Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
The ultimate guide to ESG investing
Ethical investing is not a fad. It is becoming increasingly mainstream with figures from the Global Sustainable Investment Alliance showing global sustainable investment topped $30trn in 2018.
Given that regulatory and political pressure is helping to push the environmental agenda, anger is growing over the gap between executive pay and that of ordinary workers, and shareholders continue to count the cost of corporate scandals, all of us need to start thinking hard about these issues.
Once seen as a trade-off between your conscience and your wallet, the good news is there is evidence to demonstrate that including environmental, social and governance (ESG) factors when investing can help boost long-term returns.
For example, the MSCI KLD 400 Social index, focusing on 400 US firms which score highly in ESG terms, has generated annualised returns of 9.8% over the last 25 years against 9.6% for a wider universe of US stocks.
As emerging markets investment guru Mark Mobius, who runs the eponymous Mobius Investment Trust (MMIT), says: ‘By taking ESG factors into account, investors can significantly reduce the risk profile of their investments, which over the long term not only translates into positive risk-adjusted returns, but also positively impacts all stakeholders.’
HOW TO FIND SUITABLE INVESTMENTS
One problem for an investor looking to navigate this emerging space is that it isn’t particularly well defined. Terms like ‘green’, ‘ethical’, ‘ESG’, ‘sustainable’ and ‘impact investing’ are often used interchangeably.
Less scrupulous companies and asset managers have taken advantage of this fuzzy picture by engaging in ‘greenwashing’ – making unsubstantiated environmental claims for their products or services.
ESG IN SUMMARY
– Climate change risks
– Raw materials and water scarcity
– Pollution and waste innovation, clean tech, renewable energy
– Employment policies and industrial relations
– Product and service liabilities
– Treatment of customers
– Impact on communities
– Shareholder rights
– Executive diversity
– Business ethics
– Scrutiny of key directors
But Shares is here to help. In this two-part series we will examine the ‘E’, ‘S’ and ‘G’ of ESG in turn as well as producing our own ESG portfolio of stocks and funds to help spark investment ideas.
While there are clear differences between all three areas, they are often interconnected. For example, BP’s (BP.) Deepwater Horizon rig explosion and subsequent oil spill in the Gulf of Mexico was most obviously an environmental issue but it also had a significant social impact, given the employees killed and the communities affected by the spill, as well as having governance implications thanks to management failings in the run-up to the disaster.
The ability to tap into ESG trends has been made easier as index providers such as MSCI and FTSE Russell have come up with relevant indices such as FTSE4Good and FTSE All-Share ESG.
In some cases, these involve filtering out so-called sin stocks – think arms manufacturers, tobacco stocks, gambling outfits and booze producers – but in others the weighting of shares in the index is determined based on ESG criteria. Investors might be surprised to learn, for example, that Royal Dutch Shell (RDSB) is still the biggest stock in the FTSE All-Share ESG index.
And in recent years a more active approach has developed in the form of impact investing, directing investment towards companies that actively do ‘good’.
Companies must now demonstrate they are being run responsibly and have adopted policies to address environmental issues.
More and more people want to know about the provenance of foods they purchase, labour practices, whether products are tested on animals, if the manufacturing process contaminates the local rivers and so on.
One place to find out if a company is environmentally-friendly is to look at a company’s report and accounts to see if it articulates a policy.
One might think that a company such as Royal Dutch Shell, which extracts fossil fuels, is not environmentally-friendly.
But the question is more nuanced than it appears at first sight. For example, Shell is investing in a network of electric charging stations, so one needs to think about how to quantify this into the equation.
It has also introduced a policy whereby any project producing more than 50,000 tonnes of greenhouse gasses per year must have an energy plan in place. This resulted in a project in Malaysia using solar panels as a source of energy supply and a plant in Qatar using a fuel byproduct to power the plant.
The debate extends to less obvious companies. For example, one might think that Tesco (TSCO) has a large carbon ‘footprint’ due to its large numbers of energy sapping stores and food waste. However, it built the UK’s first 100% carbon ‘positive’ store, which recycles rain water, utilises low power light emitting diode (LED) lights and is powered by solar panels.
BENEFITING FROM THE GREEN SCENE
Many businesses are benefiting from the shift to green investing, and range in activity from solar, lighting, packaging, and even, perhaps counter-intuitively, component suppliers to car manufacturers.
One example is Infineon, an electronics supplier to the global car industry. Its components help cars become more efficient and promote safety. In addition, the rapid move towards electric and hybrid vehicles is a potential bonanza.
A car run on fossil fuels contains around £230 worth of electronic components while an electric car has £700 pounds worth of electronics, a boon for suppliers like Infineon as the market moves towards electric vehicles.
Some listed companies have explicit environmental policies on their websites such as Next (NXT). The retailer aims to reduce energy used, cut back on carbon dioxide, increase energy efficiency and reduce waste by doing more recycling.
Last year, despite increasing floor space, Next reduced its carbon dioxide output by 14% and recycled 95% of waste, which otherwise would have gone into landfill. The company has installed smart building management systems in 97% of its buildings to increase efficiency and reduce usage. It has installed LED lighting and solar panels. Next has also set a target of producing 100% of renewable electricity by 2030.
Another good example is consumer goods giant Unilever (ULVR). Owning iconic brands such as Ben & Jerry’s, Unilever touches a lot of areas which impact the environment from manufacturing plants to packaging.
It has produced a blueprint for what it calls sustainable living, which is the cornerstone of its business activities. It defines sustainability as creating a world where everyone can live well within the natural limits of the planet.
A key pillar of the policy is reducing costs and using key resources more intelligently. Over the last 10 years, Unilever claims it has avoided energy costs in its factories equivalent to saving €490m, while using fewer raw materials and in turn resulting in less waste has saved the company over €260m. The company has lowered water usage through innovations such as low rinse laundry products.
FOUR STOCKS INVOLVED IN RECYCLING
Although best known as a water company, half of its business is in waste management and recycling, through subsidiary Viridor. It has 800 waste collection trucks and operates eight energy recovery centres. It produces enough power to keep the lights on in over 400,000 homes.
Biffa is engaged in collection, treatment, processing and disposal of waste and recyclable materials, as well as turning waste into energy to sell back to the grid. It operates the UK’s largest commercial and industrial waste processing business as well as collecting waste from local councils.
DS Smith (SMDS)
The company is a supplier of corrugated packaging in Europe and plastics across the world. Its packaging is used to transport food, beverages, chemicals and pharmaceuticals among other items. The company boasts that its paper mill in Kent is capable of recycling over 2.5bn coffee cups every year.
Smurfit Kappa (SKG)
A global packaging business with 350 production sites across the globe, Smurfit Kappa has strong credentials as a green company. It replaces all the natural resources used to make its boxes by replanting trees and Smurfit also uses 75% of recycled fibres in its products. The company operates a ‘chain of custody’ whereby it verifies the traceability of suppliers.
TAP INTO FUND MANAGERS’ SCREENING SKILLS
Unfortunately not all companies are this good at communicating their environmental practices; some don’t have a policy at all. That’s why it can pay to use the services of a fund manager when seeking to make investments explicitly linked to good environmental practices.
These fund managers will either have their own screening techniques or they employ a third party specialist to do the hard work.
Liontrust has a three stage approach to its investment process when it comes to constructing its sustainable portfolios. It screens for companies which it considers are negatively impacting the environment, such as miners, airlines, and oil and gas companies. It explicitly excludes investing in companies which have more than 5% of revenues involved in any form of fossil fuel extraction.
The second screening process is more about which companies to include and it has an interesting take on the environmental issue. It believes that the climate change challenge is providing good growth opportunities for some companies, at the expense of incumbents.
It believes investing in companies that are focused on providing solutions to environmental issues is the best way forward, both for a cleaner planet and its investors’ returns.
Finally, the team engage with investee company managements to encourage greater responsibility and to move towards a greener future. The screening process reduces the potential universe of investment candidates in half, but still plenty big enough to construct diversified portfolios.
DIGGING DEEPER WHEN SCREENING
Edentree Investment Management runs one of the oldest socially responsible funds, Amity UK Fund (0937175), which launched in 1988. It too starts its process by employing a negative screen and a positive screen to whittle down the available universe. As one might expect, it excludes companies involved in tobacco, alcohol, gaming, armaments and mining.
It also excludes companies doing business in countries with poor human rights records. It claims that it checks firms’ supply chains and fair trade practices as well as the provenance of raw materials.
It outsources some of the heavy lifting to a company called Sustainalytics, which is a leading ESG and corporate governance provider. It measures companies on a number of metrics to come up with a rating on over 11,000 companies worldwide.
The positive screening aims to identify companies with strong green credentials and then conducts individual research on what it believes are the best companies.
A GROWING MARKET
Asset manager Impax takes a different approach, aiming to give its investors exposure to profitable companies which have material revenues from fast growing environmental markets.
It offers a number of funds and strategies including investment trust Impax Environmental Markets (IEM) which is focused on benefiting from long term themes, such as growing populations, increasing urbanisation and depletion of natural resources.
It invests in small and mid-cap companies which have more than half of their revenues generated by sales of environmental products.
Elsewhere, there are a number of specialist investment trusts which give investors exposure to renewable energy and the environment. For example, John Laing Environmental Assets (JLEN) invests in a portfolio of operational environmental infrastructure projects. Its portfolio includes onshore wind, solar and waste and wastewater processing projects in the UK.
There are also a number of exchange-traded funds which provide exposure to the environmental theme such as iShares Global Clean Energy UCITS ETF (INRG).
INVESTORS CAN REAP HIGHER RETURNS
One upshot of all these trends is the appearance of a new zeitgeist (‘spirit of the age’). A few years ago it was assumed that investing in ESG would lead to inferior investment returns, but that didn’t matter because the primary purpose was to ‘take the moral high ground’. Today that is not the case.
In fact, due to the weight of money now dedicated to ESG, the chances are that companies considered to be ‘green’ are more likely to outperform.
A report by BNP Paribas highlighted empirical data suggesting that strong performance on ESG measures improved corporate financial performance and investment returns.
But, as far as many of the next generation of investors are concerned, the profit motive is not important when compared to wider issues like climate change, as the Extinction Rebellion protests showed. Younger people care about companies behaving responsibly and doing the right thing.
Perhaps the lesser sung of the ESG playlist, experts hope that social factors will start to emerge from the chorus line to take a more centre stage spot in investment selection and performance.
The social leg of the ESG stool has typically focused on areas like worker rights, equal opportunities and gender pay equality but the reality is that social factors are a far more broad a complex collection of issues.
‘Social looks at things like working conditions, including child labour and employee diversity, a business’ interaction with local communities and health and safety issues,’ say experts at M&G Investments.
But while many organisations have made significant strides forward in environmental and governance reporting, measuring social factors has been largely left behind.
THE WEAK LINK
‘The S in ESG has been the weak link in investment analysis so far, and investors have lacked a shared framework to assess companies’ approaches,’ says Sharan Burrow, general secretary of the International Trade Union Confederation, a global worker’s rights organisation.
In a study of 12 leading ESG frameworks in March 2017 the NYU Stern Center for Business and Human Rights found that despite the growing interest in ESG investing, reporting of the social element had failed to keep up with reporting on environmental and governance issues.
‘Measuring things that are complex, multidimensional and sometimes intangible is a unique challenge,’ say study authors Casey O’Connor and Sarah Lebowitz.
‘Social phenomena is inherently reductive in a way that measuring revenue is not.’
Uber refusing to give holiday or sick pay rights to drivers, Facebook selling user data without permission, or a supermarket’s overuse of plastic in product packaging might all be seen as social issues in varying guises.
What they share is a reputational risk to the organisations in question, a breakdown in trust that could cost sales, lose customers and see business partners (such as advertisers) walk away.
HARD FACT AND SUBJECTIVE IMPRESSIONS
The fact that many social issues must be assessed qualitatively rather than quantitatively is another gap in the analysis process.
Lara Blecher, shareholder engagement executive at investor adviser group PIRC, uses low trade union membership as an example. ‘It could be that people feel comfortable enough with approaching their employers so they don’t feel the need to join a trade union,’ she says.
But it could equally be that staff have been bullied away from trade unions and are too scared to do so. ‘Unless you have a good qualitative grasp of the issues, you don’t have a great sense of what’s going on,’ says Blecher.
When it comes to evaluating companies on their toxic waste emissions (environmental) or vulnerability to fraud and corruption (governance), investors now have tools to assist them.
But The NYU Stern analysis shows that social measurement almost exclusively targets efforts, not effects.
‘Only 8% of the more than 1,700 “S” indicators we examined evaluated the effects of company practices,’ say O’Connor and Lebowitz. The other 92% of indicators look at areas like policies or commitments, conducting audits, risk assessments, training or other collaborative and stakeholder engagement actions, but with little or no heed paid to the actual impact they have.
This filters through to limited tools for investors. According to the NYU Stern study just 14% of social ratings products aggregated by the Global Initiative for Sustainability Reporting target investors.
‘This suggests either that investors do not believe these factors are likely to improve investment outcomes (and therefore do not demand social products and services), or that there is something about social factors that make them difficult to package for investor use,’ says the report.
IMPACT ON RETURNS
Understanding what to measure, and how to measure it, is part of the puzzle but social factors’ impact on returns is also to be determined.
That leaves company bosses with an uncomfortable problem; prioritise long-term goals first for the good of the company and broader society, but risk short-term performance that could put their own jobs at risk.
There are also timeframes to be considered. The impact of social investments might take years to manifest themselves. ‘Measuring customer satisfaction levels, or the value of intangibles, such as investment in innovation, brand recognition or culture, are things companies and investors have been able to do, despite their complexity,’ notes the NYU Stern study.
Companies now need to find a way to report progress on social factors and impact ‘in a way that allows investors to see a good trajectory for their investment purposes,’ says Blecher.
NYU Stern authors O’Connor and Lebowitz accept that plenty of heavy lifting is still needed but they remain optimistic. ‘With sufficient demand and ingenuity, there is every reason to believe that the challenge of developing sound, easy-to-use measurements for “S” can be overcome,’ even if it does require a different approach.
The NYU Stern study highlights four areas where companies, and the ESG industry, should focus in a bid to move social reporting forward:
1. Measure real-world effects, not just efforts
2. Diversify the data – the ESG industry should look beyond the information provided by companies, such as data from trade associations
3. Establish and rely upon clear standards for evaluating social impacts. O’Connor and Lebowitz suggest industry-specific frameworks
4. Target investors as the primary audience. Companies and the ESG industry need to package their social data with investors in mind.