ESG stands for environmental, social, and governance, and refers to three central factors in measuring the sustainability of an investment. Environmental criteria cover themes such as climate risks, natural resource scarcity, pollution and waste, and environmental opportunities. Social criteria examine how a company treats people, which includes work conditions, health, and safety, as well as diversity and equal opportunities. Lastly, Governance criteria encompasses items that relate to how a company is governed, for example tax practices and strategy and, crucially, board quality and effectiveness.
What is the purpose of ESG investing?
There was once a consensus that the main objective of investments was to maximise short-term return for shareholders without regard for other factors like social and environmental impacts.
However, today, with the strong emergence of several key trends from climate change to social unrest exhibited through movements such as Black Lives Matter, and, as the world continues to fight a global pandemic, the consideration of ESG factors is more integral than ever. ESG investing is backed by the simple idea that companies are more likely to succeed and deliver strong returns if they create value for all their stakeholders – employees, customers, suppliers, and wider society (including the environment) – and not just the company owners.
How is it done?
There are many ways to incorporate ESG strategies into a portfolio such that there is not a “one size fits all” approach.
ESG Strategies include:
· Negative/Exclusionary Screening: This is one of the most popular ESG strategies which excludes, from the investment universe, certain sectors or companies involved in activities deemed unacceptable or controversial. Examples include tobacco, firearms, and weapons etc.
· Positive Screening: Investment in sectors, companies, or projects selected for positive ESG performance relative to industry peers. For example, an equity fund that invests in oil & gas companies deemed to be least carbon intensive.
· ESG Integration: This is when an investor takes into consideration a company’s ESG profile as part of its financial analysis when considering whether to buy a stock. This analysis can be done independently, and then there are also several agencies that provide research and issue ESG “scores.” The priority for this strategy remains financial performance.
· Impact investing: Targets a measurable positive social and/or environmental impact. Investments are generally project specific and are focused on having the greatest possible societal reach. An example could be a community investment fund that provides micro financing to low-income or disadvantaged communities
· Active Ownership: Entails engaging with companies and voting company shares on a variety of ESG issues to initiate changes in behaviour or in company policies and practices.
Investing sustainably is not without its challenges, especially as it is a fairly new concept.
Lack of Standardisation
One of the biggest challenges it faces is the absence of standardised ESG definition. Although, the acronym itself can be defined, the financial services industry and bodies have yet to find consensus on what makes an ESG product, leaving scope for misunderstandings and different interpretations. This has allowed some contenders to put the ESG label on their products whilst not fully mirroring ESG principles which is known as “greenwashing”. Essentially, it refers to dishonest or deceitful marketing about a company or product’s environmental impact.
For example, McDonald's switched to paper straws in 2019, but it turns out the straws cannot be recycled due to the UK's recycling infrastructure. However, even if they could be recycled, the cups they serve their drinks in are plastic-lined, hence they have not solved the problem of single-use plastic and merely used the switch as marketing propaganda.
However, when ESG ratings agencies created thresholds and criteria for ESG performance, they were faced by what is known as “green box ticking”. This is where investment managers are keen on getting high scores from the ESG ratings agencies that they devote much of their energy towards satisfying the specific criteria as opposed to taking a holistic approach that is much more impactful towards the planet and society.
ESG Data Quality
Many of the ESG strategies mentioned above, especially Positive Screening and ESG Integration, rely on sourcing quality ESG data which remains a significant challenge for investment managers.
First, only a fraction of companies choose to report sustainability information. Another fraction is exploiting the weak regulation surrounding this topic, reporting selectively on areas of strengths, and brushing areas where little progress has been made under the rug.
On the positive side, some players are taking a proactive approach, preferring not to wait for regulators to introduce stricter self-disclosure rules for companies. In April, the world’s largest asset manager Blackrock and technology titan Microsoft announced joint research grants to improve ESG data quality. One month later, State Street said it planned to bring together a “critical mass of asset managers” to work on climate data.
Although ESG is loosely regulated, the European Commission may have found a solution to the turmoil marking a significant milestone in the sustainable finance market.
On 12 July 2020, the EU Taxonomy came into force, which establishes a framework by setting out four overarching conditions that an economic activity must meet to qualify as environmentally sustainable. It is expected to create security for investors, protect private investors from greenwashing, and help companies to plan the transition towards a sustainable future.
In the years to come, it will be interesting to see the effectiveness of this framework and whether other global powers will follow the footsteps of the EU to reach a unified global stance on ESG requirements, solving such crucial challenge once and for all.
One of the biggest debates that surrounds ESG investing is how it impacts returns. Traditionally some argued that taking this approach could mean sacrificing returns.
But research suggests otherwise.
Fidelity analysed 2,660 firms for its Putting Sustainability to the Test report where it found that stocks with the highest ESG rating scale outperformed those with weaker ratings in every month from January to September, apart from April in 2020.
It stated: “Overall, we’re pleased to observe the relationship between high ESG ratings and returns over the course of a market collapse and recovery, supporting the view that a company’s focus on sustainability is fundamentally indicative of its board and management quality"
A Win-Win Proposition?
BlackRock, wrote an open letter this year reinforcing that “sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors.” This implies that over time, more virtue equals more money which sounds like a win-win proposition.
Although this appears to close off the debate, Robert Armstrong from the Financial Times disagrees where, in his “The fallacy of ESG investing” article, he suggests that the win-win proposition is illogical as “sometimes investors have to choose between their values and their pocketbooks.”
Let me know what your take is in the comments!
Also, if you are interested in learning more, I would strongly recommend watching the Bruin Financial ESG webinar series, here, which I found really useful.