For years, investors have debated a central question: does integrating environmental, social and governance (ESG) considerations into a portfolio enhance returns or constrain them?
The answer is neither simple nor universal.
In a recent conversation, Dr Penny Byrne, ESG and climate change investment analyst at SBG Securities, unpacked the nuanced and often misunderstood relationship between sustainability metrics and stock performance.
Correlation is easier to see than causation
Byrne says that while correlations between ESG scores and stock performance can be found, when broader macro or political developments drive markets, isolating ESG as the performance variable becomes extremely difficult.
“For instance, in South Africa, we've had this big boom in SA Inc after the Government of National Unity was formed, and you can't strip that out.”
That said, evidence of correlation is stronger in regions like the US and Europe.
“There are studies that show that when a company’s MSCI ESG score falls, the stock performance tends to fall over the next six months to two years,” she says.
Part of this dynamic is mechanical. Many asset managers in the EU and US are mandated to not hold stocks below a predetermined ESG threshold. When a company’s rating drops, forced selling can follow, which impacts performance.
“So, because of those mandates, you see the connection come through.”
In South Africa, however, most asset managers don’t operate under strict exclusion mandates. Engagement, rather than divestment, is the preferred approach. That makes it harder to detect the relationship between ESG metrics and stock performance locally.
“In theory, companies with better ESG scores – those that are taking sustainability and climate change more seriously and are preparing for the risks and taking advantage of the opportunities – should have better stock performance than those that are ignoring the issue. In practice, that's very hard to demonstrate since we can’t strip out all the other macroeconomic factors.”
Operational shocks and margin impacts
There are, however, examples of companies transitioning from fossil fuels to greener energy sources and improving margins as a result. Cost savings, efficiency gains and operational resilience can follow.
“I think you’ll find some margin improvement and, potentially, some performance boosts from those that are better with ESG.”
However, risks remain.
Companies that experience sudden supply disruptions in water or electricity may face severe financial consequences.
“Those shocks are a lot more damaging than something the companies knew was coming.”
In other words, proactive transition planning can help, but unexpected physical and infrastructure risks can still undermine performance.
Decarbonising a portfolio is not simple
One of the key challenges for investors looking to “green” their portfolios is that we operate in a deeply carbon-intensive way of life.
“It’s difficult, in this very carbon-intensive world, to decarbonise yourself or your portfolio,” Byrne explains.
Investors looking to incorporate ESG into their portfolios first need to identify what matters most to them.
“If you care about emissions and the climate, you go for companies that don't have high emissions. If you care about environmental impact, you look for companies with a smaller carbon footprint that don't produce too much of anything or, if they do, make sure it's recyclable or a better product.”
But prioritisation inevitably leads to trade-offs.
“For instance, do you keep expanding fossil fuels to help people achieve energy security, thereby increasing GDP in poorer African nations and helping uplift people in the moment? But again, those people are going to pay a higher price as the climate changes faster and worsens due to increased emissions. So how do you balance that?”
This tension between short-term development and long-term climate impact makes blanket exclusions difficult.
ESG and growth: a misunderstood relationship
A common misconception is that ESG investing implies sacrificing returns.
“ESG investing isn’t about lower financial growth; it's about higher financial gains because companies are making the right moves to adapt to the world as it's changing. But in the short to medium term, that doesn't always play out quickly,” says Byrne.
She says investors may need to make some concessions in the short term to achieve investment growth.
“It's very difficult to put a blanket moratorium on dirty industries because you might miss out on the growth.
“So, unfortunately, you might have to stay a little bit in some of the companies you might not like to get the same returns that markets are getting, without really hurting yourself from an ESG perspective.”
She suggests a pragmatic portfolio approach rather than rigid purity.
“I think that when you’re looking at a whole portfolio of investments, not every investment needs to have an ESG check. You can apply that thinking to some things and still have a positive impact.”
The views and opinions shared are for informational purposes only. They are not intended to serve as investment advice and do not represent the views or opinions of Standard Bank. This information should be used as a starting point for generating investment ideas and should not be relied upon as the basis for making investment decisions. The Standard Bank of South Africa Limited will not be responsible for the results of any investment decisions made based on the views provided.
