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Ben Dear, chief executive of Osmosis Investment Management, explains why environmental, social and governance considerations are taking the world by storm and outlines some of the pitfalls to watch out for
ESG investing is about doing good with your investments. With increasing focus on climate change and global inequalities, investors are caring more about the potential impact of their investments.
At a high level, it involves investing more in those companies that are doing good in our world and avoiding those that are not.
ESG refers to a set of non-financial measures that are used to assess a company’s sustainability and societal impact. These factors can include environmental aspects such as carbon emissions, waste management and resource consumption, as well as social factors such as employee relations, human rights and diversity. It also applies to community involvement and governance factors which evaluate a company’s leadership structure, board independence, executive compensation and transparency.
ESG investors seek to invest in businesses which demonstrate positive ESG performance, as they believe it can lead to better risk management, improved financial performance and long-term value creation.
ESG used to be considered a niche area of investing but all that has changed. There is now US$1.8 trillion invested in the ESG market and addressing it is becoming mainstream for both businesses and consumers.
NOT TO BE CONFUSED WITH ETHICAL INVESTING
Socially conscious or responsible investments are not a new phenomenon. In fact, terms such as ethical investing, socially responsible investing and impact investing are often used interchangeably.
It is important to remember, though, that from an investment perspective they describe heterogenous investment approaches that have key differences which will influence the outcome of your investments.
Socially responsible investing aims to invest in a socially conscious way to avoid doing harm and to bring about positive social change.
Ethical investing is the practice of allocating capital based on ethical or moral principles.
Impact investing, on the other hand, is more focused, aiming to generate a measurable beneficial impact to the environment or society.
ESG investing, meanwhile, encompasses many different factors and refers to a broader concept of considering the earth’s ecosystem and each criteria covers a wide-ranging set of distinct challenges.
Confused? You’re not the only one. What is and isn’t considered ESG, and the merits of different approaches, has occupied an entire industry for the past few years.
Let’s take an example. A socially responsible investment fund and an ethical investment fund sound relatively similar at the outset, but the first fund’s selection criteria might avoid addictive substances while the second fund might shun animal testing, giving two substantially different non-financial outcomes.
An ESG investment, on the other hand, aims to have a broader appeal. It involves incorporating multiple factors into investment decisions across all three metrics to assess the long-term sustainability of a company.
ARE ESG AND ETHICAL FUNDS HIGHER RISK?
In the early days of investing responsibly, fund managers and investors may have considered it risky to invest in these types of funds or investments. This was particularly the case with some ethical funds that may, by definition, have a limited investment universe.
However, as ESG has become more mainstream, more sophisticated investment solutions have been developed and there are some good examples of funds in this sector performing as well as, or even better than, their mainstream peers. Of course – as with all investments – you need to choose wisely, and past performance is not a guide to future returns.
WILL ESG INVESTMENT MAKE ME MONEY?
At the heart of ESG investing is the simple idea that companies are more likely to deliver better value for their shareholders and have a more positive impact on society as a whole.
It is difficult, for example, to argue that companies which have considered and prepared for the significant implications of climate change will not be better prepared for future shocks than those that have not.
Similarly, on the social side, we have seen many examples of companies called out for bad practices, perhaps at an employee level or through their supply chains. Reputational damage is not good for share prices and can have significant implications for a company’s future profitability.
Ultimately, though, as with more traditional forms of investing, whether you improve your investment returns will depend on the approach, manager and solution you choose.
DIFFERENT APPROACHES
The broad nature of ESG, coupled with the different priorities and risk profiles of investors, means there is no ‘one-size-fitsall approach’ and ESG considerations can be incorporated into investment portfolios using different methods. Three of the main approaches to ESG integration are:
Divestment: This investment approach strictly excludes certain categories – a typical example might be fossil fuels – from the construction of the portfolio.
Active engagement/stewardship: This approach focuses on voicing concerns to shareholders and voting either for or against resolutions presented by the companies in question at their annual general meetings.
Best in class: This involves using positive or negative tilts, avoiding the worst performers in the investment selection process while selecting those you believe are ahead of their peers.
Challenges facing ESG investors: As a relatively new concept with a relative lack of regulation, there are a number of challenges facing ESG investors today.
1. Lack of standardised metrics: One of the primary challenges for ESG investors is the lack of standardised metrics and reporting frameworks. There are numerous ESG rating agencies and indices, each of which have their own methodologies and criteria, making it difficult to compare and assess companies consistently. This lack of standardisation hinders transparency and increases the complexity of ESG analysis.
2. Greenwashing: Greenwashing refers to the practice of presenting a company’s environmental or social initiatives as being more significant or effective than they truly are. It is important to choose an investment manager who is able to differentiate between genuinely sustainable companies and those engaging in greenwashing. An in-house research function is important.
3. Data quality and availability: Obtaining accurate and reliable ESG data can be a significant hurdle for investors. Many companies do not disclose detailed ESG information, and the data that are available may be inaccurate or incomplete. Again, choosing an asset manager with a proprietary research capability should help with this.
4. Materiality and relevance: Determining the materiality and relevance of ESG factors to financial performance is an ongoing challenge. While some ESG issues, such as climate change, are widely acknowledged as financially material, there are others where the connection to financial outcomes is less clear.
5. Trade-offs and conflicting objectives: ESG investing involves navigating trade-offs between different ESG factors and financial returns. For instance, divesting from certain industries with poor ESG records may align with an investor’s values, but it may also limit diversification or potentially sacrifice financial returns. Balancing multiple objectives can be challenging for investors with different preferences and risk profiles.
Despite these challenges, ESG investing continues to grow, driven by increasing demand from investors, stakeholders and regulatory bodies. Efforts are under way to address some of the hurdles listed above, such as developing global ESG reporting standards, improving data quality and availability, and enhancing transparency and disclosure requirements. In the meantime, however, investors should carefully consider their choice of ESG investment solution, ensuring that it meets not just their values but also their financial goals.
About Ben
Ben founded Osmosis following the financial crisis of 2008, as he believed that there was an opportunity to change the way capital is allocated as a force for good.
With the intent of growing a globally recognised brand within the asset management industry, Ben sought a sustainable investment solution that would work for the economy and the environment and thus encourage mainstream adoption.
One of the first advocates of a quantifiable approach to sustainable investment, Ben is a regular speaker and panellist on the role of environmental data in the sustainable transition.
About Osmosis
Osmosis launched in 2009, in the wake of the great financial crisis, with a mission to change the way capital was used as a force for good. Osmosis believed that climate change and increasing pressure on natural resources would force companies to implement more sustainable production and business processes and that it would be these ‘resource-efficient’ companies that would outperform their same-sector peers over the longer term. Quite simply, doing more with less would be rewarded.
Today, Osmosis manages over $14bn in sustainable assets and remains majority-owned by management and employees. At the heart of the firm’s philosophy is the belief that targeting better risk-adjusted returns and delivering significant environmental impact do not need to be mutually exclusive endeavours. Through its unique model of resource efficiency, the company has demonstrated that sustainability metrics, if quantifiable and objective in nature, can be applied to mainstream equity portfolios to target better financial and environmental performance. All of Osmosis’ investment portfolios demonstrate significantly reduced carbon, water and waste footprints than their respective benchmarks.
