Why investors should put sustainability over short-term profits

An asset’s financial performance is important but the ESG model should be a priority for long-term investing

ESG offers an entry point for incorporating sustainability and social impact into traditional investing. Getty Images

Most people in the region and around the world have taken the necessary steps to reduce their carbon footprint, from taking public transport instead of driving to eating less meat. However, many probably aren’t aware of how simply moving a pension into a sustainability fund can be 27 times more effective.

Corporate sustainability goes beyond just preserving the environment. A sustainable company also treats its employees and customers fairly and has sound decision-making processes across the board.

ESG (environmental, social and governance) investing gives investors a framework to assess how sustainable and long-lasting an investment is likely to be. Think of it as a lens to evaluate an investment on top of its financial performance.

Each element of ESG investing pinpoints towards a certain criterion, from how a company handles waste to how it interacts with its communities.

The environment criteria assess how a company handles its waste, resources and environmental impact, such as its carbon footprint. An environmentally sustainable company is more likely to gain public confidence. As governments pivot towards more climate-friendly policies, these companies are also more likely to thrive.

The social criteria assess how a company interacts with its communities. A socially responsible company would treat its employees fairly, source fair labour and have diversity policies.

Organisations impact the livelihoods of whole communities and are more likely to thrive when those who come into contact with them – whether as customers or direct or indirect employees – are satisfied. This has multiple trickle-down benefits that affect a company’s bottom line: from higher employee retention rates to strong community and industry representation.

The governance criteria assess a company’s framework for decision-making and legal compliance. Strong governance ensures companies distribute their resources fairly, deal appropriately with bribery or fraud and avoid conflicts of interest at the board level. Companies with robust governance are more likely to practise fairness and transparency across the organisation and be more stable in the long term.

ESG isn’t the only sustainable investing strategy, there’s also socially responsible investing, which goes one step further by actively eliminating investments based entirely on ethical criteria. In addition, there’s impact investing, which only considers an investment’s sustainability impact, regardless of its financial performance.

ESG differs from these other sustainable investing strategies as it builds on traditional investment plans. This means ESG focuses not only on an asset’s financial performance but also how it impacts sustainability.

This shows that ESG offers an entry point for incorporating sustainability and social impact into traditional investing. However, how experts define and regulate ESG will likely evolve over time as they find ways to measure the criteria more quantitatively.

Environmental and social practices are neither universally regulated nor quantifiable in financial terms yet. These factors make regulating ESG difficult compared with traditional investing, which has established standards on financial reporting.

Despite the lack of transparency on ESG metrics, some institutions have developed ESG scoring to help fund managers build ESG-friendly portfolios. MSCI, an American finance company headquartered in New York City, for example, designates ESG ratings based on how a company manages its ESG risks compared with other companies in the same industry.

Currently, multiple ESG organisations and the International Financial Reporting Standards are taking steps to standardise ESG criteria. These steps include collaborating on efforts with other institutions to create universal standards.

In the past, many investors thought factoring ESG criteria into a business model would come at the cost of a company’s returns and, therefore, their own investment returns. After all, a company would need to take extra measures to ensure its operations don’t harm the environment, such as buying carbon credits or investing in renewable energy.

Social and governance measures include paying fair salaries, making hiring decisions that reflect a community’s diversity and implementing robust internal controls. All of these actions require time and resources.

But, in fact, sustainable companies are proving to be more likely to generate scalable returns compared with those that don’t prioritise ESG.

Beyond the ethical benefits that ESG offers, this investment model is practical because its framework can help investors identify future-proof companies. Investors can use ESG to help them avoid investing in companies that engage in risky or short-sighted behaviour, which can cost a company and its shareholders more.

Despite the challenges behind regulating ESG, increasing awareness and strong returns are driving its demand. At the beginning of 2018, $11.6 trillion in assets were chosen according to ESG criteria, up from $8.1tn just two years earlier.

Closer to home, the UAE Securities and Commodities Authority in April this year released a circular indicating that all listed companies must submit a standalone sustainability report by June 30.

The Abu Dhabi Stock Exchange and Dubai Financial Market have made formal commitments to encourage sustainability in financial markets by joining the Sustainable Stock Exchange Initiative, led by the United Nations.

Overall, investors can expect more visibility on ESG metrics in future and companies will need to adapt to global pressure and local sustainability regulations to thrive.

So when evaluating investments for the long term, investors should check how sustainable they are and not just how profitable they are.

Ramzi Khleif is general manager for StashAway Mena.