We detect three distinct yet interrelated trends in the recent application of ESG analysis: the growing role of social and environmental considerations; the role that regulation is playing in driving – and shaping – demand in credit markets; and a shift from blanket exclusions towards more refined approaches that allow sustainability-minded investors to achieve greater real-world impact.

The G gives ground to the S and E

Over the past two decades, governance has been the main consideration in ESG analysis. The G in ESG is the most ‘conventional’ element and the one whose impact has been most easily understood. This has made it easy for investors to view governance as the most financially material metric. Strong governance practices are vital for a company’s sustainability and long-term success. Investors have focused on factors such as board composition, executive compensation and risk-management policies. These have been seen as offering insights into the overall health and stability of the company, and so have become significant in credit analysis.

In recent years, however, investors have increasingly acknowledged the importance of environmental and social factors. In 2021, ratings agency Moody’s noted that social factors were cited as the key driver in 84% of ratings actions , in large part because of the impact of Covid. In 2022, as the effects of Covid receded, this figure fell to 69% but remained far higher than in the pre-pandemic years. In 2019, for example, the comparable figure for private-sector actions was just 20%. Meanwhile, environmental risks were mentioned in 25% of the 2022 ratings actions that cited ESG factors as key drivers – more than doubling the 12% of mentions in 2021.

Taken together, these statistics suggest that social risks are rivalling governance risks in significance and that environmental risks are moving up the agenda. So, in today’s rapidly changing global landscape, the E and the S in ESG are increasingly important drivers of long-term value creation and effective risk management.

The role of regulation

The increasing importance of environmental and social factors is reshaping attitudes towards ESG investments, especially in Europe. European sustainability regulations exceed those of other developed markets, notably the US. Non-compliance with these regulations can result in reduced profitability and higher financing costs. It can also expose businesses to shifting consumer preferences and stricter regulatory measures. Conversely, companies demonstrating excellence in sustainable practices stand to outperform. For fund managers like us, this represents a critical factor for generating returns. Its significance is set to increase.

Tightening ESG regulations are significantly affecting the cost of financing across sectors. In the oil & gas industry, for instance, uncertainties over the energy transition, including the risk of stranded assets, have led to depressed valuations of long-maturity bonds compared with historical levels. Additionally, the sector faces challenges from emission-reduction targets of questionable credibility and instances of greenwashing. These challenges are compounded by doubts about the scalability and effectiveness of technologies like carbon capture and storage. Meanwhile, investments in viable and scalable technologies such as renewable energy are often categorised as slow and insufficient, hindering the sector's progress towards sustainability goals [1].

While this shift aligns with the broader societal goal of fostering sustainability, there are nuanced implications to consider, especially for industries facilitating the transition. In the utilities sector, for instance, heightened scrutiny on fossil-fuel usage in power generation, propelled by regulations like the EU Taxonomy for Sustainable Activities, is prompting investors to shy away from carbon-intensive companies. The emphasis on carbon-intensity targets and benchmarks aligned with the Paris Agreement further exacerbates this trend, redirecting capital towards lower-carbon-footprint alternatives.

However, this regulatory drive can have unintended consequences, especially if it causes investors to avoid high-emission sectors altogether. Such actions risk penalising the companies leading the transition to cleaner practices, potentially impeding progress toward sustainability goals. Utilities companies actively investing in renewable-energy infrastructure may face higher financing costs due to lingering ties to fossil fuels. Despite this challenge, the utilities sector is projected to achieve the most significant reduction in carbon emissions by the end of the decade, as depicted in the chart below. While some companies still rely on coal generation, many leading utilities are phasing this out between now and 2030. 

Although certain industries rightfully warrant higher financing costs because of their adverse environmental impact, a blanket approach risks stalling the transition process and discouraging innovation in critical sectors. So, while regulations play a pivotal role in incentivising sustainable practices, a nuanced approach is essential to ensure that the transition is both effective and equitable across industries.

Looking past the screens

Exclusions are a longstanding staple of sustainable investing. By screening out companies that fail to meet certain ESG standards, managers of sustainable funds aim to align their portfolios with their investors’ values.

But the effectiveness of this approach has been challenged. When investors divest their portfolios of companies with patchy environmental records, for example, they abandon the opportunity to influence those companies directly – potentially foregoing the opportunity to effect real change.

Recently, however, we’ve seen a shift towards a more holistic approach. Since 2020, ESG integration has overtaken negative screening as the most popular strategy in sustainable investing. By ‘ESG integration’, we mean the inclusion of ESG issues in all investment analysis and decisions. Exclusions still have a place: they are uncontroversial in areas such as tobacco and gambling. But by taking an ESG-integration approach, investors can avoid branding certain companies as uninvestable on the grounds of backward-looking data. In industries where practices are improving, investors are increasingly looking beyond the wholescale exclusion of ESG laggards and towards a more nuanced awareness of ESG risks – with forward-looking assumptions integrated into portfolio decision-making to complement the investment rationale.

Another way to look at it is through environmental and societal impact. If companies at the start of their ‘green transition’ were abandoned by sustainability-minded investors, they’d have much less incentive to adopt environmentally friendly practices. Here, it’s important to consider the impact that fund managers can have. If you, as a sustainable investor, back a ‘pure-play’ renewable-energy company, you’re essentially just asking it to carry on doing what it’s already doing. By contrast, if you invest in a cement manufacturer and encourage it to pilot plants with net-zero emissions, you’re having a much greater positive impact.

In the same vein, investors could opt to exclude steel companies altogether, given their high levels of carbon emissions. But steel is vital for the construction of clean-energy infrastructure. So a company that is moving to low carbon or, eventually, net-zero steel production is both bringing down its own emissions and helping to reduce emissions more broadly by providing materials for renewables projects. If investors back companies like these, they are encouraging a positive direction of travel.

One beneficiary of the move towards integration has been EDP, a Portuguese utility company that consistently sets and meets ambitious emissions targets. As EDP currently generates 5% of its revenues from coal, it is uninvestable to strategies that operate coal-generation thresholds. But the company is phasing out its coal operations within the next two years and is on track to reduce its emissions by 98% from 2015 levels by 2030, by which point it should be one of the world’s largest producers of wind power. Investors can therefore aim to achieve a greater positive impact by owning EDP than by excluding it. In backing the company, they are helping accelerate the energy transition.

A focus on companies that are near the start of their ESG journey also offers the prospect of higher returns. Recent research from Barclays indicates that the highest returns come from companies that make the biggest improvements in sustainability, not those that are already scoring highly on ESG criteria. If a strategy focuses exclusively on ESG ‘champions’, it may be missing out on significant opportunities for returns.

The performance opportunity in data gaps

For credit investors, a final consideration is whether the same ESG standards can be usefully applied to all issuers. The differences between high-yield and investment-grade issuers are particularly pertinent here. High-yield issuers, which are often smaller or younger companies, may lack dedicated ESG teams, green-bond frameworks or the resources to produce sustainability reports.

This means companies that are committed to sustainability may be overlooked by investors because those firms lack the means to demonstrate their ESG credentials. A recent example is Ardagh Metal Packaging, which produces infinitely recyclable metal drinks cans. Until very recently, the company was a laggard in its ESG disclosures. But it is strongly aligned with sustainability principles, particularly in the areas of the circular economy and waste reduction. In 2022, its recycling efforts resulted in the estimated avoidance of 3.7 million metric tons of CO2 equivalent emissions compared with virgin materials, as shown in the chart below.

This underscores the importance of ESG being more than a box-ticking exercise. There’s no substitute for in-depth research. And investors who can uncover companies with good ESG practices but limited disclosure have the opportunity to outperform by investing before improved disclosure eventually attracts greater market attention.

Healthy evolution

Although the ESG concept has come in for criticism in some quarters, it enters its third decade in rude health. But as ESG investing matures, best practice continues to evolve. Recent developments in the market show that investors are continuing to refine and improve their sustainable investing approaches – to enhance returns, mitigate risks and, ultimately, improve societal and environmental outcomes for all.