A second, more challenging era for ESG investors dawns

At the start of the last decade, it wasn’t all that difficult to identify corporations whose stock prices would be impacted by a large scale transition to alternative energy sources. Large oil companies, for example, stood out easily—especially in the wake of the Deepwater Horizon disaster. In a similar vein, businesses with poor track records on social and governance issues could be flagged relatively easily by ESG-aware investors—and many remained unrepentant. But that’s changed dramatically in recent years, with ESG matters becoming front and center in corporate boardrooms worldwide. Now, the same oil-and-gas behemoths that made for easy targets 10 years ago have doubled down on their investments in alternative fuels—in some cases, becoming significant investors in green energy.3 Traditional mining companies, such as BHP, are now some of the largest investors in rare-earth metals that enable clean technology. Meanwhile, many of today’s well-known tech giants, routinely criticized in the past for poor governance and a lack of attentiveness to social issues, are working hard to improve their operating structures and have stepped up their commitments to the pressing social matters of the day.

The long and short of all of this is that, for a variety of important reasons, advocates for the vital importance of ESG factors in investing have won the battle. Look no further than the chart at the top of this article to see the evidence. Ignoring these factors is no longer an option—nearly all companies must seek to move down the ESG risk spectrum. This is clearly good from an ESG values standpoint, but from a return-seeking standpoint, it likely means that the opportunity for outsized returns has decreased. In other words, the companies who rate highly on the widely proliferating ESG scoring systems are likely to be lower risk than their counterparts, but any massive gains from increased awareness of the issues is likely behind them. Why? Because the knowledge of how these companies are positioning for the future, in regard to environmental, social and governance risks, is now recognized public information—in other words, widely known. This means, for instance, that a company’s plans to achieve carbon neutrality or boost the diversity of its executive team have already been factored into its stock price—leading to possibly higher valuations, sure, but possibly also to less dramatic upside surprise. We refer to this as the working of an efficient market in information—If everyone knows it and everyone values it, there is no extraordinary return to be extracted.

As these transitions from under-appreciated to fully priced-in occur, some lessons for the next stage of ESG investing are emerging. For institutional investors in this second age of responsible investing, the pathway to generating superior, risk-adjusted returns under an ESG lens will be through the ability to identify themes, handicap their likely trajectory and successfully map the impacts to asset class, sector, industry and company dynamics. No one needs to wonder anymore whether these broadphenomena, many exogenous to the financial system, can have a powerful impact on financial assets. The focus will inevitably turn from the macro to the micro, away from will things change? to how will that change impact society and corporations?

So, then, where can investors who still want to achieve strong returns while maintaining a focus on ESG matters turn in this second era of ESG investing?