Understanding ESG Investing

Written by Ben Waite

 As the world grapples with environmental, social, and governance (ESG) issues, the investment landscape is evolving. ESG investing, also known as sustainable, responsible, or ethical investing, has emerged as a strategy that considers sustainability factors alongside financial returns. Here's a comprehensive guide to understanding ESG investing and its key components:

 

What is ESG Investing?

 ESG investing integrates environmental, social, and governance factors into investment decisions. These factors encompass a wide range of issues, including:

  • Environmental: Carbon emissions, climate change, clean technology, sustainable agriculture, and more.

  • Social: Labor standards, human rights, diversity and inclusion, community relations, and ethical product sourcing.

  • Governance: Business ethics, board diversity, anti-corruption measures, corporate culture, and transparency.

 

How ESG Investing Works

 ESG funds aim to maximise financial returns while aligning with their ESG investment strategy. There are various approaches to ESG investing, including:

  • Screening Investments: Funds may employ negative screening, excluding investments that don't meet certain ESG criteria, or positive screening, seeking investments that satisfy specific ESG criteria.

  • ESG Integration: Funds consider ESG risks and opportunities in their investment decision-making process for each asset.

  • ESG Impact Investment: Funds invest to achieve specific ESG goals or outcomes, such as clean energy or affordable housing.

  • Corporate Engagement: Funds may engage with companies to influence positive changes in their ESG practices.

 

Key Considerations Before Investing in ESG Funds

 Before investing in an ESG fund, it's essential to ask critical questions and evaluate the fund's:

  • Investment Product Labels: Understand the terms used to describe the investment product and ensure they align with your understanding of ESG.

  • Investment Strategy: Review the fund's approach to screening investments, ESG integration, impact investing, and corporate engagement.

  • Alignment with Your Goals: Consider how well the fund aligns with your ESG priorities and investment objectives.

  • Management and Fees: Assess the fund's management style (active or passive) and fee structure to determine the associated costs.

 

Performance and Challenges of ESG Investing

 Recent analysis indicates that ESG funds outperformed non-ESG funds during market turmoil, such as the COVID-19 crisis and broadly tracked the S&P500 from 2021 onwards. However, challenges do still persist, including: 

Reliability of ESG Ratings:

ESG ratings can be subjective and vary between providers, making it challenging to assess companies' sustainability performance accurately.

 Despite the positive performance of ESG funds, there are concerns about the reliability and transparency of ESG ratings, which are often criticised for their lack of correlation to share price performance. Many investors, including large institutional ones, do not rely solely on ESG ratings but integrate ESG considerations into their own valuation frameworks. However, smaller investors often rely on ESG ratings or invest in products based on them.

 ESG rating providers gather data of varying quality from different sources and use models to calculate composite scores, leading to discrepancies in ratings among providers. This lack of consistency undermines the effectiveness of ESG ratings in assessing sustainability risks and determining investment decisions. While some jurisdictions are working to redefine ESG ratings and improve methodologies and transparency, it is thought that the future of ESG investing may rely on rating agencies providing reliable raw data for investors to integrate into their assessments of company prospects. 


Decline in Shareholder Activism:

Asset managers' support for shareholder resolutions on environmental and social issues has declined, raising concerns about the commitment to ESG principles.

 ‘ShareAction’, an advocacy group, notes that only 3% of the environmental and social resolutions examined in the past year received majority support, marking a concerning trend.

 Major asset managers such as BlackRock, Fidelity, Vanguard, and State Street have been notably reluctant to back such proposals compared to previous years.

 ‘ShareAction’ suggests that if these asset managers had supported more resolutions, many would have passed. However, asset managers argue that some activist shareholder demands are overly demanding and may not promote long-term shareholder value.

 There's a geographical discrepancy in voting patterns, with European financial institutions increasingly expected to disclose ESG impacts, while US counterparts have faced criticism from Republican politicians for being too vocal on ESG issues.

 

Focus on Social Impact:

ESG investing typically involves excluding companies that fail to meet certain environmental, social, and governance (ESG) criteria, following the "do no harm" principle. However, some investors seek to go beyond this and invest for social impact.

The distinction between investing for climate impact, which benefits everyone, and investing for social impact, which is more targeted towards specific groups, such as underprivileged children or people with disabilities. Social problems often involve complex issues, such as homelessness requiring not just housing but also employment and mental health support. Many investors may not directly solve these issues, they can intervene to support better outcomes for people through funding.

In terms of opportunities for impact investing, the Albanese government plans to leverage the $3.4 trillion super industry to deliver 30,000 new social and affordable housing properties, including homes for frontline workers and victims of domestic violence. However, super funds are advocating for more favourable tax concessions to enable the expansion of commercial build-to-rent housing into a broader market offering, potentially opening up new avenues for impact investing in the housing sector.

 

ESG Index Return against the S&P 500 index 2021-2024

Source: Financial Times

As the ESG investing landscape continues to evolve, investors should stay informed, ask questions, and align their investments with their values and long-term financial goals. By understanding the principles of ESG investing and conducting thorough due diligence, investors can contribute to a more sustainable and equitable future while pursuing financial returns. If you would like to learn more about ESG investing, please do not hesitate to contact our qualified Financial Advisers.

Jenni Anderson