Sustainable Investing (Part 1)

We are having lots of conversations with people who intuitively feel Sustainable Investing is something they want, but often find themselves lost in the lingo, unsure what they should expect and what it might all mean for their portfolio. Sustainable Investing is a complex topic, so we have written a two-part article to help you understand what it means and debunk some myths. Our two articles will cover the following:

Part 1

• What is Sustainable Investing

• Investor focus on sustainable investing

• Sustainable reporting challenges

Part 2 (sent next week)

• Does Sustainable Investing equate to lower expected returns for investors compared to conventional investing?

• Strategy implementation

• Regulatory Impact for investors

Defining Sustainable Investing

Most people recognise that investment capital is an important force in shaping business activity, which is in turn, an important force in shaping the world we live in. The starting point for many is to simply consider the positive and negative impact that businesses have in the world and use this information when considering how they invest.

When investors talk about preferring Sustainable Investments, they generally want to recognise the impact of their investments by either avoiding investing in companies they don’t like or investing more into companies they do.

Rather than look for a precise list of considerations that define what Sustainable Investing is, a better way to think about it is on a continuum of impact.

To illustrate further, imagine all investment choices sat on a spectrum that ranged from pure focus on financial return (conventional investing), all the way to zero focus on financial return (philanthropy).

If you have no interest in adopting any other focus than financial return in your portfolio, you will fall into the Conventional category above. But when you start to move across the spectrum, the terminology begins to blur.

Let’s start with moving one step to the right.

Socially Responsible Investing (SRI) was originally developed to allow investors to avoid companies they disliked for ethical or values-based reasons.  This original form of SRI is now called “exclusions” or “negative-screen” investing.

There are many funds today claiming to be ESG funds (which we‘ll explain shortly) that are really SRI funds.  These include funds that exclude what used to be described as ‘sin’ stocks like tobacco, gambling and weapons manufacturing.  These funds only include social concerns rather than more holistic ESG considerations, and in many cases are “marketing” ploys to attract investor funds.

The goal of this approach is to avoid harmful companies.

ESG integration is the explicit inclusion of environmental, social and governance (ESG) risks and opportunities based on a systematic approach and appropriate data for company scoring.  Managers assess company ESG scores either from buying information from large data providers or obtaining it from in-house ESG analysts.  These scores are used alongside traditional financial measures (such as quality, value, size and profitability) for investment portfolio construction.  The weights managers put on the different factors does vary widely. 

ESG investing has really come into focus in the past 15 years. Large pension funds drove the focus on examining risk beyond normal corporate reporting due to events like the BP Deepwater Horizon disaster.  There is no consensus of the exact list of ESG issues and their materiality, but we have summarised generally accepted key elements below:

Environmental – conservation of the natural world

Social – consideration of people and relationships

Governance – standards for running a company

Climate change attracts the most attention for adopting ESG principles, in particular a company’s potential exposure to carbon risk and ‘stranded assets’, which are assets whose viable economic return may be curtailed due to a combination of technology, regulatory and/or market changes.  Some analysts expect limits on carbon emissions may result in billions of dollars of energy infrastructure and reserves becoming uneconomic. 

But ESG is not concerned with climate change and greenhouse gases alone. Many social concerns are common areas of attention for investors. There is an abundance of studies indicating poor corporate governance can adversely affect corporate financial performance. In many ways, the “G” in “ESG” is not a new concept for investors.

It is important to note that whilst investment managers incorporate ESG into their funds in varying degrees, the ESG framework is not designed to compromise on risk and return. ESG strategies aim to incorporate a broader set of information when assessing the risk of a company. Many fund managers incorporate ESG principles into their existing strategies, while others have distinct ESG funds for those who want these issues to be in greater focus in the portfolio selection process.

The goal of this approach is to consider a more holistic view of a company’s activities.

Sustainable Investing

Sustainable Investing is in many ways an expansion of the ESG principles. While Sustainable Investing often leads to similar exclusions seen with ESG or SRI approaches, it also progressively tilts towards those who demonstrate strong sustainability practices relative to their peers. In our view this is a more holistic and less binary approach that still allows for well diversified return focused portfolios.

For our clients who want to incorporate their personal values with their investments, this is the most common approach to adopt. Importantly, it still targets the returns they need to enjoy the lifestyle they aspire to for their family. 

The goal of this approach is to progressively overweight or underweight stocks based on how sustainable companies are within their peer group.

Impact investing aims to provide funds to organisations or projects with the intention of generating measurable social and environmental outcomes, alongside a financial return. These strategies may be more appropriate for clients who either have surplus capital over what they need to meet their lifestyle needs and/or are considering philanthropic activities.

Sectors that commonly attract impact investors are social impact bonds, property and private equity. These investments generally take place in private markets. Stewart Partners is already helping some clients consider options in this growing area.

Impact is achieved directly by catalysing projects or businesses through investment.

Philanthropy is about using financial resources purely to generate positive social outcomes.   Stewart Partners manages over 15 Private Ancillary Funds (PAFs) to help clients in this field, whilst other clients use part of their free cashflow to donate to charities and causes.

The Continuum of Impact Summary

While not an exhaustive list of all the various permutations, the summary below should help frame some of the common terms which are frequently used. The challenge is that these terms are used somewhat interchangeably, so it’s important to ask how these ideas are being incorporated in portfolios.

Investor Focus on Sustainable Investing

Both regulatory decisions and investor preferences are driving demand for sustainable investing. In 2019, flows to sustainable funds were four times higher than in 2018.  More broadly, assets managed in accordance with the UN Principles for Responsible Investment have increased over the past 14 years from US$6 trillion to US$103 trillion. And under the Climate Action 100+ campaign, more than 450 investment entities with over US$40 trillion in assets are engaging companies globally to curb emissions, improve governance and strengthen climate-related financial disclosures.

Other studies highlighting the shift in investor preferences include:

• A 2019 study by research firm Cerulli Associates found that 56% of US retirement plans surveyed showed a preference for investing in companies that are environmentally and socially responsible. That percentage rose to 63% among participants aged under 40.

• Within Asia Pacific, a separate Cerulli study found varying levels of interest in sustainable investing, with Australia and Japan ahead of the rest of the region. As with the US study, this survey showed the greatest interest is coming from millennials. 

• Between January and April 2020, consultancy firm Greenwich Associates interviewed more than 500 institutional investors and found an increasing focus on ESG considerations, with governance still at the forefront, but with social issues rising since the pandemic began.

• In a 2019 Edelman survey of over 600 institutional investors in developed countries, 84% agreed that companies should balance shareholders’ needs with those of their customers, employees, suppliers and communities.

• In the 2020 UBS Global Family Office Report, 62% of families see sustainable investing as an important part of their legacy, with families looking to double their allocations to ESG investments to 19% over the next five years. Engagement for ESG and Impact investing is also greater for the “next-in-line” generation.

In July 2020, Morningstar figures showed that in the second quarter of 2020, over US$71 billion of new funds flowed into sustainable funds.  Europe continues to dominate the space, garnering 86% of global inflows, while the US took in 14.6%.  Flows in the rest of the world were considerably lower, being US$260 million in Canada, Australia and New Zealand combined, while Asia reported outflows.

Regardless, the quarter by quarter flows into sustainable funds continues to grow, as shown in the graph below:

As of June 2020, there was over US$1 trillion invested in sustainable funds, with 3,432 products available globally.  In Australia and New Zealand, the number of sustainable investment products available numbers only 108, but this figure is growing.

Sustainable Reporting

Standardised ESG reporting is evolving, but consensus of performance remains some way off. ESG ratings diverge considerably, as shown by Gibson, Krueger, Riand, and Schmidt (2019). They drew this conclusion using ESG scores from six prominent data providers (Thomson Reuters, MSCI, Sustainalytics, KLD, Bloomberg, and Inrate) for S&P 500 firms from 2013 to 2017. The authors found the average correlation between overall ESG ratings of the six providers was less than 50%.  

As investors push companies to quantify and publicise their ESG metrics, we can expect companies to lobby regulators to ensure they are fairly and transparently evaluated using an established rules-based framework.

Some of the challenges a widespread ESG reporting framework must overcome include:

• Size – larger companies may receive better ESG reviews because they can dedicate greater resources to prepare and publish ESG disclosures and control reputational risk.

• Geography – higher ESG assessments for companies domiciled in regions with greater reporting requirements.

• Industry bias – normalising ESG ratings by industry can oversimplify them.

• Subjective criteria - many ESG factors require subjective decisions, such as a tick-the-box approach from assessors. For example, the environmental harm of certain energy sources can be reasonably disputed. Consider how even the environmental impact of electric vehicles depends on how one weights the inputs (energy and rare earth minerals) used in producing and operating the vehicle versus its outputs (zero emissions from the cars). Similarly, social factors may depend on social norms. Governance factors can also be debated (e.g., whether a particular type of governing board known as a classi­fied board should be considered value enhancing or value destroying is widely debated in academia). ESG ratings vary in terms of the number of ESG indi­cators and how each factor is weighted in generating an overall ESG score. The scale of the ESG ratings also varies according to data provider.

It’s worth remembering various equity analysts can look at the same data on a company and issue ‘buy’ or ‘sell’ ratings, and no one seems to mind.  Similar outcomes are likely to be the norm for ESG ratings as well.

Summary

Studies show up to 80% of people are thinking about sustainable investing, but it’s important to understand there is no such thing as a pure, sustainable company.  It is a matter of degrees when determining what a “sustainable” portfolio looks like. 

For example, we adopt the approach that not all carbon producing firms are bad – we prefer to look at the performance of a company relative to its peers.  Society is not going to turn off its reliance on fossil fuels overnight, so if a company is taking positive steps to reduce its carbon footprint relative to its peers, we think it makes sense to hold that company in a sustainable portfolio in recognition of its positive intent.

However, it’s important to note ESG is not just about environmental matters, but also social and governance principles. The more investors who adopt sustainable ESG principles in their portfolio, the more companies must respond.

Next article – Does sustainable investing mean lower expected returns compared to conventional investing?

Author - Rick Walker, with thanks to our Global Association of Independent Advisors colleague Simon Brown at BPH Wealth (UK) for sharing his own sustainable investing research.

Please share this article with anyone you think would benefit from reading it. 

If you have topics you’d like us to write about in the future, please contact me at rwalker@stewartpartners.com.au

[i] https://www.reuters.com/article/us-ubs-group-sustainability-advice/ubs-advises-private-clients-to-pick-sustainable-investments-idUSKBN2610YG