A new report outlines the state of the ESG investing space, along with advantages, challenges, and the role of passive investing
ESG principles are having a growing impact on the financial system, and policymakers must play a role to encourage the trend, according to a new report from the International Monetary Fund (IMF).
In a newly released chapter of its global financial stability report, the IMF recognized the case for sustainable finance — the incorporation of ESG principles into business decisions, economic development, and investment strategies.
While firms incur operational and disclosure-related costs as they engage in “good” corporate behaviour, they also stand to enjoy efficiency gains, greater trust from stakeholders, reduced firm-level tail risk from carbon emissions, and other benefits long-term.
“Portfolio investors are increasingly focusing on ESG considerations,” the report said. “Impact and underperformance concerns have led the evolution of ESG strategies from exclusions to more selective inclusion and investor activism.”
A growing footprint
Drawing on information from Bloomberg Finance and JPMorgan Chase & Co, the IMF estimated that the number of equity funds with an ESG mandate has grown from around 300 in 2004 to more than 1,500 this year. Fixed-income funds with a clear ESG focus have moved more slowly, with less than 100 in 2004 and under 400 funds today.
It also reported that ESG funds now control some US$850 billion in assets, with equity mandates accounting from US$560 billion. It’s a far cry from the approximately US$400 billion in assets estimated for all ESG fund mandates as of 2010, though the IMF noted that it’s less than 2% of the total investment fund universe.
“IMF staff analysis suggests that the performance of sustainable and conventional funds is comparable,” the report said, pointing to a lack of consistent evidence that sustainable funds regularly over- or underperform traditional funds. Average expense ratios for retail sustainable funds also appeared in line with those for conventional funds in the retail market.
Challenges in standards
While the demand and interest in ESG investing is clear, the IMF cited a host of challenges faced by investors and issuers. A lack of consistent methodologies can make it difficult for investors to make apples-to-apples comparisons of issuers and funds; corporate reporting of non-financial information also remains fragmented and largely incomplete, though disclosure has been improving over time.
“Third-party providers of ESG scores aim to provide standardized assessments, but there are concerns about the opaqueness of methodologies and informational materiality,” the report added. It also acknowledged risks from greenwashing, which arises from false claims of ESG compliance of assets and funds.
Indices that track assets based on ESG criteria have helped open the space to passive investors. However, the IMF noted a possible need for further fund and asset standardization so that investors’ expectations regarding ESG compliance are met.
“Prima facie, passive investing is not conducive to sustainable investing, given the need for greater engagement with issuers and higher analytical burden and cost,” the report said.
The IMF acknowledged that the potential benefits of sustainable finance may not be enough for firms to justify accounting for all relevant externalities in their ESG considerations.
“Therefore, policy action is still needed to incentivize firms to carry out investment or make other changes in their business practices that would help reduce negative externalities,” the organization said.