MAJOR FORCES AT WORK- Gaining Clarity in the New ESG Era (Part 2 of 6)

By: Jonathan Neitzell and Bethany J. Schuttinga, PhD

PILLAR 1: RECALCULATING THE COST OF CAPITAL 

Investors are growing in their embrace of ESG factors as an additional component to their overall investment strategy. The impact on a firm’s cost of capital through increased efficiency, relative market share gains, lower operating cost volatility, and lower risk from regulatory penalty is growing in focus, as is the marked increase of inflows into both active and passive strategies to reward these efforts. Clients are voting with their dollars, Wall Street is listening and this collective impact on corporate financial performance is just one of the major drivers leading to an increasingly material recalculation of the cost of capital through as seen through an ESG lens. 

Demonstrating this, recent studies have suggested that ESG profiles can already explain as much as a 14% delta in the cost of capital between those viewed as responsible global citizens, and those lacking. As an example, a recent MSCI report, based on data from a study between Dec. 31, 2015, through Nov. 29, 2019, showed that companies’ ESG profiles correlated well with the cost of capital, including both the cost of equity and debt. Specifically, the average cost of capital for the highest-ESG-scored quintile in the MSCI World Index was 6.16%, or 39bps lower than the 6.55% for the lowest- ESG-scored quintile. For the MSCI Emerging Markets Index, the differential was even higher at 103bps. . 

Capital Markets Flows 

Further evidence of this accelerating choice to make more capital available to reward perceived good actors can be seen in the record inflows into ESG and other sustainable funds globally and in the US. The commitment to environmental, social, and corporate governance (ESG) has made great strides over the past decade and now has a growing sphere of influence across every industry. More recently, data obtained from Morningstar indicates that October, November, and December 2020 saw record global monthly ESG-related fund inflows of $35bn, $49bn, and $50bn, respectively, bringing total ESG assets under management to almost $1.7 trillion. 

Figure 1. Global Monthly Fund Flows 

ESG-related ETFs and other passive flows represented 30% of the total flows into ESG funds (active + passive), and 21% of the total flows into the broader ETF category. The COVID-19 crisis has accelerated the trend towards ESG investments, with evidence pointing to increased volunteerism, social cohesion, focus on public good, and community support. 

ESG & Corporate Financial Performance 

Other studies have demonstrated a direct relationship between ESG and Corporate Financial Performance (CFP), validating companies' efforts with sustainable business practices already in place, increasing investor interest, offering further incentive and catalyst for digital initiatives lowering expenses in practical areas such as paper, corresponding storage needs, cost overruns through mismanagement or miscommunication, wasted energy, as well as natural resources such as forestry, food stores, and water. Proactive management of these financially relevant ESG risks align well with management teams, community concerns, and investor interests for less risk and higher return on investment. 

ESG in the Fixed Income and Equity Markets 

Historically, fixed income portfolios have been classified by duration and credit quality. ESG provides further clarity into long term sustainability metrics to bring to light issues that can have an impact on risk mitigation and the enduring success of a business. Through this lens, investors can attempt to identify external and company specific factors that may become financially material over time. In fact, given the credit markets are roughly three times the size of equity, with broader reach across public, private and Sovereign interests – this is likely to reinforce the opportunity to broaden the implementation of use cases for ESG evaluation criteria. 

Table 1, ESG Integration Impact Considerations on Equities and Fixed-Income Markets 

 source: https://russellinvestments.com/us/blog/esg-considerations-infixed-income 

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Anduril Partners is eager to help shareholders, corporates and businesses establish, monitor, and communicate ESG data to attract and retain capital, accelerate sustainable and responsible growth, and mitigate enterprise risk.