Environmental, social and governance (ESG) considerations

ESG considerations are changing the investment landscape. Charities are consequently under increasing pressure from stakeholders to draw these considerations into their investment process.

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Nick Murphy
Published: 07 Feb 2020 Updated: 26 May 2022

Environmental, social and governance (ESG) considerations

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Environmental, social and governance (ESG) considerations are changing the investment landscape. Charities are consequently under increasing pressure from stakeholders to draw these considerations into their investment process, a big step up from previous ‘best practice’ of merely adhering to various ethical exclusions. It is vitally important for charities to get this right, or they risk impacting their charitable goals. However, we would argue that incorporating this into an investment process is more nuanced than many believe.

There have been significant and increasing flows into ESG mandates in recent years and this area is becoming a greater priority for institutional and other investors. Companies with ESG solutions are trading at a premium and in the past five years the MSCI World ESG Index has outperformed the MSCI World index by over 10% on a cumulative basis*.

It is also possible to see the phenomenon at work in individual sectors. For example, following the recent attacks on Saudi oil production, the oil price spiked higher on anticipation of supply shortages. The oil majors such as BP and Shell would normally follow suit, but the share prices remained stubbornly low. There seem to be fewer buyers for this type of company today.

Regulation has played an important role. From the Shareholder Rights Directive (SRD) II and Institutions for Occupational Retirement Provision (IORP) II introduced in 2019 to the new UK 2020 Stewardship Code, we have seen ESG regulation expand considerably - with more to come. The Paris Climate Accord targets on carbon emissions can only be achieved with what has been coined as ‘the inevitable policy response’. Responsible investing has established itself as a mega-trend and will become a bigger part of all our lives. It will affect all the companies in which we invest and their customers. Changes to MIFID II will mean that investment managers need to ask each client for their specific ESG preferences and consider them alongside the traditional considerations which make up the suitability assessment.

Many firms are already signatories to the UN supported Principles of Responsible Investment (PRI) and the UK Stewardship Code which has just been revised. Signatories are required to do things like take account of ESG factors when investing, actively engage with companies and publicly disclose voting and engagement. This requires significant commitment of time and resource – for example we have voted** on 8,867 resolutions at AGMs so far this year.

We believe experience matters in this part of the market because incorporating ESG considerations into a portfolio isn’t straight-forward and can have unintended consequences. Investors need to be really clear about the impact of their investment choices and restrictions through the market cycle. This is an immature sector, overloaded with jargon and few widely agreed definitions. For example, one 2017 study (GPIF) of Japanese equities found the correlation in the ESG scores between the different screening services to be only 0.3. Interested parties, such as the European Commission, are working on a taxonomy of environmental factors, but it will take time before there is agreement across all regions and sectors. The ESG scores generated by the screening companies are a starting point for further fundamental analysis not an end in themselves.

Most investors are part way along a journey that moves from a standard investment process, focused solely on maximising returns, through to a responsible and sustainable investment approach (which includes portfolio screening and ESG criteria), to – ultimately - impact investment. Impact investment is still difficult, not least because of limitations over measurement. Mapping outcomes against the UN Sustainable Development Goals is gaining traction for listed equity funds. Imagine trying to measure different interpretations of impact across hundreds of companies and sectors in every region of the world.

There are choices to be made at each stage of this journey. If fossil fuel companies are excluded entirely, should you also exclude the main users of fossil fuels such as power companies? The transition to net zero carbon emission requires as a first step a switch from thermal coal to natural gas, because other technologies simply don’t exist at this stage. Also coal/gas burning utility companies are often the biggest investors in wind and solar energy. Equally, ESG criteria can see a lot of larger companies with high dividends excluded: they tend to have diverse revenue streams and it can be more difficult to be entirely ‘green’. This bias can be managed, but investors need to be aware that incorporating ESG criteria can skew their investment portfolios.

Equally, investors will need to choose between different ‘shades’ of green. This is considerably more nuanced than many believe. For example, companies that score highly on ESG criteria have often already seen a wall of money moving towards them, leaving their share prices high. Investors may have greater impact directing capital to and engaging with businesses in the process of improvement.

A good engagement programme can help push companies forward. Today, BP is the largest provider of electric car points, Scottish and Southern creates wind power, while RWE in Germany has a huge alternative energy business. Divestment often feels like the easiest option, but it is important to look at where management teams are heading and try to support their journey. To our mind, stewardship is key – without it, responsible investing is hollow.

This article was originally published in STEP Journal - Nick Murphy, 'Shades of Green', (Vol28 Iss1), p, 59

*MSCI/Smith & Williamson (5 Aug 2019)
**Smith & Williamson Q3 voting report (30 Sept 2019)

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This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.