ESG Investing: What Comes Next?
Over the past 15 years, environmental, social, and governance (ESG) investing, known more broadly as sustainable investing, has moved from an outlier to a mainstay of the investment management industry. With this increase in popularity, many conjectures and concepts about sustainable investing, particularly those concerning its potential investment merits, have become established and accepted by a substantial portion of the industry.

What comes next? As sustainable investing becomes integrated across the investment management industry, we have an opportunity to think about where it needs to go to fulfill its promise — the promise being a financial system that is more aware and resilient to long-term environment, social, and governance risks and opportunities than it is today. In a recent white paper, we examined 10 trends that we believe will shape the future state of ESG investing. These are the key issues that we believe the ESG space will engage with and adopt as it evolves.

1. Risk/reward/impact will become the norm of portfolio and investment analysis: The risk-reward tradeoff is a central tenet of modern portfolio theory. Going forward, we believe investors will increasingly need to evaluate the real-economy impact of an investment on the physical environment (i.e., natural capital) and social structures and conditions (i.e., human and social capital), as well as longer-term transformations that are needed for sustainable development and low-carbon energy transitions.

2. Climate change modeling will become part of investors’ macro processes: Climate change, and its impacts on governments and corporations, will become a central concern for long-term investors, requiring them to engage in a focused way with the various types of climate risk and evaluate the potential impact of these risks on portfolios.

<b>Exhibit 1: International Panel for Climate Change (IPCC) Scenarios</b>

3. Engagement and active ownership focus will expand from a focus on corporations to include a focus on public policy: We’ve seen a significant increase in shareholder engagement with companies on ESG issues in recent years, and their proposals are drawing more and more support. We believe this trend will continue in the coming years, and anticipate that it will expand to include a focus on public policy, which is necessary given the interconnected nature of public policy and corporate behavior concerning issues related to sustainability.

4. China’s increased role in global investment markets will recalibrate perspectives on sustainable investing/ESG issues: China’s prominence is growing in the investment industry. It is also becoming a leader in environmental efforts globally, while at the same time being the largest investor in coal and the largest carbon emitter. As global investors seek to engage with the opportunities in China, they will have to recalibrate their approach to ESG investing to fit within the unique confines of the country’s ever-evolving political and business environment.

5. Investors will have to contend with the systemic impact of concentrated ownership through passive investment giants and through increased monopolization of industries: With the rise of passive investing, a handful of investment managers may soon control a majority of most publicly listed companies in the world’s largest equity markets. This concentration of ownership could impact many aspects of financial markets, including creating incentives or deterrents for improving corporate governance and compromising the ability of small investors to impact corporate behavior.

<b>Exhibit 2: Ownership Concentration of the U.S. Stock Market&rsquo;s &ldquo;Big Three&rdquo;: BlackRock, Vanguard, and State Street</b>

6. Investors will adopt new approaches for evaluating ESG characteristics in private companies: A majority of the momentum in ESG investing to date has been in the public equity and fixed income universes. With fewer companies going public and many public companies deciding to go private, we believe that in the future, private market investing will become a larger part of institutional and retail investors’ portfolios. As such, the investment industry will need to develop new approaches to engage with private companies on ESG issues in the same way that they have with public companies.

7. Investments in fossil fuels will take on additional complexity as large oil and gas companies increase their investments in renewables: ESG investing will concentrate on environmental concerns broadly, and climate change specifically, and fossil fuel companies will continue to be the target of significant attention from ESG-focused investors. But we believe investors will have to contend with a more complex set of questions about these companies as many expand and diversify their investments in renewable energy, including solar, wind, and biomass.

8. The professional wealth management community will take a more active role in ESG integration: As wealth accumulates within certain segments of society, the assets with some wealth management practices have grown to rival or exceed some of the largest pension funds. The upcoming wealth transfer between Baby Boomers and Millennials, which will see roughly $30 trillion change hands in North America alone, will present an opportunity for these wealth managers to integrate ESG into their practices, thereby helping to ensure capital markets become more proactive about ESG factors.

9. Divergent approaches to regulation will further complicate ESG integration requirements: National regulators, who reflect a country’s policies and cultural norms, drive the financial regulation of ESG issues. While some take a top-down approach, mandating asset owners and asset managers to intentionally integrate ESG considerations into investment processes and disclose these approaches, others will offer more flexibility to individual entities. This will require ESG-oriented investors to develop a more nuanced and place-based understanding of regulation and approaches.

10. Investors will see themselves more as collaborators than as competitors for systemwide challenges: Investors from around the world are combining their efforts, resources, and collective voice to amplify their ability to influence some of the broad, system-level changes needed. We believe we will begin to see an increase in investment industry competitors coming together to use their collective size and scale to push for changes in areas such as diversity, compensation, political and lobbying disclosures, and other critical topics.

While some investors may already be moving in the direction described above, we are quite confident that such movement is by no means universal and is much slower than what is needed. In general, since the first chapter of ESG integration has come to an end, we believe the financial industry’s approach and efforts to further integrate ESG considerations into capital markets and its constituents will only increase, and that the questions and approaches that investors adopt will become increasingly sophisticated.

These issues are complex and will require significant effort from asset owners, asset managers, regulators, and the broader public. The financial industry has a significant way to go to ensure that the worlds’ savings is invested in a way that is aligned with broader sustainability of our environment and social conditions. To move forward in a meaningful way, the industry will need to approach these issues with even more seriousness of thinking, openness toward collaboration, and clarity of intention than has happened to date.

Download the white paper to read more about the future state of ESG investing.