How far has ESG come from being a philanthropical factor for show. We were joined by Ethan Levine at Commonfund Capital, speaker at SuperReturn International, as he explains why it is crucial to have ESG in your investment process for risk mitigation, which areas are showing strong secular growth trends, and how both private and public markets could work on embracing ESG further in its implementation and reporting.
You’ve previously said that market-rate returns are typically a non-negotiable hurdle for institutional investors. Does the amount of capital pouring into strategies that have integrated ESG standards suggest that the connection between ESG and financial returns has been conclusively proven or is there still work to be done in this area?
The connection hasn’t been categorically proven, but data is becoming more robust all the time. I would say though that there’s a growing number of investors out there who are convinced there’s a connection.
I think it’s helpful to break ESG down a bit further into risk-adjusted and absolute returns. ESG in a broader sense is a risk management tool and should apply to every investment decision one makes. So, if you're utilising an ESG framework or filter as part of your due diligence process, you are reducing the risk of your investment because you are including a detailed analysis of three factors that can have a material impact on performance.
Even if you’re achieving the same absolute level of financial returns as you expect without this filter, you're reducing the risk and that in aggregate improves your risk-adjusted returns. From this risk management standpoint, there's widespread belief that it's helpful. Whether applying an ESG framework incrementally improves absolute returns has yet to be fully proven.
There is another aspect to this, which is ESG themed investing. If you have conviction that there are particular environmental or socially responsible themes that are going to be growth areas, then you're essentially investing alongside a thesis that you believe has secular growth trends.
Take the area of environmental sustainability, which is where I spend much of my time, we’re very excited about the potential and our belief that there are strong secular growth trends. And because we're investing in that area, there could be tailwinds associated with some of the different investments you're making. We’ve found compelling investment cases and have been actively investing in areas like renewables, including late stage development and pre-construction, as well as sustainable food, agriculture and water, up and down the value chain and in resource efficiency, such as energy efficiency and recycling.
Are GPs doing a good job of reporting ESG alongside financial returns? How could they improve and what are the challenges?
They’re definitely doing a better job and it's an area that’s constantly evolving and improving. One of the big challenges is that there's no single recognised standard, rather there are a handful of credible standards out there - and different standards leads to inconsistent reporting.
Another is that ESG reporting can come across as a bit abstract and qualitative – and this contrasts with financial returns, which are not! They're very concrete and quantitative. The more that gap can be closed, and one can genuinely report more concretelyon the ESG side, the more effective that reporting will be to investors.
Will the emergence of common reporting standards and taxonomy - for example SASB, TCFD, EU non-financial reporting directive – improve ESG practices in private markets? And do you think it will aid understanding of ESG’s impact on financial returns?
Intuitively I'd hope so! It’s a bit of a virtuous circle; the increasing utilisation of reporting will lead to an increased set of data, which in turn allow people to generate a better correlation between ESG and financial returns.
There's a self-fulfilling prophecy there, that as there's more standards that are accepted, there's more reporting, that will lead to more data, that will lead to more credibility – and this will continue to snowball.
A 2015 review by DWS and the University of Hamburg of more than 2,000 studies found that 63% showed a strong correlation between ESG performance and positive returns. Given this, do you expect to see private markets investors increasingly focus on ESG as part of their value creation strategies?
I have a different a slightly different take. Our CEO and CIOs recently published a paper in the Journal of Portfolio Management called: “The Sustainability Conundrum” where we looked at a lot of the past literature. Our assessment was that some show a correlation and others do not - there's enough on both sides that lead to a conclusion that it's not yet clear. That's one of the challenges, as I've mentioned before. I'm not suggesting people cherry pick studies, but there are studies to prove both sides and support any point of view.
(How) do you think an economic downturn will affect investor sentiment towards ESG?
It will dissuade some because they see it as a cost centre, but I think that view is really on the margins. Overwhelmingly we’re seeing a systemic shift towards making ESG a priority as part of due diligence processes and as part of portfolio management and I don't believe an economic downturn will dramatically affect sentiment.
Indeed, downturns have a tendency to surface issues – particularly governance-related - that may not otherwise have been exposed, with which will likely only further incentivise a focus on ESG as part of due diligence processes.
I certainly don't think it will have a negative effect in aggregate, rather anywhere from neutral (i.e. continue to grow along the current path) to positive (i.e. growth at an accelerated rate).
Can – and should – ESG practices in public markets investing be applied to private markets investing?
I certainly think the public markets do a better job of building awareness and marketing what they're doing in ESG, but I think it is more hype than reality. I'd go as far as saying that public markets have done a disservice to ESG, when it comes to how they execute both oversight and implementation. It's squishy, inconsistent and has opened it up to attack leading to some investors’ bias against the utilisation of ESG because – broadly speaking of course - it's not been done in a thoughtful and genuine way.
There's an opportunity for private markets to go well beyond public markets on this. In particular, ESG risk factors can be better suited to the longer-term alignment of interests and incentives of the private markets. This isn’t to say public companies aren't looking towards the long term, but private markets are more aligned with longer term incentives and it can fit more neatly with looking at ESG factors.
Under the spotlight: Ethan Levine
Ethan Levine is a Managing Director, Co-Head of Natural Resources at Commonfund Capital and serves as an observer on the firm’s Investment Committee. Ethan rejoined Commonfund Capital in 2011 to work primarily on the firm’s natural resources programs, while also contributing to the private equity, venture capital and distressed capital teams.