Another day, another chapter in the active v passive debate. Yes, that old cherry keeps rumbling on, but when it comes to environmental, social and governance criteria (ESG), and sustainability more broadly, it really is worth looking again at the value proposition.
Why does this matter? Because of the importance of the pricing signal – in other words, using the capital allocation process as a way of signalling to companies that those with more sustainable business practices will be rewarded with better share prices.
There are essentially two ways investors can influence companies to improve their business practices: stewardship and valuation.
Stewardship is the most direct mechanism. Portfolio Manager A talks to Company B, asks questions about how the company might improve their record, a constructive dialogue follows, and then Company B goes away and takes some positive steps to improve. Portfolio Manager A has subsequently influenced the company to improve its record on ESG issues. Reality is of course rarely this simplistic, but the key part of this process is the dialogue and direct interaction between the investor and the company.
The other way investors can influence companies to improve their business practices is through the pricing mechanism. If enough fund managers are using ESG criteria in their stock selection process, then we should see a feed-through effect in stock prices so that companies with better ESG scores start to outperform those with low scores.
This is a vital step in the mainstreaming of ESG and sustainability because, if this pricing signal is working, then the risks and opportunities associated with extra-financial factors would automatically be captured in the stock price. By extension, investments managed passively against traditional market-cap benchmarks would capture the same information. And, at that point, investors no longer have to make a conscious choice about whether to integrate ESG into their portfolios or not. It would already be built in.
So how do we get to that point?
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A quick cuppa with Faith Ward, Chief Responsible Investment and Risk Officer, Environment Agency Pension Fund