ESG investing — not so much about ethics, but it can still have impact

My favourite economics question from high school was, “When do you cut your trees?” Turns out the answer is that we need to start planting a lot more…

Last Wednesday night, I was fortunate enough to take a friend’s place in the small audience at an ESG investing talk (“Socially Responsible Investing”) at UNSW, led by local investment professionals who work around ESG matters in investing.

The following are my notes and takeaways:

The quick tl;dr

• ESG stands for Environmental, Social, and Governance. Some people assume the E is ethical. It’s not. In fact, ESG as a label does not indicate any ethical investing, but indicates a financial approach to measure risk and return that take environmental impacts, social impacts and governance into consideration.
• Financial institutions take environmental (climate) risk seriously, regardless of what the political scene says.
• There is some change in the market because of consumer demand, but mostly it’s driven by financial risk at this point.
• In Australia, about 1/3 (1 trilllion) of the investments are now under the “ESG umbrella”. This is much bigger than I expected.

My background in “ESG”

A few years ago, I announced to the wonderful Texans who manage my savings that I wanted to get out of unethical businesses, like fossil fuels, tobacco, and companies who manufacture or distribute jeans shorts for caucasian men. They helped me shift my portfolio to eliminate those investments.

On my last Austin visit, they were kind enough to arrange a call with one of the “ESG” funds to which they had shifted some of my investments. It was a frustrating call, because I was mostly interested in their criteria for “negative screening” (what they will not invest in), and they wanted to talk about how they maximise financial return. After listening to the panel at UNSW, I completely understood the disconnect!

The panel at UNSW

The panelists included an ESG researcher on the sell side, an ESG Risk Manager inside an insurance organisation, and the manager for Corporate Responsibility (creation of the investment strategy).

There are really four categories of ESG investing:

1. Traditional. From client demand in the religious space. Negative screening (i.e. I don’t want to invest in anything to do with…). Tobacco. Weapons. Gambling. Porn. Etc.

2. Ethical. More exclusions. Animal testing. Fossil fuels, sugar. Some movement into the positive: EVs, renewables.

3. Integrating. Funds that use processes that identify ESG risks that can impact financials. $$$ focused. Not ethically or morally focused.

4. Impact. The most aggressive, with social outcome goals. I.e. you want your funds to do more than earn money. Example: 17 UN sustainable development goals.

I realised at this point, that the call with an ESG fund manager when I was in Austin was largely focused on #3, Integrating Risk, rather than negative screening or impact.

How to determine if something is “ESG”?

ESG is broad. ESG research could be investigating the impacts of human capital (ethical use of workers) on long term performance (i.e. if Modern Slavery laws are passed, the cost of capital will increase). The proposed amendment around vulnerable workers in Oz is an example of what investors need to understand and apply.

There are a number of sources for responsible investment, one being the PRI — principles of responsible investment, from the UN.

The drive for financial return appears to be stronger than consumer demand in motivating ESG:

The amount of investments under ESG is large. One firm saw 48% growth in the “ethical investment portfolio” one year. Just under a trillion in funds are under mgmt in ESG funds, which is almost a third of the funds under management. But consumer demand and the desire to have impact are not the motivation.

• Hedge funds are looking at the short side. I.e. what companies are vulnerable because of climate risk or other ESG risks. This is amazing — the firms often viewed as the greediest know there is money to be made on the ignorance of corporates who are not prepared for climate change.
• The growth is very much in integration, not in ethical or impact investing. Minimal filtering is being done — it is largely focused on risk. “Risk is moving the industry.”
• Governance — the “G” in ESG, really means regulation, the theory being that smart governance is good for financial stability of our economies, but again doesn’t move investments for ethical purposes.) The EU has requirements on “sustainable finance” which will (or does?) incorporate ESG.
• The Environmental (“E”) part of ESG again doesn’t mean animal rights or love of nature, but needs to assess the potential impacts on business from drought, flood, or climate change. Making financing take into account the Paris climate goals is where “sustainable finance” will interact with the environmental policies of organisations like the EU.
• What will likely appear is a “Colour coding” of investments (Green= low ESG risk), much like bond rating (AAA, AA, etc). A green rating would get you a lower cost of capital, so that motivates corporations to move towards a Green rating.
• The state government of California has created a sustainable finance roadmap — focused on climate impacts. Australia sustainable finance has been industry led, then government supported in Australia, largely due to inaction on the part of the federal government in this sector.
• Free trade agreement with the EU (e.g. between Australia and the EU) would likely come with some ESG requirements — the EU won’t want to disadvantage their own producers by allowing cheaper ‘dirty’ products from other countries into their market.
• Super funds — longer term investment (low ESG risk) is the main motivation driving their attention to ESG, not consumer demand. Though, millennials are changing this, and social media campaigns and new companies have made it much easier to switch funds, so this may change.

Note: There’s a cool new Super Fund for women by women called Verve Super, who I had the luck to meet recently. Amazing example of ethical investing with a strong financial view but equally driven by the impact that both the investments and the organisation can have.

Do ESGs perform better?

Maybe? Some say yes, some say no. My opinion: Certainly incorporating ESG risk should help with long term returns, though motivated Impact investing would likely involve some tradeoffs where you’re willing to accept slightly lower returns for social impact. A friend recently asked if any one has modeled what the tradeoff would have been over the last 100 years if you had undertaken each of the 4 investment approaches compared to a baseline of “invest in growth regardless of ESG risk or ethics.” Another interesting question is whether ESG performance will peter out? If everyone uses ESG, what’s next?

Thanks to Jodie, Sharanjit, Phin, and William for a great panel.