What makes successful environmentally and socially sustainable companies: Disruptive technologies

One of the most important societal debates of the present day deals with the question of whether capitalist economic growth inevitably blocks ecologically and socially sustainable development or is able to explicitly promote such. Most classical economists are convinced of the latter. In the middle of the last century, the American economist and Nobel laureate Simon Kuznets established a link between economic growth and income inequality. His prediction was that while the gap between rich and poor would initially widen as the economy grew, incomes would later level off. The so-called „Kuznets curve“ looks like an inverted U, its highest point marking the maximum income inequality, after which incomes are distributed more evenly again. Empirically, this statement has been considered increasingly questionable since the 1980s and 1990s . Economists suggest, however, that the Kuznets curve could apply to the relationship between economic growth and environmental sustainability („environmental Kuznets curve“, EKC). Developments in recent years in industrialized countries do indeed suggest such a dynamics. In many places, economic growth has begun to decouple from growth in the release of climate-damaging gases. In Germany, France, England and most other European industrialized countries, greenhouse gas emissions are falling even though the economy continues to grow. This is also the case in the USA, albeit to a lesser extent. This development can be quantified more precisely using the ratio between CO2-equivalent greenhouse gas emissions and global economic output. In 1971, the value of this ratio was still 8 kg CO2/USD; by 2019, this ratio had fallen to 0.53 (already in 1990, however, this value stood at only 1.7). For Germany, this value is now around 0.2, in the USA around 0.3, and in China around 0.75.

Do societies have to go through climate-damaging economic growth before the technologies are developed that enable increasingly sustainable economies? Or perhaps, as people become more prosperous, their preferences change from consumption to non-economic aspects, such as cleaner rivers, healthier forests, or a more stable climate? Indeed, environmental, social, and governance („ESG“) sustainability has become an important consideration not only for policymakers, but increasingly for managers, investors, and consumers. Principles of environmental and social sustainability have thus also opened the door to new guiding principles for international investors. In parallel to the eloquent political promises of climate neutrality, in December 2020 30 major investors, including large asset management houses, fund giants, banks and insurance groups, committed in a „Net Zero Asset Managers“ initiative to invest all the assets they manage in a climate-neutral way by 2050 at the latest. According to the promise, the companies in their investment portfolios must not emit more greenhouse gases in total than they remove from the atmosphere. In the case of pharmaceutical companies, the ESG balance is e.g. affected by the access that developing countries have to medicines and other health services. And companies that process cobalt, an important raw material for batteries, must prove that no child labor takes plance in their value chain.

The financial institutions are hardly doing this out of pure altruism. They have long recognized that social and environmental sustainability also offers good opportunities for returns. A study published in June 2020 by the Imperial College London and the International Energy Agency, which analyzed stock market data from the last five and ten years in Germany, France, England and the USA, shows that ESG-based investing indeed generates attractive returns. Here, the first thing to go was the „E“: returns on renewable energy investments have been substantial over the past five years. In Germany and France, such investments left fossil fuel investments far behind with 178.2 percent returns, while the latter actually lost money at -20.7 percent. In the United Kingdom, the ratio was 75.4 percent to 8.8 percent, and in the United States, 200.3 percent to 97.2 percent. No wonder nearly 400 new ESG funds were launched in 2019, and more than $100 billion in new direct money flowed into the industry in the first half of 2020 (add to that the fact that existing products are also being increasingly aligned along ESG criteria). The ESG wave is also reflected in the number of third-party providers offering ESG data services and ratings for investors and asset managers. Meanwhile, there are hundreds of them. They include established global data providers such as MSCI and Bloomberg, as well as ESG specialists such as Sustainalytics, ISS and Arabesque.

Where do these extra returns from ESG investments come from? Are companies that better meet ESG criteria simply more resilient and better positioned over the long term? It is reasonable to assume that companies that are socially responsible and have a more transparent corporate culture are less exposed to risk. Conversely, companies that fail to consider their environmental, social and governance impacts are exposed to significant legal and regulatory risks. ESG-driven companies expose their investors much less to investment fiascos like Wirecard or Enron. But this hardly explains such excess returns as those listed in the Imperial College London study. There must be another significant factor that has driven those in recent years.

Here we encounter the second „megatrend“ in the global capital markets of the 2020s besides ESG: disruptive technologies. The rapid development in the areas of digital technologies (artificial intelligence (AI), Big Data, Internet of Things (IoT), etc.), energy (solar, wind and other renewable energies, smart grids), biotechnologies (genetic engineering, bioinformatics, neurotechnologies, medical diagnostics), quantum technologies (nanotechnologies, new materials, quantum sensors, quantum computers), etc. are today changing business models, institutions and society as a whole more fundamentally and faster than ever before. This trend will accelerate as technology advances. The 2020 returns of Apple (+83%), Amazon (+77%) and Tesla (+732%! ) reflect the imposing return opportunities that come with disruptive technologies. Does this perhaps also give rise to the extra performance of ESG-managed equity portfolios observed in recent years? What about the link between technological innovation and ESG?

One thing is clear: Technological developments also have a significant influence on the environmental sustainability of companies, which possibly manifests itself at the macroeconomic level in the environmental Kuznets curve. For example, the „green revolution“ of recent years has been driven to a large extent by technologies. Without the steady increases in the efficiency of solar cells and ever more efficient batteries, without the AI-controlled smart grids in electricity distribution and without the ever better adapted wind turbines, the transition toward renewable energies would have hardly been possible. Driven by the convergence of several key technologies at once, photovoltaics, wind power and energy storage, in combination with nanotechnology, new materials and artificial intelligence, the energy sector is on the threshold of the fastest and most profound upheaval in the last 150 years. What is also clear is that renewable energy technologies will continue to undergo remarkable developments. Their costs are very likely to drop by another 70% (PV), 40% (wind energy) and 80% (batteries) in the next 10 years. If under appropriate weather conditions the established energy sources of coal, gas and nuclear power are already no longer competitive with solar and wind power in generating electricity, they will be even less so with these price dynamics, as their prices are more likely to rise than fall.

Investors in energy stocks for example have long understood this. This dynamic is also reflected in the stock market value of energy companies. In early October 2020, for example, something groundbreaking happened: The market value of NextEra Energy, the largest U.S. renewable energy company (wind and solar), overtook that of oil giant Exxon to become the most valuable energy company on the U.S. stock market (meanwhile, at the end of December 2020, Exxon is slightly ahead again). As recent as  in 2013, Exxon had been the most valuable publicly traded company in the world, but in less than seven years the company has lost about two-thirds of its market value, while NextEra gained almost 300% during this period. The Zurich-based firm Singularity specializes in systematically identifying companies like NextEra in all possible technological fields.

So it should be clear: A green or social image and strong future earnings power are both key criteria for successful investing in companies according to ESG criteria. Simply defining and evaluating criteria according to static environmental or social criteria and rules, as most ESG data providers used by investors today still do, holds potential for disappointment. In fact, according to modern portfolio theory, such a process should have a negative impact on (risk-adjusted) returns because constraints per se make for less optimal portfolios. For successful ESG-aligned investing, therefore, another factor, a fourth one in addition to „E,“ „S,“ and „G,“ must be considered. And there is much to be said for this factor being „technological innovation“. New technologies play a key role in implementing and improving long-term ESG criteria. Technological innovation enables environmental sustainability, social alignment of human capital, and long-term business profits. Not only does it enable ever new approaches to solving environmental and social problems, but it also enables companies to adapt in an ever faster changing world.

Technological innovation is much more closely linked to ESG criteria than many investors today realize. Innovative technologies could even be the decisive factor that makes ESG criteria successful investment criteria in the future. In other words, a filter for innovativeness could make the all-important difference in using ESG criteria to invest successfully in terms of returns and sustainably over the long term. Therefore, when addressing ESG issues, investors must also give an important place to how innovation is managed and how it fits into a sustainable business strategy. It is no surprise that the most successful mutual funds that invest according to ESG metrics or consider such as an important part of their selection process hold stocks such as Apple, Amazon, Tesla or Microsoft as a position, but also NextEra, Vestas Wind Systems, Osram and TSMC (Taiwan Semiconductor Manufacturing). Maybe we should talk about „ESGI“ in the future?