Big debate: Does ESG enhance performance?

Partners Group’s Esther Peiner and EDHECinfra’s Frédéric Blanc-Brude give their views on the impact of environmental, sustainability and governance measures on infrastructure investment

Yes, says Esther Peiner of Partners Group

Does ESG compliance improve financial or operational performance?
At the portfolio level, increased global awareness of the critical importance of ESG issues has itself unlocked fundamentally attractive investment opportunities that otherwise would not exist, generating strong financial returns.

In infrastructure, these newer opportunities exist especially around sustainable energy generation. For example, the combination of maturing technologies and long-term government renewables support incentives has led to a surge in opportunities to construct offshore wind farms around the world.

Partners Group has captured attractive financial returns for clients by constructing several of these assets. Our clients are increasingly choosing to screen out assets – or investment managers – with ESG concerns. In line with this, the universe of potential buyers for assets with negative ESG features is steadily shrinking. An ESG-compliant portfolio has a lower exit risk and an exceptional ESG track record might drive higher exit returns.

At the asset level, while we have yet to see the impact of ESG-focused initiatives or improvements on financial or operational performance being systematically tracked, there are positive impacts that can be highlighted. For example, energy-savings initiatives have significantly lowered construction or long-term operating costs at several assets within our infrastructure portfolio.

If it does improve performance, how do you prove it?
At Partners Group, every individual ESG-related project is assessed against its expected net value impact in relation to the investment net asset value. Projects are implemented and tracked against these original projections of operating and financial KPIs and performance is reported to the asset’s board. ESG is still a relatively new focus area within infrastructure, but we expect the body of industry evidence around its impact on performance to grow significantly as the current generation of funds reaches maturity.

In the case of financial performance, should that be measured on an absolute or on a risk-adjusted return basis?
Investment decisions are made on a risk-adjusted basis, and ESG risk cannot be excluded from this. Best ESG practices should mitigate the associated risk. The impact of ESG management on financial performance should therefore be measured on a risk-adjusted basis.

Do you consider existing ESG benchmarks to be adequate?
The introduction of a robust benchmark for the private infrastructure industry is highly desirable, but existing ones are inadequate. Some good attempts at standardisation have been made, but existing benchmarks tend to be too generalist.

At Partners Group, we have established an ESG dashboard that is comprehensive in terms of the metrics included but takes into account the materiality of each metric as it relates to an individual asset. The overarching materiality assessment is based on public benchmarks and principles, but we then adjust it according to our knowledge of the underlying portfolio asset.

Given that ESG covers a broad range of topics – from sustainability to workers’ rights to corporate culture, would it be more useful to measure the E, S and G separately?
Yes. We believe another downside of using general industry benchmarks is the need to assign an overall ESG score, when in practice the relevance of the E, S and G can vary substantially from one asset to another. Therefore, we prefer a holistic view of the ESG performance of our assets by measuring and prioritising specific targets across each of the E, S and G work streams according to materiality.

No, says Frédéric Blanc-Brude of EDHECinfra

Does ESG compliance improve financial or operational performance?
Financial performance is driven by the risks investors choose to take and at what price. When risks are priced, they impact discount rates and expected returns. Hence, this question revolves around what ESG means in terms of risk.

If higher ESG always improves financial performance it implies that ESG embodies an increased exposure to various risk factors, such as regulation or offtake prices. Looking at the solar sector in various countries today, it is clear that contributing to the energy transition is not without risks.

Conversely, numerous managers explain that better ESG leads to de-risking projects, which suggests lower returns, but they often argue that ESG also increases performance.
Better ESG can imply generating alpha in the sense that a manager can transform an investment into a better managed, more resilient business and thus create value.

This is, however, transitory. Once this business has been de-risked, it can be sold for a higher price, generating a one-off return, and after that it must have lower returns, assuming the de-risking is effective.

As long as investors in infrastructure take a reasonable long-term view, only systematic risks should matter and long-term rewarded risks have a simple and well-known relationship with returns – unless you think infrastructure investing consists of flipping assets.

If it does improve performance, how do you prove it?
First you need to define your terms: what does ESG mean in terms of risk? The rest is straightforward even though the marketing sometimes takes a life of its own – partly because the terms of the equation are not defined.

In the case of financial performance, should that be measured on an absolute or on a risk-adjusted return basis?
Investment is always a trade-off between risk and returns. Even when performance is expressed on an absolute basis – for example, a risk-free rate plus 500 basis points – it must be delivered by taking risks. Unless the strategy is to deliver a 5 percent alpha while taking no risk.

Investors need to know what these risks are, including what higher or lower ESG ratings imply.

By bundling risks together in ill-defined categories like ‘contributes to the energy transition’, investors make their life more difficult because they cannot easily identify nor manage the risks they take.

It is more important to understand what risks are implied by the ESG characteristics of firms and focus on those.

Do you consider existing ESG benchmarks to be adequate?
No, and the reason is simple: existing ESG metrics in infrastructure investment do not measure impact.

Whereas the reasons why investors care about ESG stem from a desire to focus on high-positive impact projects. If impact was properly measured, then investors could define the relevant investment universe for them, exclude certain assets and resume their focus on risk and returns within that space.

Given that ESG covers a broad range of topics – from sustainability to workers’ rights to corporate culture – would it be more useful to measure the E, S and G separately?
Yes. In fact, it is essential to do that since they are unlikely to move in the same direction – system dynamics can be complex – and can imply very different risk exposures.

Answers have been edited for brevity and clarity