Europe Leads Way In ESG As Favorable Regulation And Demand Help

European investment managers are well ahead of their U.S. peers in allocating assets based on environmental, social and governance, or ESG, principles, but the American market is likely to begin catching up as returns match or better those on traditional investments, market participants say.

Some 85% of European investors said they incorporated some degree of ESG analysis in their investment approach, compared to 49% in the U.S., according to a survey published by RBC Global Asset Management in October. Meanwhile, data published by the Global Sustainable Investment Alliance, a grouping of five responsible-investment associations in Europe and North America, showed that more than half (52.6%) of European managed assets were allocated to ESG strategies in 2016, compared to just 21.6% in the U.S.

Regulation designed to push companies toward following ESG principles has helped drive investment in Europe, as they have a general willingness to invest along ESG lines and the greater availability of opportunities for ESG-focused asset managers. In the U.S., by contrast, political headwinds and overall skepticism toward ESG-based investing have served as a brake on the market.

"Europe has been more open to and interested in responsible investment, having become the source of innovation in the industry," said Matt Christensen, global head of responsible investment at AXA Investment Managers SA, the asset management arm of French insurer Axa. He said this "partly reflects a less polarized environment," pointing to the contrast between Donald Trump's decision to pull the U.S. out of the Paris climate accord and France's implementation in August 2015 of legislation requiring investors to disclose how they are meeting climate goals in their investment allocations.

Christensen also noted that financial markets in Europe moved away sooner than those elsewhere from so-called negative screening, an ESG strategy whereby certain sectors, such as coal or oil, or companies are excluded from a portfolio. Instead, the focus in Europe is increasingly shifting toward channeling investment specifically into companies that stand out in ESG terms, for example, through positive performance relative to peers or against a set of minimum standards.

In addition to the 85% of European investors who told RBC that they incorporate ESG principles in their investment strategies, 45% said they did so "significantly," compared to 16% in Canada, 12% in the U.S., and 21% overall.

EU regulation

Regulation at the pan-European level is also helping the push toward ESG investment, said Carola van Lamoen, head of governance and active ownership at Dutch asset manager Robeco. She pointed in particular to the European Shareholder Rights Directive, which was updated in April by the European Council to push institutional investors to take a longer-term view in their strategies, in part through disclosing how they engage with investee companies or explaining why if they opt not to make such disclosures.

EU member states must adopt the directive, and set out "effective, proportionate, and dissuasive" penalties for noncompliance by mid-2019.

Collaborative approaches to sustainable investment also exist on a local level, van Lamoen said, including the Dutch governance platform Eumedion and Eurosif, the European social investment forum. The U.K.'s Stewardship Code and a set of Dutch practices for involved shareholdership "have played an important role in pushing the interest for sustainability investing," she added.

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"There is a real investor appetite that has been created," Laurent Mignon, CEO of French investment bank Natixis, told S&P Global Market Intelligence. He pointed to the growing appeal of green bonds, funding instruments targeted at low-carbon and other environmentally beneficial initiatives.

"There are funds to invest in, and so this generates a higher capacity for green bond issuance," he said, adding that although "for the moment the dedicated green investor capacity is lower in the U.S.," demand will grow as investors begin to see the benefits of long-term green investments.

"We are raising funds in that space more easily than in the U.S. but ... I'm convinced that there will be more money that will go into funds with a green and ESG connotation in the years to come," he said, adding that Natixis' responsible fund manager, Mirova, is analyzing ways of increasing ESG awareness in the U.S.

Change of heart?

U.S. investors are showing signs that they are perhaps taking sustainable investment more to heart, with 97% of European investors and 85% of U.S. investors intending to boost their climate-related and low-carbon investments, according to a report commissioned by HSBC. Though that represents just one segment of the ESG universe, asset allocation in the broader sector has also been growing, up a third to $8.72 trillion at the beginning of 2016 from $6.57 trillion in 2014, according to the 2016 Global Sustainable Review.

Global growth in socially responsible investment assets, 2012-2016

"Things change very quickly. The socially responsible investment market has been very weak in the U.S. but we are seeing it picking up," said Tanguy Claquin, head of sustainable investing at the investment banking division of French banking group Crédit Agricole SA.

One of the central questions for U.S. investors may be what return they will get for their investment. According to the RBC survey, 96% of European investors see ESG strategies performing as well or better than non-ESG, compared to 74% in the U.S.

RBC noted that more than three-quarters of respondents across all geographies said "Will returns suffer?" was the ESG-related concern aired most often by clients, although more than half of respondents overall expected ESG-oriented strategies to do at least as well in generating returns as strategies that do not incorporate ESG.

Institutional investor attitudes to ESG* investing (%)

"This lack of clarity may explain why a large number of investors — in North America, at least — continue to take a 'wait and see approach' to ESG investing," RBC said. Its survey indicated that 25% of U.S. investors plan to increase their allocation to ESG strategies in the coming year, compared to nearly 50% in Europe.

Slightly-higher returns

But those fears may be unfounded, according to a report by the Smith School of Enterprise and the Environment at the University of Oxford and Arabesque Asset Management, which delved into 200 research studies to determine the relationship between responsible investing and profitability. The report found that 88% of the studies showed that solid ESG practices result in better operational performance for companies, and that 80% demonstrated that stock price performance is positively influenced by good sustainability practices.

Similarly, a report by the Morgan Stanley Institute for Sustainable Investing, based on a review of performance data from 2008 to 2014 for 10,228 open-end mutual funds, found that sustainable funds tend to produce slightly higher returns and lower volatility than their traditional counterparts.

"That's why this market is so successful," Claquin said. "It's like asking people to buy organic and fair trade coffee at the same price as normal coffee."

And as many more geographies change to more cost-effective renewable energy, financing is going to develop in those kinds of ventures, which will ultimately increase investment products and pull in more U.S. investors.

"We are going to see a lot more financing coming, and not just in the historical markets like Europe, which was traditionally a leader but this is global," said Scott Lawrence, partner at fund manager Glennmont. "This is going to continue to happen in the (U.S.) despite political noises otherwise."