ESG investing stands for Environmental, Social and Governance based investment approach. In a nutshell it is about avoiding or reducing investments in companies that score poorly on these parameters and increasing the same in companies that do well on them. For example, a company that runs several coal-fired power plants is likely to score negatively on environmental attributes while another company that helps poorest section of the population with access to credit is likely to score positively on the social parameters.
The unusual clubbing of E, S and G
In common practice and academia, environmental science and social sector studies do not quite go hand in hand. Governance is yet another domain in itself – closer to corporate finance than either of the other two. However, in investment world, ESG has become a bit of a catchphrase. This speaks of the ignorance of these attributes by the investment managers in the past. The fact that E, S and G are clubbed together to signify awareness of factors beyond financial performance already speaks volumes about the single-minded returns-pursuit at all costs by money managers. Nevertheless, it is a welcome change that ESG is even thought about now.
Europe is at the forefront of this change. More than a quarter of institutional money managed in Europe is already ESG-compliant. Also, this proportion is going up. Increasingly, institutional investors in the US too are asking about the ESG status/scores of their investments. Equally important, retail investors are now starting to be aware of ESG attributes of their holdings.
ESG is not exactly an investment strategy
Unlike deep value or equity market neutral, ESG is not exactly a specific investment strategy. It is more of an overlay to an underlying investment strategy – which can even be simple indexing. For example, if one starts with market-capitalization weighted index and then applies ESG overlay to it, one gets an ESG fund. The starting point can also be a value strategy, as another example.
The ESG overlay itself can be applied in one of three ways – negative list, positive list and tilts. In negative list, one removes a given set of companies that are known to score poorly on one or more of the ESG parameters. In the positive list approach, one invests only in a specific sub-universe that has positive scores on ESG parameters above a threshold. The tilt-based approach doesn’t change the starting universe of the underlying strategy but alters the relative weights of various stocks – increasing them for positive scores on ESG and reducing them for negative scores on ESG, both proportionately.
The reason to think about ESG specialist funds or ESG compliant general funds is not for the reasons of superior returns. The idea behind preferring to investing in ESG-compliant stocks is that there is more to running our economy than just making profits. Till recently, companies saw their shareholders as the only relevant stakeholders and sought to maximize shareholder wealth. Initially this seemed to be a sensible approach. However, there are a few reasons why this approach starts to alarm people.
1. Companies often went overboard in pursuit of profits – thus damaging ecosystems (typically far away from their home countries, but not always so), causing pollution and also exploiting human populations (again, typically away from their home countries).
2. Sometimes companies resorted to semi-legal or outright illegal practices to generate profits. Also, even the law-abiding companies chose to follow the letter of the law instead of its spirit. In essence, they ignored everyone other than shareholders. This included employees, communities, customers and vendors. Governance standards kept slipping across the board – ranging from benign but in-spirit wrong accounting practices to outright fraud.
3. Even if companies stuck to their mandate within the law and didn’t explicitly exploit resources or people, their very business models started to seem unsustainable. A coal-based power generator is technically doing nothing wrong by producing electricity by burning coal. However, the negative externality of this on the environment in terms of greenhouse gases is huge. The cost is usually bear by the entire humanity in the form of global warming.
Investors that choose to invest using ESG metrics are essentially telling the companies that they need to clean up their act on all of these parameters. It is an attempt to influence the behavior of the companies through the one stakeholder they listen to – their shareholders!
Does it cost to make one’s portfolio ESG compliant?
While one may think that investing with ESG constraint is likely to reduce returns performance of an equity portfolio, in practice this is rarely the case. There are various reasons for it. The biggest of them is that several companies are actually quite fine on ESG counts – if you leave aside the biggest polluters and poorly run companies, you are still left with a fairly large subset of the investment universe.
Second reason is that a high ESG score is actually good for business in the long run. This is clearest for the governance (G) angle. Companies that have clean accounting practices tend to be transparent and rarely experience shocks to their stock price on account of underdelivering on a false promise – a problem typical of artificially propped up quarterly earnings. The social component of ESG uses metrics like gender equality, employee fairness and such. Here too, companies with better gender equality policies and higher quality of employee engagement tend to perform better over the full business cycle.
Third reason is somewhat circular but yet true. As more and more investors start to become aware of ESG attributes of their investments. Additionally start to refine their portfolios to reflect these scores. Eventually the companies that are higher on these will tend to perform better than those that are lower. This is somewhat of a self-fulfilling prophecy. However, since it will play out over many years instead of months, one can still benefit from it!
Where do I find ESG funds?
There are a few funds that exclusively focus on ESG attributes of their holdings. There are some fund houses that claim that most of their funds are ESG compliant. An investor can choose to go with either of these options for ESG investing.
However, the most reliable and transparent way to keep your portfolio ESG-compliant is to design it yourself. For this, you will need an advisor that can tell you the ESG score of various companies in your investment. At ASQI, we have created a platform that does just this. You can check out the details at MakeMyFund