Financial risks of unsustainable investments

The financial risks of investing unsustainably, like stranded assets, reputational risk, and other negative impacts of unsustainable business practices can destroy shareholder value. There is a widespread myth that investing sustainably means sacrificing returns. But if anything, the evidence suggests the opposite is true.

If you believe you must sacrifice returns in order to invest sustainably, you are not alone. In fact, 53% of investors assume that sustainable investing requires a financial trade-off. But contrary to popular belief, adding unsustainable investments to your portfolio could actually be increasing your financial risk.

Research conducted on the performance of nearly 11,000 mutual funds between 2004 and 2018 found that not only did sustainable funds provide returns in line with their traditional counterparts over the short and long-term, but they were also 20% less risky.

As we transition towards a low-carbon economy, the economic viability of energy companies’ heavy investments in the extraction and production of oil and gas will be under pressure.

Recently, this risk has been clearly demonstrated by the energy sector, which once led the world economy and stock markets, but has now become the smallest sector in the S&P 500. Investors who have chosen to avoid this risky sector have seen their returns prosper. Since its inception in 2012, the S&P 500’s Fossil Fuel Free Total Return Index has consistently outperformed the S&P 500 overall. When you examine individual companies, their performance can be seen as a microcosm of the energy sector’s sharp decline. For instance, ExxonMobil, which was the world’s most valuable company in 2011, was removed from the Dow in 2020.

Over the years, investors have seen how ESG related risk can negatively impact a company’s stock price as well as its reputation. By ignoring ESG issues, companies are financially liable to pay hefty regulatory fines and settlements while simultaneously tarnishing their brand. For instance, in 2010 during the Deepwater Horizon oil spill, British Petroleum’s stock price plummeted 50% over the course of two months. Some reports estimate that the company’s cleanup cost for this disaster alone were upwards of $90 billion. To this day, BP has still not recovered in value and has been unable to shake its soiled reputation.

While some investors still question the short-term performance of sustainable investments, numerous studies have shown that these types of investments are more risk adverse in the short term, particularly during social and economic crises. In 2020, financial markets experienced unprecedented losses due to the outbreak of the coronavirus pandemic. Employees across the U.S. saw their 401(k) account balances drop by an average of 19% in the first quarter of 2020 alone. These dramatic losses stemmed in large part from investing in funds which included oil and gas companies. And due to the intricacies of retirement plans, most employees are currently unaware that they are likely invested in these risky and volatile industries.

Not only are sustainable investments less risky in the short-term, simply put, companies that have strong ESG values are inherently more fit to thrive in the long run.

On the other hand, in 2020, U.S. sustainable equity funds’ median downside deviation, which measures the risk and price volatility of investments, was 3.1 percentage points less than traditional peer funds. Additionally, investors of U.S. sustainable equity funds earned an average return of 4.3 more points over those who chose to invest in traditional funds. Overall, during a year highlighted by market volatility, sustainable stocks and bonds weathered the storm better than their traditional counterparts.

Not only are sustainable investments less risky in the short-term, simply put, companies that have strong ESG values are inherently more fit to thrive in the long run. By addressing issues of climate change and social inequities head on, these companies are proactively taking the necessary steps to adapt their businesses to a constantly changing world. The message to companies: if you don’t adapt, you will be left behind.

Companies that do not plan for the future are also at risk of increasing their exposure to investments in stranded assets. A stranded asset is a resource or equipment that turns out to be worth less than expected as a result of external changes. As we transition towards a low-carbon economy, the economic viability of energy companies’ heavy investments in the extraction and production of oil and gas will be under pressure. As a result, investors in these industries may see their returns dwindle, and many already have started to see this firsthand.

Businesses need to adopt to a changing world for the long-term viability of their operations, but also for the investors they seek to satisfy. Demand for ESG investments has doubled over the past four years, and tripled over the past eight. The global value of assets incorporating ESG in some way now represents over a quarter of all investments worldwide, translating into roughly $45 trillion in 2020. In response, institutional investors like BlackRock have pledged to make ESG a central component of their investing strategy as they seek to satisfy this surge in demand.

As investors across the world continue to enter the ESG market at an exponential rate, they are beginning to realize that sustainable investing is no longer a zero-sum game. It is possible to invest sustainably, avoid financial risk, and support the transition to an economy that is based on justice and sustainability. Visit our Action Center to learn more about how you can work with your employer to ensure your retirement plan is sustainably invested.

Additional resources

Risks of fossil fuel investments

The myth of ESG underperformance