It has taken Arjan de Boer, head of markets, investments and structuring, Asia at Indosuez Wealth Management “several years to understand what ESG really is”, and now asset managers must burnish their credentials by identifying themes that can generate returns that tap into ESG trends.

“A lot of fund managers have jumped on the ESG bandwagon, but early adopters have a clear advantage, because track record and experience are the most important qualities at this stage,” he said at FSA’s recent SpotlightOn: ESG event.

The impetus has been a widespread recognition of the need to recalibrate the global economic machine to prevent a further erosion of natural capital. It is become an imperative to forge a link between returns and sustainability, and identify sectors and individual companies in the vanguard of innovation.

A green revolution is underway, and the Cop26 meeting in November will likely lead to an even greater focus on the necessary transformations. The capture of biodiversity and circular economies will be major themes, according to Noel O’Halloran, chief investment officer at KBI Global Investors, part of the Amundi Group.

“But the lens has moved from ESG being a challenge to an opportunity, especially since the Covid-19 pandemic,” he said.

Demand has accelerated for thematic and focused portfolios, and asset managers are responding with a wide range of targeted funds. Themes include sustainable infrastructure, water, clean energy, and agribusiness.

“Governments are spending on sustainable technologies and incentivising greener practices, which helps investable companies in a tangible way,” said O’Halloran.

Net zero

Decarbonisation and sub-themes associated with it will be the major issues for fund managers over the next few years, according to Hamish Chamberlayne, head of global sustainable equities at Janus Henderson Investors.

“The political alignment to tackle climate change is heartening, but fossil fuels still make up 80% of global energy usage,” he said. “It is monumental challenge, but we have a choice of either doing nothing or do something to effect shift in corporate behaviour.”

During the next decade, he believes there will be a massive in the adoption of alternative energy sources, and especially in the electrification and the digitalisation decarbonisation nexus.

“Innovation, backed by high research and development spending as a percentage of sales, will be a key attribute of companies that should prosper and deliver strong investor returns. Innovation will change the world,” said Chamberlayne.

The pandemic induced lockdowns initially caused disruption, but it has prompted a recognition that the extraordinary conditions could be a catalyst for change.

“It has led to vast environmental stimulus policies in Europe, the US and China, as well as a shift in consumer behaviour and choices,” said Harry Thomas, portfolio manager for the TT Environmental Solutions Fund.

“It is clear that we are not on track to meet net zero emissions targets, so carbon-catching, blue hydrogen, and electrical solutions will be major themes. Policy support for the corporate sector is essential,” he said.

However, there are coordination problems: for instance, understanding better how geological storage works and determining nature-based solutions to carbon emissions.

Will Pomroy, head of impact engagement at Federated Hermes agreed with Chamberlayne that electrification will dominate the sustainability agenda over the next few years.

Social factors

However, social issues have also come to prominence during the pandemic, with inequalities in society and rising levels of poverty becoming more apparent and increasingly unacceptable.

“Although most attention has been focussed on President Biden’s plan to raise spending on physical infrastructure, there is a bigger emphasis on addressing social problems that have been neglected in the past,” said Pomroy.

The positive outcomes are less tangible, but more companies now understand the costs to business from ignoring social issues.

Thomas agreed, noting that there has been a shift in norms at the corporate and government level on social issues such as return to acknowledging the beneficial role of unionised labour.

“Active share ownership will become more important, and successful companies will be characterised by the ‘authenticity’ of their dealings with suppliers, customers and employees, as well as their shareholders,” said Pomroy.

“ESG is a great source of alpha which can be combined with other alpha drivers into a package for investors,” added O’Halloran. However, investors should identify companies with strong fundamentals substantiated by their balance sheets, and not get distracted by ESG embellishment and hype.