake of the pandemic, ratings agencies are putting greater emphasis on companies’ impact rather than their rhetoric.
Investors should also consider the broader risks arising from social problems. Poverty and inequality can lead to political and social upheaval, disrupting businesses and depressing shareholder returns. Even more broadly, inequality – as between the sexes – also limits the potential for economic growth.⁴
The funding gap
The scale of the opportunity in social investing is made plain by the UN’s SDGs, 64% of which have a social focus. To achieve the SDGs by 2030, the UN estimates that investment of between US$5 trillion and US$7 trillion is needed each year.⁵ This amounts to between 5% and 8% of the world’s nominal GDP. It also means that current investment of approximately US$3 trillion per annum needs to be doubled.
That represents a huge investment opportunity in the making. Companies that can improve social outcomes are poised to do well. And if this investment gap is filled, businesses will be able to deliver social services and solutions on a huge scale, generating both a positive impact on society and strong, sustainable returns for their investors.
Where the opportunities lie
Many social solutions are economically viable and generate attractive and rapid returns. Demand for such solutions is increasing rapidly. So where do the best opportunities lie?
There are three broad areas of especial interest to investors. Each of these addresses a huge swathe of the world’s population, highlighting the scale of the global opportunity.
The first of these concerns vital needs. These are the basic resources that people need for their long-term wellbeing: clean air, water and sanitation, nutrition and affordable housing. Even today, a large proportion of the world’s population struggles to access these resources. According to a 2019 report by UNICEF and the World Health Organisation, 2.2 billion people lacked access to safe drinking water in 2019. Some 4.2 billion were living without adequate sanitation, and 3 billion were without basic handwashing facilities – a crucial means of preventing disease.⁶
The second area is inclusion. Once people’s vital needs are met, the next step is to ensure their participation in the formal global economy. This is a vital means of reducing inequality. To do this, education, digital connectivity and infrastructure need to be improved. Four billion people, for example, still lack access to the internet, which severely impairs their economic prospects. Achieving greater participation will support economic, technological and social inclusion, regardless of sex, race or ethnicity. And this in turn will reduce inequality and its negative effects on social stability, political outcomes and economic growth.
The third key theme is empowerment. This is what allows people to create lasting wealth and improve their wellbeing beyond vital needs and economic inclusion. Areas of importance here are health solutions, innovations in productivity and financial engagement. At present, 400 million people have no basic healthcare while 2 billion have no access to financial services.
These three areas offer abundant investment opportunities. They include sanitation services, health foods, affordable and efficient healthcare services (including those delivered online) and online learning platforms, to name a few. Companies that can deliver effective solutions in these areas will be very well placed to capitalise on the resulting growth – to the benefit of the investors who back them.
Thomas Sørensen, who co-manages Nordea’s Global Social Empowerment strategy, describes investment in these areas as providing an “unmatched opportunity”.
“This is win-win,” he says. “By investing in businesses that provide social solutions, investors can have a positive impact on society while achieving sustainable and positive long-term returns.”
The role of research
While this opportunity is huge, it is not without challenges. The scale of the SDG funding gap shows that the social theme is currently under-researched, which means that there’s a tremendous opportunity for active investors here. To take full advantage of this, active managers will need to have the right analytics and the ability to engage with companies in depth and in detail.
The past failings of ESG ratings agencies show that there’s no substitute for proprietary research. One way around this is for investment managers to use ratings from several agencies to create a proprietary rating with multiple inputs. But this is should be only the starting point in the ESG screening process and is no substitute for direct engagement with the companies concerned.
Defining our future
The nascent theme of socially-focused investing is one that investors cannot afford to ignore. As increasingly vocal stakeholders continue to make their views on important social issues felt, all companies will be compelled to respond in order to reduce risks.
Meanwhile, those companies that can drive social progress through innovative products, platforms and services will be extremely well placed for growth, given the size of the addressable markets and the SDG funding gap.
That’s why institutional investors should pay particular attention to the S in ESG. Social solutions constitute a theme that will define our future and reward those that back it. Investors should ensure that they don’t miss out.
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