'ESG' funds that integrate environmental social and governance criteria into how they select investments are not 'fluffy'. They are not necessarily designed to 'do good'. They are about improving risk-adjusted returns.
Sitting in a conference on climate change recently, I was struck by the persistent perception that ‘ESG’ is about ethically responsible investment. That it is designed to ‘do good’ rather than generate outperformance. This is perhaps the biggest barrier to mass uptake of funds that integrate environmental, social and governance (ESG) criteria into their stock selection.
It’s a simple taxonomy problem.
ESG v impact
The issue stems from the fact that, as yet, the evidence to show ethical or impact investments outperform traditional benchmarks is inconclusive. Yet, for ESG, there is a highly compelling and growing body of evidence that shows it outperforms over the long run.
The reasons for this are intuitive.
“If you’re not looking at climate change,
you’re not doing your job as an investor.'
Sandra Carlisle, head of responsible investment,
HSBC Global Asset Management
The difference between ESG and ethical/impact investment comes down to definitions. Ethics or impact investments are designed to ‘do good’, in that to some extent financial returns might be sacrificed in order to uphold a particular belief system or maximise on social outcomes, for example. With ESG, the goal is fundamentally different.
ESG does not start from the premise of ‘doing good’. It starts from the perspective of risk adjusted returns. In this context, ESG is just a way to make a more informed decision and to account for significant risks and opportunities.
Cllimate change - a secular shift
Consider climate change, for example. Globally, governments from all but one UN country have signed commitments to address climate change under the Paris Accord. And even within the US, many economic powerhouse states are still honouring their commitments so policy will change across much of the US too.
Whether you believe in global warming or not is irrelevant. Enough people and authorities do believe and so the top-down, secular direction for policy has been set: the world will transition towards low-carbon solutions. The only big unknown is how fast that transition will happen.
Accordingly, climate risk is now a major issue for all companies all over the world. And, as Sandra Carlisle, head of responsible investment at HSBC Global Asset Management, says: “If you’re not looking at climate change, you’re not doing your job as an investor. The starting position has to be not causing a loss.”
ESG: risk-adjusted returns
So, while ethical or impact investment might start from a basis of doing good, ESG is just about making informed investment decisions that account as fully as possible for known risks (and opportunities, of course).
ESG is not ‘fluffy’ and it’s not necessarily ethical – many highly ranked ESG funds still invest in tobacco, for example. It is designed to maximise the chances of sustainable financial performance. As Carlisle says: “ESG is not a ‘thing’. Sustainability or responsibility are the ‘thing’.” ESG is part of the process of arriving as sustainable or responsible solutions.
This doesn’t mean the two are mutually exclusive. Because ESG takes into account factors like strong governance, environmental and social impact as risks or opportunities, basing investment decision on ESG analysis tends to lead a portfolio towards a more socially responsible profile.
The point, however, is that ESG investment doesn’t mean giving up financial return. Quite the opposite. It means protecting financial performance by selecting assets whose return streams are sustainable. As such, given the powerful secular shift towards low-carbon solutions globally, it is intuitive that companies that are well prepared for that future scenario stand a better chance of outperforming those that aren’t.
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A quick cuppa with Faith Ward, Chief Responsible Investment and Risk Officer, Environment Agency Pension Fund