Sustainable investing needs to evolve. Fast.

Sustainable investing has been the subject of fierce debate recently. But rather than arguing about how well it has worked in the past, it would surely be more useful to figure out what kind of investment approaches we need now – and that starts with taking a view on what the future looks like.

An obvious thing to say is that the future looks pretty scary unless we get better at allocating capital to tackling climate change and other pressing sustainability concerns. Annual climate finance needs to increase almost six-fold, according to the Climate Policy Initiative, to limit global warming to 1.5C.

Crucially, this capital needs to go to the right places. Today, around 80% of the world’s financial assets are located in developed markets, but at least 70% of the investment required to achieve the Paris Agreement climate targets and the UN’s Sustainable Development Goals must be directed to emerging markets. The net-zero transition, and sustainable development more broadly, remain woefully underfunded in the developing world.

This is unlikely to change with today’s sustainable-investment approaches, many of which essentially involve giving companies an ESG (environmental, social & governance) score and dividing them into ‘good eggs’ and ‘bad eggs’ for portfolio inclusion or exclusion. Often, emerging market companies end up in the bad-egg pile because their scores tend to be lower than those of their developed market counterparts.

Return potential

As well as potentially hindering sustainable development in emerging markets, this ignores emerging companies’ potential to deliver growth and profits for the benefit of shareholders. Many in the West fail to appreciate that being a leader in sustainability can be a growth tailwind for these businesses, too. Surveys show that developing-world consumers also care about biodiversity and nature loss. The Chinese, in fact, are even more willing to buy electric vehicles than Germans.

So the first item on the to-do list is to evolve today’s simplistic and backwards-looking sustainability assessments into more intelligent, contextualised appraisals. This way, the babies will not be thrown out with the bathwater and emerging markets will be properly represented in sustainable portfolios.

Understanding externalities

Next, we need to adapt the way we invest to reflect changes in the business world. Perhaps the most significant of these is that companies are increasingly being held to account for their externalities – that is, their impacts on the environment, society and individuals; or, put another way, how they impact the world’s stock of natural, social or human capital. ‘Good egg/bad egg’ sustainable-investing approaches are not equipped to value externalities. So we can add ‘develop externality-valuation tools’ to the to-do list.

At this point, you may be hearing hoots from traditional portfolio managers, who will say that their valuations have always accounted for any factor that may influence a company’s financial return, including externalities.

But how? Details on companies’ carbon emissions has only been collected relatively recently. And that’s at the data-rich end of the sustainability spectrum. There is a paucity of metrics and methodologies that enable portfolio managers to calculate the value of the environmental-capital companies create or destroy through externalities that impact biodiversity, land, water and air quality. Ditto estimating the social-capital value of companies’ impacts on communities, and the changes in employees’ aggregate human-capital value caused by their workplace practices. These tools need to be developed.

More sophisticated assessments

You may be thinking that ESG data-providers collect information on all this stuff. They certainly collect myriad data points. But what does the percentage of women holding board seats or executive roles really tell you about a company’s future growth and profitability?

These oft-cited diversity metrics offer a neat illustration of where sustainable investing is today, and where it needs to get to. By itself, diversity will not make a company more innovative and responsive to customers’ needs. These drivers of growth will only be unlocked if the company is run in a way that enables people from all walks of life to contribute and exert influence. Is the company a melting pot, or just a salad bowl? To answer this, the analyst needs to appraise not only a company’s diversity, but its inclusiveness.

This is a more complicated, qualitative assessment that requires in-depth, direct knowledge of a company – the kind of knowledge that portfolio managers ought to possess. The final to-do, then, is for them to stop relying on external ESG ratings, and to fully incorporate proper, in-depth sustainability analysis into their fundamental analysis.

In short, this is no time to give up on sustainable investing. We just need to get better at doing it.

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