The Business Case for ESG – Moving from ‘Why?’ to ‘Why Not?’

The United Nations Secretary-General calls climate change “the most systemic threat to humankind” (New York Times, 2018). The World Economic Forums’ 2018 Global Risks Report (World Economic Forum, 2019), published ahead of the 2019 Davos summit, cites 3 of the top 5 risks both in terms of impact and likelihood as being environmental in nature. Reinsurance broker Munich RE estimates economic impact from natural disasters in 2018 was $160bn (Munich RE, 2019). It is evident that climate change is happening all around us and investors are starting to take action. Ahead of COP24 held in Katowice (Poland) in December 2018, a group of over 400 investors managing assets of $32 trillion called on governments and businesses to increase their collective efforts to tackle climate change (CNN, 2018). In recent years our focus on climate change has developed from deeming it an issue to be dealt with in the future, to identifying that it is already upon us, and that immediate and ongoing action is required.

What’s more, aside from the environmental benefits, there is also a growing body of evidence that there is an increased financial benefit from doing the right thing by the planet.

In a November 2018 report, indexing company MSCI showed that companies with improving ESG credentials have, on average, outperformed by 14.4% in emerging markets and 5.2% in developed markets over a 5-year period (Investment Week, 2018). Research from Axioma showed that over a 4-year period to March 2018 portfolios weighted towards companies with better ESG scores outperformed their benchmarks by between 81 and 243 basis points. Whilst data are not reliable over a longer time period, Anthony Renshaw, director of index solutions at Axioma says “ESG has been doing very well over the last 3 to 5 years. In general, increasing exposure to ESG rarely underperforms the market, and often outperforms the market, especially during the last few years.” The research also found that over 80% of S&P 500 companies now report on ESG metrics compared with just 20% in 2011. (Financial Times, 2018)

Why is this happening? It seems that many investors are using ESG factors as a risk management strategy for their portfolios, particularly within emerging markets. Jack Deino, Head of Blackrock’s Emerging Markets Corporate Debt Team, says in the company’s 2019 “Sustainability: The Future of Investing” report  (Blackrock, 2019) “ESG information has been our primary tool for evaluating qualitative risk when appraising the standard credit rating of a company”. The same report cites a previous study of insurance companies with some $8 trillion of assets under management, 83% of companies surveyed indicated that an ESG investment policy was important to their firm, with as many as 80% already having one in place or planning to introduce one within the coming year.

In terms of real estate, the benefits of an ESG focused approach are broad, ranging from increased rental and sales returns and a decreased risk of obsolescence to lower void times and lower operating expenses. The ‘holy grail’ of green real estate however, must be an increase in employee productivity. With staff costs typically representing the largest cost of doing business, even a small demonstrable improvement in productivity can and will materially shift the business case for ESG in real estate. Whilst this is incredibly difficult to accurately measure, research published in Building and Environment Journal in March 2017 begins to explore this link with thought provoking results (MacNaughton, et al., 2017). The study, carried out across 10 high-performing buildings, showed a range of benefits compared with just compliant buildings. Amongst those benefits was a 26.4% increase in cognitive test scores, 6.4% increase in sleep quality and 30% lower ‘sick building’ symptoms in the buildings which surpass the ASHRAE standard for ventilation and volatile organic compound concentrations (the definition of high-performing buildings used in this report). These benefits had been debated on an anecdotal basis for several years but with scientific evidence now presented the argument has shifted.

All the above evidence lends itself to the theory that the argument for ESG has shifted from ‘why?’ to ‘why not?’. With robust evidence now starting to prove the long-debated benefits, more and more companies are implementing ESG strategies within their own operations and investment companies, pension funds and others are integrating ESG metrics within their overarching strategies and at individual fund level. Whilst it might be surmised that regulation may be playing its part in driving this uptake, a survey conducted by the New City Initiative suggests otherwise (New City Initiative, 2019). Of the 46 companies surveyed, not one cited regulation as a driver for their adoption of ESG. The biggest driver amongst those surveyed was risk management with investor pressure and return pressure scoring equally, a clear example of the ‘why not?’ approach.

With more companies committing to ESG strategies it could become increasingly difficult to differentiate between those who are simply paying lip service and those who are following through on their commitments. Third-party certification at either the portfolio level or the building and asset level is one way of verifying this. Having an independent assessor coming in and confirming that a developer or asset manager is doing what they say they are doing is the next step forward for transparency in the ESG investment space, be that through BREEAM or another third-party certification scheme. Savvy investors will get ahead of the market by increasing the concentration of third-party certification in their portfolios to show their commitment to ESG investment so that in a few years the conversation around certification of real estate assets will too move from the ‘why?’ to ‘why not?’.

Written by Matthew Holden Senior Economics Consultant, BRE

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