An evolving roadmap for ESG integration

Sustainability is becoming a bigger issue today for investors precisely because it is becoming a bigger issue for society. In particular, the relationship between society and large corporations is shifting and people’s expectations are shifting with it. 

A good example is climate change where there is a growing expectation that companies should be part of the solution rather than just avoid being part of the problem. This extends far more broadly to include expectations around governance, use of technology and indeed a company’s societal license to operate.

This idea that companies and society are interacting with each other is driving the need for investors to think more holistically and in far more detail about sustainability issues within their portfolios. 

This raises three questions for (retail) investors – while society is demanding more positive accountability, how is this being measured from an investment point-of-view; secondly, does this shift in expectations challenge some of the initial thinking on sustainability; and thirdly, are there longer-term implications of investing sustainably that investors should be positioning for?

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ESG IS A JOURNEY

Much has been written in recent years on how environmental, social and governance (ESG) factors can evaluate a company’s sustainability. Investors are no longer surprised to learn that ESG in some form has been around for decades, even centuries. There is also a growing awareness of the different motives for sustainable investing, from values-based to more practical, as well as the various investment approaches, from exclusions to ESG integration to impact investing.

But even with this growing appreciation of sustainable investing, there remains confusion given the current lack of agreed definitions and standards. It is not uncommon to find that different analysts may have differing views as to the ‘greenness’ or sustainability of the same company. How can this still be?

It is worth remembering that addressing ESG issues is not an overnight fix. The route to improvement, whether environmental, social, or from a corporate governance point of view should be seen more as a journey.

This is perhaps best demonstrated by the recent introduction of the European Green Deal, which has the ultimate environmental goal of making the European Union (EU) a net-zero emitter of greenhouse gases (GHG) by 2050. 

The EU has also advanced legislative proposals to reduce GHG emissions to 55% below 1990 levels by 2030 as part of the roadmap to net-zero by 2050. The ‘Fit for 55’ legislative proposals cover a wide range of policy areas including climate, energy, transport and taxation. The EU Emissions Trading System will also be an important part of the solution.

There are two points that are worth highlighting: the first is that government policy is a key mechanism for driving change. This in turn reflects how societal norms have developed over time and which then gets codified into legislation and regulation – as we are seeing in Europe today. Companies need to be very aware of changes to legislation and make sure that they are on the right side of those policy changes. Investors also need to be mindful that changing legislation and changing policy can have a big impact on portfolio returns over the long term.

The second point is perhaps more immediately relevant to Australian investors – particularly given that Australian climate action ambitions are at a nascent stage – namely that the path to sustainability is a journey. Common standards will evolve and develop and coalesce around those that are the most supported. Don’t obsess on the contradictions or the small print, instead focus on the direction of travel.

It is frustrating and challenging that non-financial disclosures today are not completely reliable, not always consistent or even uniformly verifiable. But this will improve.

There may not be consistency across all ESG guardians and promoters – sometimes with good reason – but they are all adding something to the discussion and taking it forward.

One thing that is clear is ESG awareness and integration across quality fund managers has been far better communicated over the last few years. One needs only consider the commitment to the Principles for Responsible Investment (PRI) by Investment Managers and Asset Owners, with assets under ‘PRI’ management today north of $120 trillion, a figure which has nearly doubled in the last five years.

As this ESG journey develops further, it is possible that some commonly-held beliefs about ESG ‘best practice’ also evolve.

A FIX FOR TODAY OR MEND TOMORROW?

A relatively well-understood approach to ESG investing is to apply a negative screen and exclude companies whose business activities do not meet client-specific values or guidelines. These may include so-called ‘sin stocks’, such as those involved in tobacco or gambling. But perhaps this net of negatively screened stocks (and industries) is now being cast too widely.

There is a risk today that ESG-labelling is winning out over ESG action – after all, carbon divestment has no real ESG impact. It might fix your investment problem, but it does not fix the underlying GHG issues.

ESG is a dynamic space; static definitions risk becoming obsolete. Companies that may score poorly on today’s subjective (and often backward-looking) scale, might be part of the long-term environmental solution. Thinking about divestment in a holistic sense, is it ethical to make your problem someone else’s? Maybe a better indication of an investor’s ‘ESG-ness’ is to mark them on their willingness to engage to effect ESG change rather than just exclude ESG risk.

The reality is that while net zero is a lofty ambition, tackling decarbonisation will require significant capital expenditure.

Partly this will be addressed by government programmes and incentives, but much will also rely on the private sector. And those companies with the biggest incentive to drive change are those in related industries – think integrated oil companies, for example. In most cases, they also have the cashflow to make it happen.

As the thinking on ESG investment, especially the environmental component, matures, the hope is that investors increasingly give due consideration to the full implications of divestment and lean instead towards managing those assets more sensibly – and indeed remove the investment ownership stigma. It is becoming clear that you need to be invested to be part of the solution.

The other incentive is the return opportunity. Not only are these companies out of favour and trading at attractive valuations, they may also provide good access to duration given the required long-life investment of a de-carbonising world. With net zero likely to be a hot topic over the coming months and years – for companies, industries and governments alike – the regulatory and political environment are also likely to be supportive.

INFLATION: THE COST OF DOING GOOD?

A focus on net zero and how we collectively get there also introduces a different investment implication for investors to think about – could ESG-initiatives be inflationary? Sustainability is about accounting for externalities and putting a price on something that used to be free.

For example, think about the EU’s ‘Fit for 55’ initiative. The plans are extremely ambitious and if implemented in full would transform the way economic activity is carried out. But this has a cost to implement. 

The EU’s aim of zero emissions by 2035 for passenger cars and light trucks implies the complete phasing out of diesel and petrol cars in favour of electric vehicles and would necessitate a network of electric charging stations. The imposition of a carbon border tax by 2026 that would tax polluting imports or the push for ‘green’ steel could also raise prices.

If you accept climate change science, then you must adopt these environmental policies. How will society react to higher prices driven by these initiatives as it is almost inevitable that prices will rise in the energy complex? Cash handouts may be offered in conjunction with policy initiatives to ease the burden, especially on lower income households – can all of society afford to be green? 

The inflation debate, especially in the longer term, may hinge on policy change, but an observation from the pandemic policy response is that there is a higher tolerance today for handing out money. If this thinking is carried forward into government support for implementing green policy, then this could also bring an inflationary impulse.

While much of the current debate and implementation focuses on the environmental aspect of ESG, the broader concept of sustainable investing is a movement that is gathering pace. What is apparent is that the debate on ESG is no longer in its infancy and the focus on climate change has become mainstream – indeed ESG is rapidly becoming a ‘hygiene factor’, with ESG integration into the investment process becoming the rule rather than the exception.

ESG does remain a fast-moving environment in terms of implementation. And while there continues to be some frustration with the lack of clear standards, policy roadmaps and associated legislation is providing much more clarity, led by Europe. These will be accompanied by new benchmarks and greater scrutiny on green investments – given the red-hot demand for ESG products, we should not be surprised to learn that definitions around what constitutes a ‘sustainable’ investment are also being handed down to reduce the risk of misrepresentation – or ‘green-washing’.

The direction of ESG is both clear and maturing in terms of the shift away from simple ESG positioning towards more ESG engaged action. It is a journey that will include advisers and trustees in their pursuit of best interest duties as well as investors more broadly. ESG is here to stay and is a long-term factor for all investors to consider. Being green may not be easy, but we have an increasing responsibility to try. 

Charles Stodart is an investment specialist at Zurich Investments.