How a different kind of investment could transform Latin America

Latin America and the Caribbean is now the epicentre of the COVID-19 pandemic. More than 170,000 people have died from the disease as of 23 July, and there is a strong likelihood that the region will lose several points of GDP as a result of the pandemic and its various ramifications by the end of the year.

But these are not the only upheavals the region faces. The climate crisis, albeit unfolding over a longer time period, has many parallels with the pandemic, and ultimately threatens the region, and the world, with even graver economic and health consequences.

People in the region have shown a keen awareness of that threat, even during the COVID-19 crisis. An online survey conducted by Ipsos in April showed that more 71% of people in 14 countries agree that climate change is as serious a concern as the pandemic over the long-term, and nearly two-thirds believe it should be prioritized as part of the recovery.

The good news is that the pandemic creates an opportunity for transformation in numerous areas – and the financial system can play a critical role, specifically through investments that take into account environmental, social, and corporate governance (ESG) factors. Such investing can help to achieve a sustainable recovery and a better future for current and future generations.

ESG investing today focuses on companies' performance when it comes to climate change, as well as human rights, gender equality, labour protection, forest conservation and a host of other socially and environmentally conscious concerns. It accounts for more than $20 trillion – or one quarter – of all professionally managed assets worldwide and often equals or even outperforms investing that ignores ESG factors. We believe it could be extremely valuable for sovereign wealth funds (SWFs) and government-regulated pension funds in the Latin America region, helping to spur much required changes.

There are several reasons that focusing on ESG investing is particularly important for SWFs and pension funds. To start with, governments have a particular interest in investments that are aligned with their development priorities. Investing in firms that pursue unethical and unsustainable practices – such as high carbon emissions, corrupt practices, or unfair labour practices – can be counterproductive. The costs of those practices will be borne by society, and in the case of domestic investments by communities, employees, and perhaps the nation as a whole.

SWFs and pension funds also have long investment horizons, and the risks of poor management of ESG risks can increase over time. For example, investing in oil or coal firms during the next six months may not be a problem. But in the long-term, those firms are likely to become much less valuable as countries change their energy profiles and move to renewable sources. Further, SWFs and pension funds control a large share of global assets and can use their size and influence to create incentives for firms to improve sustainability, benefiting the countries in which the firms operate.

ESG investments by SWFs and pension funds make sense when it comes to climate change. Such investments help shift investment from polluting industries to cleaner ones, which over the longer term helps the planet while ultimately providing more employment in areas like energy efficiency and renewable energy. Moreover, for governments concerned with fiscal budgets during the recovery, ESG investments don't involve significant new outlays of cash. They are instead a low-cost policy whereby money is shifted from firms that make little or no effort to address climate change to firms that take the threat seriously and are making a major effort to address it.

Of course, SWFs and pension funds do not want to sacrifice financial returns, so it is important to determine how ESG investing performs financially. In a recent study, we compared the actual performance of Chile’s two SWFs and five government-regulated pension funds against their conventional market benchmarks. We then created a counterfactual in which we replaced the funds’ benchmarks with their ESG counterparts and compared it to the conventional benchmark and actual performance. We found that over the period of our analysis (generally from 2013 to today) the SWFs and pension funds could have restricted their investments to those with good performance in environmental, social and corporate governance without decreasing financial returns.

When we examine one of Chile’s sovereign wealth funds, the Economic and Social Stabilization Fund (ESSF), for example, we find that from August 2013 to May 2020, the financial return of the counterfactual using ESG benchmarks delivered a cumulative return of 20.13%, compared to 19.82% for the actual return of the ESSF during that time period and 19.04% for the counterfactual using the current benchmarks. When we conduct a similar exercise for Chile’s five pension funds, constructing an ESG portfolio with the same asset allocation as the average allocation of each fund, we find that financial returns of the ESG portfolio were similarly superior. Interestingly, ESG investing substantially outperformed traditional indexes even during the coronavirus period – perhaps because firms that prioritize environmental and social factors as well as corporate governance are more experienced and better managed, and can thus better steer their way through crises.

There is, in short, no business or fiduciary case for failing to make investments more sustainable. A country can prioritize the battle against climate change and other socially and environmentally conscious concerns in its investments without losing out financially. The idea that there is a trade-off between such investment and financial returns is merely a poor excuse for avoiding the transformations that need to take place.

Despite its already immense influence, the field of ESG investing still has a way to go. The problem lies in the fact that there is no standardization in the type and way that various ESG metrics, like climate change and gender equality, are reported by firms or the standards that third-party rating agencies use. As a result, there is less transparency than needed to give investors confidence that the firms they invest in fit their values; it's more difficult for the market to reward good ESG performance; and it's harder for firms to improve their metrics, because while many different organizations award ratings, their ratings are not highly correlated.

Nonetheless, the trend towards incorporating ESG performance in investment decisions is not a fad. It is part of broader re-definition of the role of firms, in which the maximization of shareholder value is no longer the sole objective. It is gaining force in Latin America and could be essential to rectifying some of the myriad problems that afflict many countries, including an over reliance on fossil fuels and the underdevelopment of renewable energy.