An Introduction to ESG Investing
When we think about companies, we tend to see them in terms of the goods they sell or the services they provide. However, these days that view seems rather old fashioned. Companies are far more than just producers and sellers. They are also buyers, employers, innovators and taxpayers. Every company affects more lives than just those of their consumers, and when they don’t take this into account it can have unfortunate consequences.
Companies must make a profit to survive and thrive, but those that prioritise profits over everything else may lead to a disillusioned workforce, a tacit acceptance of human rights abuses in their supply chains and a disregard for their effect on the environment.
More and more investors are beginning to realise this, and are concerned about the activities and wider impact of the companies they are investing in. However, in the past there has been little that can be done about this, as there was little to no transparency about their operations. Now, this is changing, and fast. These concerns have led to a new form of investing, Environmental, Social and Governance (ESG). ESG seeks to encourage companies to operate more sustainably and consider all stakeholders, rather than just focussing on financial returns to shareholders.
The history of socially responsible investing
Ethical considerations around investing are nothing new. In fact, the spiritual predecessor to ESG, Socially Responsible Investing (SRI) has been prevalent since the 1960’s. The first SRI strategies relied mainly on excluding sectors and companies that conducted business practices which didn’t engage with the values of investors. SRI screens may exclude companies which produce all kinds of things ranging from military weapons, pornography, tobacco, alcohol or fossil fuels.
This is all well and good, but there are a few issues with this approach. One is that it may be too exclusionary, not investing in entire sectors means the composition of an SRI fund or portfolio is likely to deviate fairly dramatically from the total market, and so returns are likely to be vary quite a bit from a full market portfolio. These issues have led to the widely held belief that money and morals don’t mix, and returns must be sacrificed to pursue ‘loftier’ goals.
Another issue with this exclusionary approach is that it only judges companies by their role as producers, it does not take into account how they treat their workers, suppliers or their environmental impact. Lastly, simply not investing in certain companies provides very little opportunity for engagement. Companies who are excluded have little motivation to change, as they can simply ignore the investors that are excluding them.
How is ESG different?
ESG seeks to answer all of these problems. It does this by taking a much more systematic approach to investing decisions. It does this by investing in companies based on metrics based on ESG considerations:
- Environmental criteria may include carbon emissions, resource depletion, deforestation, water use, and waste management.
- Social metrics cover diversity of management and workforce, employee satisfaction, gender pay equality, health and safety, and working conditions.
- Governance can be understood by analysing executive pay, corruption and board diversity and oversight.
Generally, sectors are weighted in line with the total market, but the companies that perform best on ESG metrics are weighted higher than those who are not doing so well. This means that a systematic ESG fund will have similar sector weightings to the total market, so returns will be broadly in line with their benchmarks. Companies are also incentivised to compete with each other to improve their ESG metrics, as this will lead to a higher weighting for them in ESG funds and subsequently reduces their cost of capital. Some ESG funds will not invest in the worst performing companies in each sector and may choose to omit controversial sectors like tobacco, coal and cluster munitions.
Shareholder engagement
A crucial part of ESG is shareholder engagement. Investors have a right to share their opinions with companies. Many ESG funds have a policy of having regular conversations with company management to encourage them to take ESG factors under greater consideration.
ESG funds may also use their voting power to bargain with management over ESG criteria. They may also participate in drafting and presenting shareholder resolutions to companies to increase their transparency around ESG issues or to implement a change. This means that by investing in ESG funds, your money could be putting weight behind arguments that would encourage companies to implement real world changes that may be better for society as well as a company’s long-term outlook.
Does ESG affect returns?
Systematic ESG investing should be viewed as a way to invest more sustainably while still achieving close to market returns. However, because of how most new funds are, it is impossible to say with certainty how returns from ESG investing will compare to regular funds over the long run. Despite this, there is a growing base of theory and evidence which looks positive.
ESG investing recognises that governments, regulators and consumers are growing more concerned with transitioning to a more sustainable and fairer economy. These concerns may become regulatory burdens, social pressures and lawsuits, which all pose material financial risks for these companies. By taking this into account, ESG provides a new way to mitigate longer term risks to investments.
Research by Morningstar, published in July 2020, examined the performance of a sample of 745 Europe-based sustainable funds and found the majority of strategies had done better than non-ESG funds over one, three, five and 10 years1.
Growing momentum
Interest in ESG investments (or funds) has skyrocketed in recent years and has been accelerated by the pandemic, where they were sourced significantly throughout the market turbulence. Net assets held in UK-domiciled ESG funds went from £29bn at the beginning of 2017 to £71bn by the end of 20201. If investments into ESG funds grow at 15%, just half the pace of the last five years, they will represent $53 trillion by 2025, more than a third of global managed assets.
Although growing rapidly, ESG investing is still relatively new. Problems still remain around interpreting the data companies share as well as firms who attempt to ‘greenwash’ i.e. make commitments or frame data in misleading ways without supporting their messages with action. However, regulators, investors and ESG ratings houses are rapidly innovating, improving and creating frameworks to ensure the goals of this new form of investing are met to an improved degree.
The EU has recently developed an official taxonomy defining the different levels of ESG integration, while the Securities and Exchange Commission in the US has created a Climate and ESG task force to regulate how both companies and funds disclose and market ESG.
If you would like to know more about ESG investing, please find our in-depth guide here or speak to your adviser.
1https://www.ft.com/greenpensions
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