Environmental, Social and Governance (ESG) investing is a relatively-new name for something that isn’t new at all.
Ever since stock markets were first established, investors have considered their own personal values when making an investment decision. Wanting to do good – and not do bad – has always been part of human nature.
Perhaps the oldest term relating to this phenomenon is “ethical investment”.
It stretches back to the early nineteenth century and the idea was pioneered by religious movements in America.
Many church grandees considered the stock market a form of gambling --- it was therefore taboo.
However, after a period of investigation and reflection, the Methodist Church decided it would start to invest in markets in the early 1900s.
The New York Stock Exchange traded its first securities in 1792, so equity markets were avoided by American churches for more than 100 years after they first opened.
Although investing in shares was not then regarded as an unethical form of gambling, investment in companies operating in certain areas was prohibited --- these were mainly businesses involved in alcohol or gambling. The Quakers soon followed the Methodists and started investing in stocks, but weapons manufacturers was the sector they chose to avoid.
The Swinging Sixties gave us “socially responsible investing” with investors excluding individual shares or entire industries based on business activities such as weapons production. Indeed, it was the Vietnam War that prompted the launch of the world’s first ethical fund.
The Pax World Fund was set up in 1971 after outrage at American companies involved in the manufacture of Agent Orange.
This herbicide, which was used by the US military to clear forest canopies in the long-running war, had some pretty nasty effects –- babies were born deformed and there were higher cases of leukaemia, Hodgkin's lymphoma, and other kinds of cancer in US military veterans that fought in South East Asia.
The apartheid regime in South Africa accelerated the promotion of ethics in investment during the 1980s. Many people wanted to avoid funding the regime or any companies that were prepared to do business with Pretoria.
Investing by exclusion
The most significant thing about all these examples of “ethical” portfolios is that they were all investing by exclusion. They were writing off companies – perhaps for just one particular issue – without examining the businesses’ direction of travel. This means investors could be missing out on potentially great investments.
ESG is a natural evolution of this approach, but it will come with a turbo-charge. ESG investing is not about exclusion alone – it benefits from being much more nuanced than that. It moves away from a pure negative-screening approach, instead focusing on companies that are taking positive actions to manage these issues or transform their business to significantly improve their ESG score in the future.
The areas covered are as follows:
- Environmental criteria examine how a company performs as a steward of nature.
- Social criteria consider how the business manages relationships with employees, suppliers, customers, and the communities where it operates.
- Governance deals with a company’s leadership, executive pay, audits, internal controls and shareholder rights.
ESG investing adds nuance to the blunt methods of the past. Instead, investors assess the opportunities and risks that the E, the S, and the G factors pose to an investment in any sector. It involves really getting under the bonnet of a business and looking at issues that have previously been ignored. This is often done with the aim of identifying those companies that are better placed than their peers, or ‘best-in-class’ within their sector.
For example, a polluter with a rapidly-declining carbon footprint as its business practices change may have a higher ESG rating than its competitors, and an investment firm considering ESG risks will factor this into its decision making when deciding whether an investment represents good long-term value for the client’s portfolio.
A management that focuses narrowly on the immediate interests of its shareholders, and fails to manage its non-financial risks, could do serious damage to their business. A failure to consider ESG factors is more likely than ever before to be found out, with all the sanctions, reputational damage and loss of licences, customers and revenues that could potentially follow.
It’s not just regulators that are driving this ESG trend. It is being driven by investors themselves – both institutions and private individuals.
That’s because people are becoming more aware and informed about these issues– and the important part that large companies can play in improving, or exacerbating, the problem.
Unlike the “exclusion investing” of the past, adopting an ESG approach does not necessarily mean acceptance of lower performance. This is because -- in theory at least -- companies that demonstrate their awareness of ESG principles are more likely to have higher standards of corporate governance, which should translate to improved resilience in adverse economic conditions.
ESG is not merely a welcome addition to an investors’ tool kit, it is an issue that will significantly impact the valuations of many listed companies.
As more investors choose ESG benchmarks over traditional indices, the difference between being an ESG “winner” and “loser” could become much more meaningful.
This focus on ethics in investment, kicked off by Methodists and Quakers almost two centuries ago, is now becoming mainstream best practice. Their small germ of idea they planted 200 years ago on the other side of the Atlantic has now grown into a mighty oak.
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