ESG has become an unstoppable force for good
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MILLENNIALS have played a big role in the global trend towards more environmentally and socially supportive, sustainable ways of doing business, but there are now multiple drivers behind its increasing momentum.
In a presentation on investing based on ESG (environmental, social and governance) criteria at the recent Investment Forum 2021, Claire Hedley, executive director of the alternative investment and manager selection division of Goldman Sachs Asset Management, said the trend towards sustainability was underpinned by humanity’s need to address two of the biggest challenges of our time: climate change and social inequality.
Three sets of dynamics are at play, Hedley said. They are:
1. Changing preferences. The impetus came originally from millennials, she said, “who wanted to live, invest and purchase differently. But there is an increasingly widespread change in thinking about what we wear, what we buy, what we eat, and that’s having a big impact on the consumer market broadly.”
But it’s not only consumers, Hedley said. “There’s a shift in how workers engage with their employers – people want to work for companies that have value, that have representation in the community and that look after their workforce. There’s a shift in companies themselves, which are setting ESG targets along supply chains. We’ve also seen asset managers engaging more collaboratively with the companies they invest in; and there’s changing regulation.”
2. Growing consequences. The negative consequences of inaction are becoming far more apparent, Hedley said. Physical climate risks – fires, floods, rising temperatures – are creating “a sense of urgency that we haven’t seen before”. Increased connectedness through social media is driving awareness of these issues.
3. Improved economics: efficiency, innovation and growth. ESG issues are forging greater efficiencies and technological innovation, and for this reason there is a strong case for investing in ESG-focused companies, Hedley said.
Investors are waking up to ESG. Hedley said that almost $3 billion flowed into ESG investments last year, bringing total assets globally, across about 3 000 ESG funds, to about $1.5 trillion.
ESG issues are also now top of mind for corporations, with a “real shift” from being at the periphery of company strategy to being central to it. In two years, there has been a 28% increase in signatories to the United
Nations Principles for Responsible Investing, and last year a survey of Nasdaq companies found that 70% of them had highlighted ESG developments in letters to shareholders.
The social factor has really come to the fore during the pandemic, Hedley said. Social considerations previously seen as a “nice to have” have become a core operational value affecting a company’s bottom line.
“Companies have really had to focus on the health and safety of their workers to get through the pandemic,” Hedley said.
ESG INVESTING 1.0 VS 2.0
Hedley said that ESG investing has traditionally entailed scoring companies on environmental, social and governance criteria, and then selecting those that score highly, or screening out those that do not. But this is a somewhat superficial approach, because the data itself is superficial. For instance, a company might tick the box on a question about whether it had a health-care policy for its employees, but there would be no indication of how beneficial that policy had been for the employees.
“We need companies to publish more data, so that investors can focus on areas of that data that are most material to the company or industry they are analysing. And the areas will be different for different companies or sectors – for example, an engineering company will be different from a financial company.
“With increasing data, we need to focus on those data points that matter more for the investment that we’re making,” Hedley said.
Premal Ranchod, head of ESG research at Alexander Forbes Investments, says the ESG movement has spawned the practice of “green washing”, which investors must guard against.
“Green washing has been used to call out practices that seek to appear ‘green’ or responsible, but on deeper assessment are not entirely so. When companies manipulate financial statements to deflect from poor performance, it is referred to as ‘window dressing’ – hiding the true state of a company from shareholders, lenders and stakeholders.
“In the same way, when the conduct of business has environmental consequences, there could be a propensity to highlight the positive aspects (which might in isolation be true) but ignore the total effect on the environment or climate.
“Humans are naturally wired to focus on the positives, and hence there’s a risk of a bias that impacts investment outcomes and share prices. It becomes more of a risk when a broad economic theme, such as sustainability or climate change, becomes topical.”
So what can investment professionals do to recognise and combat green washing?
A strong analyst, Ranchod says, would consider the following in trying to identify potential green washing:
1. Focus on the evidence, not the narrative or crafty product marketing.
2. Understand well the company, its operations, history, and the sector within which it operates.
3. Make sure that the ESG assessment appreciates financially material risks that are applicable to the entity and sector.
4. Spot selective disclosure practices or generic reporting in integrated reports of companies. “Companies have been found to cherry-pick the ESG risks they wish to show their progress toward, but report thinly on other matters,” Ranchod says.
5. Identify symbolic actions, via marketing or reporting, which draw attention to minor matters without material meaningful action. For example, a global fashion company could donate to charitable causes but not address unfair labour practices in its supply chain, he says.