ESG Investing – the Why, What and How?

Author Tatiana Bateson
Category Business, Columnists, Lifestyle, Town
Date January 13 2024
Reading Time 6 min.

ESG Investing – the Why, What and How?

If you are worrying about ‘plastic-bergs’ in the Pacific Ocean but everything in the supermarket is wrapped in convenient but apparently ‘deadly’ plastic then you are not alone. Perhaps you are wondering, as you drag out your blue recycling bin, why nobody addressed this and many other glaringly obvious environmental issues years ago? Although you might feel like joining Extinction Rebellion, arguably a more powerful route to change is how we collectively manage our cash.

The Ethics of Don Draper

It turns out that public awareness of the environmental concerns facing the planet is a relatively new phenomenon and only a few decades old. Back in the 1960s it was not even questionable to have the biggest gas guzzling car possible or as Don Draper in the series ‘Mad Men’ throw your picnic rubbish over the park. Only in the early 1980s did the UK decide it was unreasonable to dump radioactive nuclear waste in the sea just off the English coast.

Although they did not manage to resolve the existential plastic bag problem, groups like Greenpeace and Friends of the Earth became major early influencers of public opinion. They educated the public and highlighted the need for more environmentally aware policies. The environmental agenda has moved slowly but surely addressing and publicising a range of important topics from holes in the ozone layer to logging in amazon rainforests and more recently global warming and climate change.

To the environmental factors were gradually added social concerns as the unrelenting progress of globalisation led to offshoring of manufacturing. Western consumers, despite enjoying cheaper clothes, sneakers and zillions of plastic toys, realised that having them made by child labour under terrible working conditions whilst polluting third world countries was simply unethical by modern standards.

Managers Running to Catch-Up

To this evolution of higher ethical standards, the finance industry has been struggling to catch up. Believing for many years that ethical or responsible investing was a fad or fashion amongst a few hippie, fringe types or eco-warriors, they chose to ignore it.

The reason for the intransigence of fund managers was the painful realisation that many of their current practices, honed over decades, would have to be modified. Instead of looking at how much profit a company made and various other financial metrics before investing they would instead have to interrogate companies on a range of subjective issues on how they made a profit and whether it was aligned with ethical considerations.

Much of this new information was previously not disclosed by major corporations and the extra new focus would lead to some awkward conversations with CEOs and company directors. Some major companies would become ‘un-investable’ unless they too changed.

The fund management companies now realise the writing is on the wall and are changing their products and services to align themselves with the now mainstream customers’ views on a range of environmental and social issues.

Now behemoth money managers such as Blackrock, Fidelity etc have re-orientated their entire business models to address responsible investing. This is the biggest ideological revolution in how and why money is invested arguably since the advent of the first publicly traded stocks and it is here to stay. In the new paradigm, pure profits and monetary shareholder value are not the only performance criteria for a company investment.

An Unsustainable Forest of Sustainability Jargon

However, for the uninitiated investor environmentally and socially responsible investing has become jargon orientated and confusing. As if investing literature is not difficult enough, the fund management industry has come up with a whole new range of expressions and acronyms. Responsible or ethical investing sounds reasonable but what are SRI, ESG or “impact” investing?

The early funds addressing ethical or responsible investing used a simple ‘exclusion’ methodology. If a company was in what was viewed as a ‘sinner’ sector, such as traditionally firearms, alcohol or tobacco, it was removed from the portfolio. To the list of exclusions was progressively added casinos, weapons, fossil fuels, coal mining etc. This sector-based ‘negative’ screening process became labelled Socially Responsible Investing (SRI).

Although this approach had huge clarity for investors and was a first stab at the problem of responsible investing, it was perhaps overly simplistic and quickly limited the universe of investable companies. Another shortcoming was that companies that lay outside these specific sectors but who exhibited irresponsible and unethical behaviour could not be automatically excluded.

A more nuanced approach, called ESG investing was developed where equities would be individually screened on the basis of detailed Environmental, Social and Governance scores. This modernised style of ethical investing provides a more holistic and scientific method for investment allocation but the E, S and G need a bit more explaining.

What is the E, S and G?

E is for Environmental. Obviously, we are all aware of climate change and pollution but Environmental impact of companies and the factors considered is much more wide ranging. It will include measurements of carbon footprint, water usage, waste management, pollution, environmental litigation and moves towards clean energy. For example, chemical companies polluting rivers, mining companies with toxic tail-offs and packaging companies with non-recyclable products would all be penalised. Companies with high levels of environmental disclosure and improving practices would be promoted. Even oil companies that are divesting themselves of fossil fuels, building sustainable energy portfolio and transitioning to a low-carbon future could be considered in certain ESG portfolios.

S is for Social. High street retailers making Christmas cards in Chinese gulags, smartphone manufacturers using rare earth metals mined by children and on-line distributors with bad labour practices in their warehouses are all high-profile examples of violation of socially acceptable practices. However, S encompasses many minor considerations that are not news-paper headline worthy but important none the less such as human rights, workers rights, controversial products, employee turnover, business facilities and health and safety practices. Positive practices such as personnel diversity, maternity rights and charitable donations would lead to higher Social rankings.

G is for Governance. It is a bit less clear for most investors but is arguably the most important factor for future share price performance. Governance concerns how a company is run and controlled and includes corporate culture, board independence, renumeration policy, role of independent directors and business ethics. Bad governance can lead to business destroying decisions and massive lawsuits. For example, banks that have allowed money laundering and sanctions busting, German car manufacturers that fixed emissions tests with the complicity of senior management or raiding the company’s pension scheme to pay extra-large dividends. Companies that are well managed, transparent and with clear policies and business plans achieve higher Governance scores.

ESG Portfolios in Practice

Whereas ESG investing might include companies that are positive or neutral from an ESG perspective, another more extreme form of ESG investing is so called ‘impact’ investing.  An ideal impact portfolio only includes companies that are highly ESG positive and beneficial impact for the World. Typical examples of such companies might include water treatment, healthcare, electric cars and renewable energies like wind farms, solar etc. Impact portfolios are thus much more positively focused than generic ESG portfolios and some fund managers find the pool of available companies too constrained.

Traditionally it used to be thought that ESG investing sacrificed performance but academic studies* have shown this is not the case. This was well illustrated by the out-performance of many ESG funds in the recent coronavirus stock-market sell-off. Higher rated ESG companies are found in numerous studies to have a lower cost of capital, deliver higher shareholder value and surprise markets less.

The latter consideration is important since although a company’s ESG profile usually changes very slowly, sudden, unexpected ESG events (like a corporate scandal or chemical leak) can have a profound short-term impact on share prices. ESG criteria in stock selection is found to reduce equity portfolio risk and to lower volatility and thus improve long-term performance.

Other academic research findings are also interesting. For example, emerging market stocks are most impacted by ESG factors due to higher volatility and often laxer regulations*. Also, ‘forward looking’ ESG strategies, such as ESG trends, that focus on improvements in company ESG factors, can increase portfolio performance. Thus, companies that were badly ESG ranked but are improving should also be considered, in my opinion, for inclusion in portfolios.

How are your funds invested?

Now you may at this stage have started to ask the question, ‘how are my own funds invested?’ You probably have pension fund or stock and shares ISA but know little about the investment process or equity selection. The chances are you are invested in a generic index tracker or legacy fund that is not ESG compatible and probably does not adhere to your own personal ethics and morals.

Although passive ESG indices have started to appear, for example FTSE4Good and the S&P ESG Index, these are essentially rules based, and the new, subjective domain of ESG is perhaps best handled by ‘active’ managers. Active managers can analyse and review the ESG information and ratings from different providers and embed their own level of ethics into the process.

Unfortunately, too many fund managers jumping on the ESG bandwagon, indulge in so-called ‘greenwashing’ and have simply relabelled existing equities funds as sustainable or ESG with minor modifications to their investment criteria.

To avoid falling into this trap, one of the first things to check when choosing a manager is whether they are signatories to the UN-PRI which are the United Nations Principles for Responsible Investment. The UN-PRI is a starting point for compliance with ESG investing and contains 6 principles which ‘recognise that applying these Principles may better align investors with broader objectives of society’.

This is however just a starting point for your future journey of ESG investing to build a more sustainable and healthier planet.

*MSCI ESG Research, 2020; Allianz ESG in equities, 2016

This article and the views expressed here are my own and do not necessarily reflect the views or values of any companies which I am affiliated with.

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