ESG, Call It What You Want, It’s Still Investment Risk (And Opportunity)

The Controversy Around ESG

Environmental, social, and governance, or “ESG,” has become an ever more controversial topic, becoming so disputed that Larry Fink, the CEO of BlackRock (the world’s largest asset manager), has admitted to expelling it from his vocabulary. ESG has emerged as a contentious issue within the U.S. partisan landscape, with 17 of the states that voted Republican in the 2020 U.S. presidential election proposing anti-ESG bills, while 11 states that voted Democratic proposed pro-ESG bills.[1] In certain states, these anti-ESG bills have been enacted into legislation, including in Texas, which in 2021 introduced laws restricting government contracts with companies that boycott the fossil fuel industry. This legislation led the Texas School Fund to terminate BlackRock, which managed USD$8.5B on behalf of the fund, in March 2024.[2] Texas is not an outlier, with other U.S. states, including Kentucky, Oklahoma, and West Virginia, having implemented anti-boycott laws, authorizing these states to maintain a list of restricted financial institutions. Why the opposition to ESG?

One of the key issues has been defining ESG. The inherent ambiguity of the term has allowed it to become politicized by various actors harbouring different agendas. Environmental factors can include climate risks, natural resource scarcity, pollution, and waste. Social factors encompass labour issues, data security, and broader stakeholder relationships. Governance factors can include corporate governance such as board quality.

Relevance of ESG in Investment Decision-Making

Regardless of whether they are formally categorized as ESG risks, incorporating a more fulsome set of risks, including environmental, social, and governance, into investment decisions has historically led to relatively better investment outcomes. In a global study across 13,000 companies from 2013-2021, it was found that ESG leaders (as determined by MSCI ESG ratings) earned an average annual return of 12.9%, compared to 8.6% earned by laggard companies.[3] Depoliticizing the term is important as focusing on the risks represented by ESG can translate into a tangible financial impact and therefore is an important component of investment decisions, not just from a risk mitigation lens, but also as a lever to add value. 

ESG as a Value Lever

One of those value levers is human capital, an integral part of the "S" in ESG. Actively disengaged and/or employees in the U.S. are estimated to have cost approximately USD$1.9 trillion in lost productivity in 2023.[4] Globally, the economy suffered losses of around USD$8.8 trillion, equivalent to 9% of global GDP.[5] Estimates vary, but replacing employees can cost anywhere from 20% of the departing employee's salary to multiple times that amount. Companies listed in the "100 Best Companies to Work For in America" generated 2.3% to 3.8% higher stock returns per year compared to their peers between 1984 and 2011.[6] While attracting top talent is crucial to delivering topline growth in a business, research has also demonstrated a link between Diversity, Equity, and Inclusion (DE&I) initiatives and performance. Specifically, companies ranking in the top 25% of their industry for gender diversity in their executive teams achieve EBITDA profit margins that are 3% higher than those in the bottom quartile.[7] Ultimately, understanding human capital policies can yield valuable insight into companies that are at an elevated risk of employee attrition, lower productivity and ultimately higher costs. 

Importance of ESG in Infrastructure Investments

ESG factors carry significant relevance in infrastructure investments due to the long-term nature of the underlying assets, which often have a multi-decade operating life. Unlike private equity investments which are typically held for 3-5 years, infrastructure investments typically have a 7+ year hold that may extend up to 20+ years. The long-term investment horizon heightens the risk of longer-term changes, such as changing weather patterns, driving additional costs. For example, U.S. electric utilities in the Pacific Northwest are now required to spend significant amounts on underground distribution networks to minimize the potential liability and insurance premiums related to wildfires. Stranded asset risk (risk that an investment loses value prematurely due to factors like technological advancements and regulatory change) is particularly relevant to non-renewable energy producers in the current global environment. Accessibility to financing is also increasingly contingent upon ESG metrics as certain banks refrain from lending to poor ESG performers or will offer a preferential financing rate to businesses that demonstrate ESG improvements. The Sustainability-Linked Loans (SLL) market which began ~7 years ago is now estimated by BloombergNEF to be worth USD$1.5T.

A long-term focus also presents opportunities to invest in the infrastructure required to decarbonize and achieve global climate targets. It is estimated that USD$9.2 trillion in infrastructure investment would be required to meet international climate goals through 2050, an annual increase of USD$3.5 trillion above current investment amounts.[8] The global political appetite to reach these targets was highlighted at COP28 when 100 countries agreed to triple renewable energy capacity to 11,000 gigawatts by 2030.[9]

Implementing ESG into Investment Decisions

Understanding that ESG presents both risks and opportunities for infrastructure investments, Nicola Global Infrastructure Limited Partnership (NGI) includes a general sustainability assessment for all new investments. Recently, we surveyed all of our existing investment partners and co-investment companies to capture ESG-related information that is not included as part of regular ongoing reporting.

Key highlights from our survey include:

• 100% response rate to the survey.
• 97% of NGI’s partners have an ESG/responsible investing policy in place.[10]
• 100% of NGI’s co-investments report both scope 1 & 2 emissions data.[10, 11]

NGI provides exposure to a diversified portfolio of infrastructure assets, with 18% invested in energy transition and 12% invested in power and renewables.[12] We believe this strategic weighting positions the portfolio to benefit from the push by governments to achieve global climate targets and decarbonization goals.

Our team believes investing in managers that have strong ESG governance incorporated into their investment process will result in a better-performing portfolio. Regardless of what acronym is used, ESG is just another form of investment risk that, in our opinion, if well managed, can lead to increased investment returns.

[1] Capital Monitor, "Mapped: The Polarisation of ESG in the US."

[2] Reuters, "Texas Schools Fund Pulls $85 Billion from BlackRock Over ESG Policies." March 19, 2024.

[3] Kroll, "ESG and Global Investor Returns Study."

[4] Gallup, "New Workplace Employee Engagement Stagnates."

[5] Gallup, "State of the Global Workplace: 2023 Report."

[6] Edmans, Alex, "The Link Between Job Satisfaction and Firm Value, With Implications for Corporate Social Responsibility."

[7] Bain & Company, "Do ESG Efforts Create Value?"

[8] McKinsey & Company, "The Net-Zero Transition: What it Would Cost, What it Could Bring."

[9] COP28, "Global Renewables and Energy Efficiency Pledge."

[10] Based on NAV as of March 31, 2024.

[11] Excludes co-investments made in the 12 months ended March 31, 2024 (held for less than 1 year).

[12] As of March 2024.