Materiality materialising

Evidence that ESG has a material impact on an issuer’s risk-adjusted return is strengthening, with ESG return drivers transmitted through three key channels:

• Cash flow (higher rated ESG companies may benefit from efficient use of resources, robust human capital development and innovation to support earnings growth).
• Systematic risk (companies with higher ESG profiles tend to have lower cost of capital, which can translate to higher relative valuations).
• Idiosyncratic risk (companies with stronger risk management practices and regulatory preparedness may have more downside protection).

However, it is important to note that the materiality of individual ESG issues is often dynamic and can change over time. This can be driven by ESG factors interacting with traditional return drivers or the risk associated with an issue shifting in response to varying external conditions.

Differences between public and private market ESG implementation

ESG investing should be applied across public and private markets, though it is also vital to consider some crucial differences. First is the information environment. Private companies typically face fewer obligations to disclose information publicly, so direct engagement is often a critical source of data gathering. Second, investments in private assets may involve larger ownership stakes or effective control, which is less common for investors in public markets.

Third, private market investors are presented with a different set of risk-return characteristics, including more extended holding periods, additional liquidity constraints, and more complex exit strategies. Arguably, this makes ESG considerations even more relevant in the origination stage because ESG issues are typically more likely to impact business performance or valuations over longer time horizons. ESG considerations also can be significant during the exit process. There is a strong incentive to work with management and other stakeholders to demonstrate and report ESG characteristics and improvements at the end of the investment cycle (see chart below).

Fidelity’s view of ESG in public markets vs. private markets

ESG investing in private markets is expected to accelerate in the coming years. We know the pace of change will be swift and uncertain. Building a robust foundation will help enhance the ability to respond quickly to changes, based on our public market experience and its practical application to private markets. Furthermore, ESG standards must be applied just as rigorously whether assets are in the public or private sector. Otherwise, we risk regulatory arbitrage, whereby asset owners can sidestep public scrutiny by shifting into the private sphere - undermining investors’ long-term sustainability goals along the way.

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