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From the cars they drive to the products they buy to where they invest, consumers are increasingly drawn to the idea of sustainability.Mihajlo Maricic

Sustainable investing is having a moment – just not necessarily the kind associated with positive returns.

A Morningstar.ca report for Canadian investors found that 71 per cent of sustainable equity funds underperformed their peers in the first quarter of 2022. While the environmental, social and governance (ESG) category aims to help investors avoid companies that are mired in controversy, Elon Musk has stirred it up. In May, Tesla Inc.’s CEO tweeted that “ESG is a scam.”

He was reacting to Tesla’s recent exclusion from the S&P 500 ESG Index. Tesla, which designs and manufactures electric vehicles and energy storage, was the target of concerns over its social and governance practices. Mr. Musk’s tweet drew attention.

“These kinds of comments are adding fuel to the fire about whether sustainable investing makes sense and can actually make a difference,” says David O’Leary, founder of Kind Wealth in Toronto, which specializes in sustainable investing strategies.

Still, Mr. O’Leary believes sustainable investing will only gain momentum, driven by shifting consumer behaviours. For instance, a 2021 global survey by Ipsos found that 56 per cent of respondents said they have changed products and services they consume over concerns about climate change.

The Morningstar report also noted the rising demand from investors, with 28 new sustainable investment products launched in Canada in the first quarter of 2022, more than in the previous two quarters combined. Net in-flows of capital into all sustainable mutual and exchange-traded funds in Canada were $2.2-billion in the first quarter, and total assets grew to $33-billion, up 43 per cent year over year.

Is the enthusiasm warranted? Investors need to look beyond the hype to find the genuine potential, says Mike Thiessen, chief sustainability officer at Genus Capital Management in Vancouver.

“There is a lot of marketing without substance in the financial industry with investment firms saying they’re ‘green,’” Mr. Thiessen says.

Many public corporations have made net-zero commitments while striving for high ESG scores from providers like MSCI Inc. Yet critics argue that some companies engage in superficial actions to boost their score, as opposed to making costly, difficult changes with more beneficial impacts.

That’s “gaming the system,” says Douglas Chow, CEO of PortageBay, a Toronto company specializing in assessing ESG performance of publicly traded companies.

“It can be a bit of a wild west,” Mr. Chow says. His company employs artificial intelligence (AI) to pore over news, financial reports and other information about corporations, providing an alternative to major providers such as MSCI and S&P Global.

The challenge for many investors is figuring out which companies are making meaningful change and which ones are “greenwashing.” Mr. Chow says PortageBay’s technology aims to solve this problem, sifting through 200,000 websites in real-time across 100 nations in 65 languages.

Links between ESG and financial performance

Sustainable investing is about more than scores. It’s also about benchmarking ESG to financial performance.

Mr. Chow points to PortageBay research showing, for example, that e-commerce companies that use less energy earned higher stock-price returns over the past three years, and that oil-and-gas companies with lower emissions typically trade at higher valuations.

Companies that truly score higher on ESG often do well, and one reason is that they tend to better manage climate change risks, says Qayyum Rajan, Toronto-based global head of ESG Analytics, another provider of AI-driven sustainability research.

He explains the three main risks: physical (extreme weather events), transitional (shifting to a low-carbon economy), and regulatory (meeting government-mandated requirements to reduce emissions). How well all three are managed can have material impacts on a company’s financial and stock performance.

“For any industry or company, understanding how they are exposed to these risks, you can see how they might weather the storm and do better from a relative perspective,” Mr. Rajan says.

There are always other risks. That’s why it’s also important to look beyond whether a company is an environmental champion or laggard. Green reputations matter, as does overall ESG achievements. But so do other fundamentals.

Consider Tesla, widely considered “green”, Mr. Rajan says. The company’s share price soared last year over perceptions that it’s at the vanguard of climate-motivated consumer behaviour. Yet the price has gone down significantly since, for many reasons, including overvaluation.

As investors assess a company’s risks, ESG practices and potential to grow, sustainable assets under management could rise from US$35-trillion globally to US$53-trillion by 2025, according to a forecast in a recent Morgan Stanley report. The report described such investments as a prudent, risk-adjusted approach. Daniel Simkowitz, Morgan Stanley’s head of investment management, says sustainability is increasingly viewed as core to the future of investing.

On this point, Mr. Thiessen agrees: “It’s a good long-term strategy.”