Environmental, Social and Governance (ESG) investment is on the increase but many are often confused by what ESG investment means in practice.
World problems creating risk for investment
The world is facing an increasing number of environmental and social challenges. As a consequence, the nature of what makes a good investment has changed. These evolving challenges create a myriad of risks for investors but they also open up the possibility for thinking differently about capital allocation.
There are three major environmental and social forces challenging the investment landscape; climate change, the growth in inequalities and unsustainable consumption patterns.
Climates are changing: we are constantly exposed to rapid changes in weather patterns.
San Francisco, British Columbia and Delhi all reported all-time high record temperatures this year. Other unusual weather occurrences including storms, flooding and giant hailstones across Europe and Asia, and typhoons and hurricanes across the Far East and Americas have been prevalent in the media this year. As the cause is associated with the rise in carbon dioxide in our atmosphere from industrial activities, this poses a risk for any company exposed to heavy carbon industries.
The inequality gap is widening: the gap between the ‘haves’ and the ‘have nots’ is growing and is driving social pressures and trends. The pressure on companies to ensure they are not exacerbating this gap, as well as the pressure to demonstrate a ‘purpose’ and deliver more than just a financial return, needs to be factored into investment considerations.
Consumption is unsustainable: we also continue to consume at unprecedented rates. This year, earth overshoot day (the day we have used more from nature than we can replenish in a year) occurred on 29th July, two days earlier than in 2018. All companies consume natural resources and they need to manage how they do so, as natural resources become scarcer and harder to access.
Companies cannot operate in isolation. What they do, what they make, the services they provide, and how they treat their stakeholders and communities all affect their ability to continue to operate freely, and influence their ability to return cash to shareholders.
ESG Integration is a process
This is where ESG integration plays an important role in investment. ESG integration is not making a moral judgement about an investment but rather thinking about ESG issues in relation to how they would affect a company’s ability to generate sustainable returns. ESG matters should form a holistic part of understanding the risk processes, governance mechanisms and operational standards of any company. Corporate scandals from the past demonstrate how material poor risk management, operational control, culture and governance structures can be. Examples include BP’s Macondo oil spill, Enron’s business ethics, Nike’s accusations of child slavery in factories, the Volkswagen emissions scandal and Facebook’s data privacy issues.
The rise in legislation relating to single-use plastic, a growing move away from fossil fuel use and providing access to basic services are all examples of ESG trends. Investors need to understand how these themes affect different sectors as well as individual companies. Assurance needs to be sought that investments have well established governance frameworks, strong board composition, risks assessments, policies, audit mechanisms and target setting relating to key ESG factors.
While ESG integration is about making better informed decisions, there is another aspect about ESG investment worth exploring. Beyond risk management, there is a growing desire to think about capital allocation strategies that support sustainability objectives. While the world faces significant challenges, it is worth remembering that problems often drive innovation, opportunity and encourage the belief that you can make money and make a difference.
More recently, the UN Sustainable Development Goals (SDGs) have been established which identify key problems that the UN wants to address before 2030. These goals can be used to establish investment strategies, and Socially Responsible Investment (SRI) funds, focused on driving investments into those companies that are helping to provide tangible solutions and develop business activities in a way that support the goals.
Over the past 30 years, we have seen a spectrum of capital developing that incorporates environmental and social aspects into investment strategies driven from a set of values and sustainability beliefs. This ranges from the integration of these factors into mainstream investment analysis, through to using ESG factors to develop sustainable investment strategies that focus more on how investments benefit society and contribute to the solutions the world needs, to solve the issues and problems we face today. The Impact Management Project developed a spectrum of capital that considers how investments can fall into three areas: avoid harm (reduce risk), benefit stakeholders and contribute to solutions. The chart below provides examples of how this spectrum can be applied if you were to invest in a specific sector.
Two methods to gain from developments in ESG
The awareness of environmental, social and governance issues has risen yet investors can be confused with the terminology and its application. ESG factors can be used in one of two ways – the first is within the investment process; to ensure a better understanding of the ESG issues that impact investments and so to drive change for a better financial return. The second is to create a ‘socially responsible’ outcome or product where the investment strategy embeds greater considerations of sustainability factors. In conclusion, we see sustainable investment influencing ways that capital is allocated, as well as how sustainable returns can be created.
Global Head of Responsible Investment –
Aberdeen Standard Investments
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