Malagasy people crossing the river by the wooden bridge. © Shutterstock | Pierre-Yves Babelon.
The rising importance of environment, social and governance (ESG) factors in infrastructure investment decisions isn’t new. Our 2019 Global Infrastructure Investor Survey of institutional infrastructure investors with the EDHEC Infrastructure Institute showed that around 36 percent of institutional investors now consider ESG to be a “first order question, possibly at the expense of performance.” This sentiment more than doubled since just 2016 when 17 percent reported they consider ESG a first order matter.
However, we understand there are numerous criticisms for including ESG in infrastructure investment decisions. They include: consideration of ESG reduces the universe of investment opportunities, sacrifices financial performance, and conflicts with the fiduciary duty to maximize returns.
Why does this view persist? Perhaps it’s due to beliefs that ESG investing only means the use of exclusionary project screening, driven by an investor’s values rather than financial analysis. Further, greenwashing—or investors “going green” as a marketing tool to attract capital—has not been viewed favorably in the investment management industry.
In this context, what’s driving increased investor interest in ESG?
Push and pull factors
First, infrastructure investors are increasingly recommending their investment managers report ESG impact. This is driven by investors’ stakeholders who care more holistically about the long-term impact of investment decisions, evidenced by the number of signatories of sustainability initiatives such as the United Nations’ Principles of Responsible Investment. Marissa Szczepaniak of Vantage Infrastructure said that “Growing awareness [of ESG] has completely changed the conversation in the infrastructure community…Nowadays, investors expect integration of ESG.”
There is also growing evidence that ESG factors and financial performance are positively linked. There is growing recognition that ESG integration is an important risk management tool that can lead to higher risk-adjusted returns over the long term. This is arguably more vital when investing in infrastructure projects, which tend to be highly illiquid and long-term making them more vulnerable to ESG risks that grow or only manifest themselves over time, such as rising sea levels.
In a 2015 Deutsche Wealth Management (DWS) meta-analysis of over 2,200 studies that measured the correlation of ESG and financial performance, 62.6 percent showed a positive correlation between the integration of ESG criteria into the investment process and corporate financial performance.
Second, government policy and regulatory needs are pulling investors along in reporting ESG impact. Aligning with the Paris Agreement, the European Commission appointed an expert group on sustainable finance to develop a plan to recommend “strengthen(ing) financial stability by incorporating ESG factors into investment decision-making.” As part of this plan, new EU rules were recently introduced that requires financial institutions to disclose how they integrate ESG in their processes. Independently, France was the first country to introduce such disclosure regulations in 2015.
We also see such policy and regulatory factors outside of Europe. Japan has also encouraged considering ESG issues in investing, most prominently through the Ito Review. Following that review, GPIF—the world’s largest pension fund—began to take ESG seriously and further guidance on ESG disclosure has been developed by federal ministries. In 2018, GPIF and the World Bank Group launched a new initiative to promote Green, Social and Sustainability Bonds. And the U.S. Department of Labor acknowledged in 2015 that ESG factors can hold financial value in investments.
What’s next for ESG?
By now, integrating ESG in investment decisions should be standard practice among infrastructure investors. Beyond risk management, it’s also a way of identifying investment opportunities. Assessing and managing ESG risks in detail, particularly for emerging market investments, can reveal t opportunities that may otherwise be screened away.
The important issue now is exactly how ESG is considered in investment decisions. ESG evaluation needs to move beyond ‘theme-based’ investing (such as carbon reduction) or ESG screening (investing that excludes projects that have certain ESG features )—commonly employed by infrastructure investors according to the World Wide Fund for Nature (WWF).
Instead, ESG evaluation should be about deeper analysis on how each ESG factor affects costs, revenues, and cost of capital and economic benefits so they can be holistically considered. To facilitate this, investors, thought-leaders, governments, and regulators need to work together to find a better way to quantify the impact of ESG factors.
Do you have ideas to share? Please leave your comments below.
Disclaimer: The content of this blog does not necessarily reflect the views of the World Bank Group, its Board of Executive Directors, staff or the governments it represents. The World Bank Group does not guarantee the accuracy of the data, findings, or analysis in this post.
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