Climater change has given ESG investing a boost. Photo / NZ Herald
Investment in companies with high environmental, social and corporate governance (ESG) standards is gathering pace, and it's an approach that's here to stay.
United States financial institution MSCI, which supplies investment tools for the industry, defines ESG investing as the consideration of environmental, social and governance factors alongside the usual financial issues when making investment decisions.
Larry Fink, the influential head of gargantuan international fund manager BlackRock, argues that the Covid-19 pandemic has brought ESG into sharper focus for investors.
In his regular letter to chief executives, Fink wrote: "I believe that the pandemic has presented such an existential crisis – such a stark reminder of our fragility – that it has driven us to confront the global threat of climate change more forcefully and to consider how, like the pandemic, it will alter our lives.
"It has reminded us how the biggest crises, whether medical or environmental, demand a global and ambitious response."
From January through to November 2020, investors in mutual funds and exchange traded funds invested US$288 billion ($415b) globally in sustainable assets, a 96 per cent increase over the whole of 2019.
Fink believes this is the beginning of a long and rapidly accelerating transition – one that will unfold over many years and reshape asset prices of every type.
"We know that climate risk is investment risk. But we also believe the climate transition presents a historic investment opportunity," he says.
For fund managers, ESG considerations have become part of their everyday decision making when they choose where to put their clients' money.
The origins of ESG are often said to date back to the US in the 1950s and 60s, when some unions began investing pension capital in affordable housing and health facilities.
In the 60s, anti-Vietnam War protests in the US and the push for peace was not the sole preserve of university campuses. Time magazine, in an article titled "Behind the Anti-War Protests that Swept America in 1968", cited the example of financial brokerage house Paine Webber, Jackson & Curtis, which ran an ad saying that peace in Vietnam would be "the most bullish thing that could happen to the stock market".
Some of the impetus for ESG can also be seen as a pushback against the view espoused by legendary free market economist Milton Friedman, who held that the social responsibility of a business was just to increase its profits.
Environmental disasters of the 1980s such as the Prudhoe Bay, Alaska, oil spill also gave ESG investing a boost.
But fund managers say the ESG investing phenomenon has accelerated in the last year or so.
Matt Goodson, managing director of Salt Funds, says questions about whether a business is socially acceptable have become a big part of funds management.
Companies need to be asked whether they can keep operating with their current cost base, and if there could be significant threats in the years ahead.
"A classic example of that might be [fuel company] Z Energy, where one day when electric cars become cheaper than petrol cars and you see a rapid adoption," he says.
Goodson says investors these days have to think along ESG lines.
Part of that is "negative screening" - filtering out the likes of cigarette companies.
"But increasingly, other companies such as the thermal coal companies and coal-powered electricity and even oil and gas exploration is increasingly starting to come into some negative ESG screens," he says.
"In addition, it's not so common yet but some investors will have negative screens for gambling and most certainly for pornography."
While ESG investing, in some form or another, has been around for decades, Goodson says it has now come into much sharper focus.
Salt Funds has an ESG specialist who engages with companies in a way that encourages positive change.
Behind the scenes, Salt Funds was involved when low pay rates in the aged care sector hit the headlines in 2018.
"One of the ways we engaged with the companies was to say that we thought it would be a good thing - even if it affected company profits in the short term - to do in the medium to long-term for workers and ultimately for your company to lift wages by a decent degree," he says.
"We would not have been the only ones with that message.
"Ultimately, it's the companies that make the decisions, but that sort of positive engagement is an increasingly important part of it.
"Rather than ticking a box, it's much more about what is an appropriate set of questions for these companies or what are an appropriate set of disclosures for the company, and how we can help them deliver on those because the companies really want to know what to do."
While there may have been a degree of initial scepticism about ESG, Goodson says the reverse is true today.
Over time, he sees companies adopting a much more consistent set of disclosure standards.
But one problem with ESG is that people have different ideas of what is and what isn't ethical. There is no universal standard, so investors need to do their homework to ensure they know what they are getting into.
"There are always difficult questions at the boundaries which have to be weighed up," Goodson says.
But investing themes come and go. Could ESG be another passing fad?
"Fads are things that don't last," says Goodson. "ESG standards and a greater focus on adherence to them are here to stay, so I don't think it's a fad at all."
Increasingly, he says, ESG has become an agent for change.
But while ESG investing has gathered pace, so has "greenwashing", when companies are not as squeaky clean as they makes themselves out to be.
"If you are calling something sustainable, then it sure as hell better be," Goodson says.
"For us, the perfect company is something that generates a lot of cashflow and has really good reinvestment opportunities at good rates of return from that cashflow.
"If you are in an industry that is dying because of ESG concerns, or is doing the wrong thing, then those reinvestment opportunities are just not going to happen."
Robbie Urquhart, senior portfolio manager at Fisher Funds, said that when it comes to ESG decisions, things are rarely simple, but through engagement fund managers were more likely to be able to nudge companies in a positive direction.
"Regardless, it's great news that ESG, with all its complexity, is being discussed and debated more," he said.
"Responsible investment managers will always differ in their approach to ethical investing but our goals are almost always the same," Urquhart said. "This bodes well for our future."
This April, New Zealand became the first country in the world to legislate mandatory climate-related disclosures. This will come into effect in 2023, pending final parliamentary approval.
It will apply to about 200 companies: all NZX equity and debt issuers, and all banks, credit unions, insurers and registered investment schemes with $1 billion in relevant assets.
These climate disclosures will be in line with the global best practice set out in guidelines from the international Task Force on Climate-Related Financial Disclosures.
When Devon Funds portfolio manager Victoria Harris started in the funds management industry10 years ago, ESG was barely discussed in meetings with companies.
Now it is.
"At every single meeting there will be comment for an analyst and investor like ourselves on ESG," she says.
"It is becoming more and more prevalent.
"The environmental side of ESG gets a lot of focus and I think that's due to climate change and the risks that that poses to a lot of businesses.
"You can't really invest in a company without really considering it or adjusting for it in your model.
"It's a real risk. Just like increased competition is a real risk and raw material import prices is a real risk.
"It's another piece of the puzzle.
"I think that the direction that we are going in is positive in terms of companies reporting on ESG as well as reporting on their financial metrics."
But like others, Harris is wary of the risk of greenwashing.
"When you have an environment where there is a lot of demand from investors and a lot of focus on this space, you do get companies that greenwash where they want to have access to this pool of money from investors, so they tidy themselves up to look better than they are in terms of ESG.
"I think that is a big risk for unsophisticated investors or the likes of exchange-traded funds that kind of invest blindly.
"Also, the issue that there is no standard of reporting around ESG yet.
"There is a lot of room for error in terms of what is actually a good ESG company and what is not."
With no over-arching body to dictate standards, it's up to the investor to make that call. "Which is all well and good if you are an institutional investor and you have that ability to dig into a company with more detail."
Harris says ESG investment is heading in the right direction, particularly as governments create more frameworks and things such as carbon-neutral targets for companies to measure themselves against.
But investing with a social conscience has its pitfalls, and things can get complicated when it comes to investing in gambling, for example.
And ESG investing can have surprising side effects.
As an example, Harris cites Woolworths Australia's decision to get out of the alcohol business.
In June, Woolworths Australia shareholders voted to split off the company's retail drinks and hotels business Endeavour Group, making Endeavour a standalone, ASX-listed entity.
That left Woolworths as a purely supermarket business, and the market lifted its assessment of the company, because ESG investors could then invest in it.
She says companies are realising that parts of their business, which many not fit the ESG ethos, can act as a drag on the group.
She says things have now reached the point where companies which ignore ESG principles may find themselves starved of capital, while the pool of ESG money gets larger by the day.
"We are seeing the big pension funds saying we are not going to invest in X, Y or Z."
She says funds are also not averse to tapping companies on the shoulder when they see something untoward.
"There is collaboration with other funds if there is a company we don't think is doing something appropriate.
"We feel that there is a lot of opportunity for them to improve if we collaborate with other funds and with other industry bodies such as Climate Action 100 or Responsible Investing Australasia."
But establishing whether a company makes the grade can be a moral minefield, as views differ on what is appropriate and what isn't.
"There is a point sometimes where too much is too much," says Harris. "You have to draw the line somewhere, as you do with any business."
Fund managers say the rise and rise of ESG investing can be partly put down to generational factors, as more and more socially conscious millennials become interested in investing.
"They are the ones wanting not just a financial return on their investment, but also wanting it to have a positive impact," Harris says.
"So I don't think this is going away, but I do think that it is a moving beast and that we are still learning what is the best approach is to make.
"Some of the older guys in the industry are saying that this is the biggest thing that they have seen in the financial markets."
During last year's market meltdown, when share prices plunged worldwide, the expectation was that ESG-centric funds would be starved of investment capital.
Harris says the opposite turned out to be the case, as the flow of money into that area continued unabated. "It made me think that it's here to stay."
Ratings agency S&P Global says the focus on ESG initiatives worldwide has led to an "inevitable and exponential" rise in the volume of green claims made by companies as they attempt to show off their sustainability credentials.
In a report, S&P estimated that issues of sustainable bonds - including green, social, sustainability, and sustainability-linked bonds - could collectively exceed US$1 trillion ($1.44 trillion) this year, five times 2018 levels.
"This growth trajectory is staggering; however, a lack of consistency in instrument labelling and post-issuance disclosure has raised investor fears that sustainability claims made by issuers might be overstated or unreliable - or what's known in the industry as 'greenwashed'.
"With ESG becoming mainstream, key stakeholders, including consumers and investors, have started pressuring companies to demonstrate their ESG credentials either through commitments and actions at the corporate level, the products they offer, or the instruments they use for financing," said S&P Global sustainable finance analyst Lori Shapiro.
"Regulations and principles could also help mitigate environmental, social, and governance (ESG) washing risks, although the road to global harmonisation is long and winding."
ESG had quickly become mainstream, Shapiro said.
Governments and regulators have also introduced enhanced standards and regulations to support increased disclosure and consistency of ESG reporting.
"This ESG push, which has been propelled by legitimate risks and concerns important to market participants, has led to an inevitable and exponential rise in the volume of green claims made by companies in their attempt to demonstrate sustainability credentials to their stakeholder base.
"However, the sheer volume of ESG marketing and labelling, in combination with no uniform sustainability commitments and reporting, has made it increasingly difficult for stakeholders to identify which claims are trustworthy and reliable and which are unreliable - or greenwashed."
The term "greenwashing" was coined by environmentalist Jay Westerveld in a 1986 essay in which he claimed a hotel was encouraging consumers to re-use towels to help protect the environment, when in reality the request was just a marketing ploy to help the hotel cut costs and improve its profit margins.
It gained prominence in the years following, as more consumer and media attention focused on environmental risks, leading to an influx of environmental marketing and product labelling campaigns to capitalise on the growing demand for "green" products.
Over time, the definition of greenwashing has morphed.
"While in Jay Westerveld's example, environmental benefits were still ultimately achieved despite the primary motivation being cost-cutting," said S&P, "concerns about greenwashing have become broader in scope with companies perceived to be making exaggerated or misleading environmental claims, sometimes without offering significant environmental benefits in return."
The mainstreaming of ESG has had an impact on how sustainability factors are incorporated into investment decisions, including at the financial instrument level.
A survey conducted by UK-based Quilter Investors in May, found that when it comes to ESG investing, greenwashing was the biggest concern for about 44 per cent of investors.
According to the survey, investors looking to act more responsibly and minimise their environmental impact have become "increasingly sensitive" to the companies potentially viewed as exaggerating their green credentials to capitalise on the growing demand for environmentally safe products.
In New Zealand, the Financial Markets Authority (FMA) has issued guidance to companies making ESG claims.
"As demand for these types of financial products grows, we want to ensure that investors can be confident these products deliver what they promise and that investors are protected from poor product design and confusing or misleading disclosure and marketing (i.e. greenwashing)," the authority said.
In developing the framework, the FMA is supporting New Zealand's transition to an "integrated financial system" – which not only takes into account financial returns but also non-financial factors such natural, social and human capital impacts.
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