ESG investing more important than ever

Many investors are interested in the impact of their investments on the world around them, as well as in the financial performance of the companies in which they invest.

| 6 min read

Next year, the investment industry in the European Union (EU) will be under a regulatory requirement to take Environmental, Social and Governance (ESG) matters into account when making investment decisions about how to generate the best return for the amount of the risk the client is willing to accept.

The EU’s "Regulation on sustainability-related disclosures in the financial services sector" comes into force on March 21 next year. Whilst the duty to seek good investment returns taking into account risks remains central, the manager will also need to consider the impact poor management of ESG matters can have on shares in a company.

It defines sustainability as "good governance and the precautionary principle of do no significant harm, neither environmental harm nor social harm". The aim is for investment to reinforce its ambition to build a circular low-carbon economy. The UK too wishes to encourage ESG informed investing.

Nothing particularly new

At Charles Stanley, we have been looking into these factors when making investment decisions anyway. It is canny investing to identify risks that come from poor management of a company or from the way it could alienate its customers and the wider communities it serves.

We have seen in recent years the big damage to share prices from the Volkswagen emissions scandal and the BP and oil service industry's problems with the Deepwater Horizon well blow out in the Gulf of Mexico. When companies make large and public mistakes, they end up paying plenty of compensation, suffer reputational damage and spend more on improving their management and governance to prevent a repeat.

All of us are learning how to be more formal in the way we look at these issues and report them to clients. It is no longer satisfactory to rely on common judgements and rumours that Company A is broadly well-intentioned and company B sails close to the wind.

Analysts are combing through much reported data and finding indices and published figures that give insight into how well run and how risky a company is. Rating agencies are providing quantified data summaries of how well companies do. MSCI, for example, rates all main companies relative to their sectors in ESG factors, and awards scores ranging from AAA to CCC as indicators of risk. As more and more people worry about these matters, so we may find further outperformance of the companies that emerge relatively well from such an exercise.

A world of issues

The three main headings of environment, social and governance matters contain such a varied range of issues that a company may score well with one but badly with another. An oil company which emerges badly over carbon dioxide and climate change matters may have excellent governance and good employee relations. An electric car company that is dedicated to cutting CO2 may get a bad score for its board or for it attitude to customers and staff. Whilst the index makers are keen to find objective facts to inform the ratings, there is of course a big element of judgement in what factors are included and how they are assessed.

Some individuals with strong views on ethical investing want to go further than having a good score on ESG matters and knowledge that the investment manager is taking these things into account. They may wish to express a strong preference against various activities they dislike. If they have a discretionary portfolio then, of course, they can block investment where they wish. This may cost them performance if they avoid investment in areas that do well.

Charity issues

Charity Boards cannot express personal preferences in the same way but can direct against investment in areas that conflict with their charitable purpose. Some medical charities for example want to ban tobacco investment. Some green charities who are very concerned about climate change wish to ban investment in any producer of oil, gas and coal, however well run they may be or whatever journey they may be on to reduce their dependence on carbon fuels. Some religious charities want to ban investment in manufacturers of aggressive weapons of war. Trustees need to take advice to see how far they may go in limiting the investment pool they can draw on.

The EU approach will require investment managers to spell out what their policy is to integrate sustainability into their investment process and ensure good reporting of the ESG impact of the chosen investments. Ratings agencies are producing guides to company performance based on data which managers can use to choose their shares and report to their clients the results.

It is likely as we go into the next year that more managers will want to show compliance and will wish to reflect some of the trends this is likely to encourage. The green or environmental part of this movement is anyway being boosted by public policy and the likelihood of a Biden win in the US. Investors are also very concerned about corruption and company management that cuts corners in everything from health and safety to employee relations, so managers need to consider the ‘S’ and ‘G’ as well as the ‘E’ seriously.

Companies scoring well on ESG have, in aggregate, gently outperformed this year and may continue to do so as we approach implementation time in Europe. This week, the EU Council took another step towards accelerating the EU’s progress to net-zero carbon. This will be a dominant influence on investments over the next few years, as carbon fuel-related investment is wound down and written off, and green investment is subsidised and expanded.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

ESG investing more important than ever

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