Environment, social and governance (ESG) and responsible investment have come of age. Concepts that were once seen as occupying the fringes of investment have moved squarely to the mainstream – yet, with this newly found prominence come challenges.
As with all emerging trends, confusion and misinterpretation surrounding terminology and definitions is widespread and there is some debate over whether this new industry focus is a passing fad or the future of investment.
Given how rapidly responsible funds are being launched and ESG factors are being integrated into the investment processes across all sectors of the market, it would seem the investment industry thinks they are here to stay.
Seismic shift
Three factors have driven this seismic shift in the attitudes of both those who are offering funds and those who buy them. First, the legislative and regulatory agenda in the UK and across the EU is seeking to tackle wide-reaching issues such as climate change and poor corporate behaviour.
Second, investors are becoming increasingly aware of the impact their money can have for the greater good. As they seek to conduct their lives in a way that has a positive – or at least less harmful – impact on the environment and broader society, so they expect their investments to be managed to a similar philosophy.
Finally, certain leaders of asset management groups themselves have become keen advocates for the industry need, as a whole, to reconsider how securities are assessed to fully ascertain their impact upon society and the planet, and how this can be improved.
As Schroders CEO Peter Harrison unequivocally puts it: ‘We [Schroders] think sustainability-driven investing will be one of the fastest growing and most exciting sectors in the coming years. Identifying investments that have a beneficial impact on society and the environment, as well as generating positive financial returns, is of increasing importance to investors around the world.”
The need for clarity
Views such as Harrison’s as well as the growing interest among consumers in understanding how their savings are invested mean an unambiguous understanding of ESG and responsible investment is more important than ever. This must not only address the need for clarity, but also meet incoming MiFID II regulation, which will see advisers obliged to build an assessment of each client’s ESG preferences into their suitability tests.
For this regulation to be implemented effectively, there must be common language that defines and distinguishes ESG and responsible investing. As this sector of the industry has burgeoned, so has the vocabulary associated with it and without a common set of terminology accepted and understood by investors, confusion is an inevitable outcome.
Fundamental input
ESG should be seen as an input into the fundamental company analysis conducted by analysts and portfolio managers to better establish the potential risks of an investment and how to mitigate them. Importantly, this analysis can be applied to any and all funds – not just those with terms such as ‘sustainability’ in their name.
The use of the word ‘input’ in relation to ESG is key because, contrary to what many have been led to believe by loose terminology, ESG in itself does not produce outcomes for either society or the environment. It is simply another lens through which to consider risks to a company or an investment thesis.
The consideration of ESG factors within company analysis may lead a portfolio manager to reconsider a position or its weighting due to a perceived risk. However, ESG does not imply exclusions at a company or sector level or a focus on companies that are helping the world transition to a more sustainable future. Similarly, it does not imply investment in companies or entities that have a positive impact on society. These three areas fall under the umbrella term of ‘responsible investment’.
Focus on outcomes
Responsible investment is focused on outcomes and what a fund is trying to achieve alongside financial returns. These funds actively seek to contribute to a positive outcome for society, the environment or to avoid harm, or a combination of these goals and can be grouped into three broad categories.
First ‘exclusion’, which is what investors have traditionally associated with responsible investing. These funds exclude so-called ‘sin’ stocks’ which can have a harmful impact on society or the environment, such as tobacco or oil companies.
The second grouping – ‘sustainability’ – include funds that reward and encourage positive change and are leaders in sustainability. Last up are ‘impact’ funds, which actively include companies or entities that have a positive impact upon society or the environment. Of course, some funds may employ more than one of these three characteristics in their investment approach.
Clear, communal language
The investment industry is experiencing a rapid sea-change in the way it views itself and its responsibilities within broader society. This has immense potential for good but can only be successful if the industry develops a clear and communal language with which it communicates with fund selectors and end-investors.
Of utmost importance is defining and differentiating what is meant by ESG integration and responsible investing – without doing this, there is the risk that confusion will overshadow the positive benefits these approaches to investing can bring.
John Monaghan is head of research at Square Mile Investment Consulting & Research
