How can we be sure that when we invest responsibly, we do so in a meaningful way?
The popularity of investing in ESG has certainly taken off over the last few years. Investors must scrutinise the investment manager they are using to ensure that what they are purveying is responsible, long term and enduring.
For us, it is a question of undertaking thorough due diligence, analysing the strategies an investment manager is purporting to use to claim that they are being responsible, and then looking for proof that backs up that claim.
As stewards of our clients’ capital, we believe it is vital that companies follow processes that can grow their share price and provide enduring value over the long term.
Are ESG scores useful in discerning good investments?
The challenge with ESG scoring is that it boils down to condensing some very complex issues into a single score, which isn’t reflective of environmental, social or governance risks in isolation.
An obvious example is Tesla. On some metrics, Tesla scores highly as one of the world’s most sustainable companies given its deployment of electric vehicles globally. On others, it scores as one of the worst because of social and governance concerns.
This highlights the nuances that are needed when thinking about ESG – you cannot boil it down to a single score.
You also have to think about what that ESG consideration means for financial returns and risks. We answer around 150 questions before a stock is considered for one of our portfolios. Only when we have integrated all this information can we assess, both from a capital protection and a financial return perspective, whether to invest or not. It’s very much an integrated approach rather than relying on a single ESG score.
Can investors actually effect change just by excluding certain companies from a portfolio?
Empirical evidence points to a higher cost of equity and debt for companies that are exposed and vulnerable to climate change.
However, you have to be cognisant that we are still in the early phases of the energy transition; we still need to radically deploy capital away from fossil fuels towards renewable energy sources if we are going to meet the Paris Agreement. And so, if we have to change the capital structure of the global energy system, then it points to greater risks for certain sectors that are vulnerable to a shift towards a more sustainable world.
Do you invest in companies which have a low sustainability score today but are on an upwards trajectory?
We deploy our clients’ capital into both thematic and sustainable investments. This will inherently screen out some portion of the investment universe just by the very nature of where we believe sustainable returns can be generated.
Generally, we will invest in companies between A and D ratings. There is little we can do to influence potential change with an E-rated company, and so we won’t invest in those.
Also, some things are harder to change than others. For example, changing a D-rated company’s governance can be much more of a challenge than changing its operational practices from an environmental perspective.
Some have argued that sustainable investing has exacerbated the energy crisis by discouraging investment in fossil fuels before we can leave them behind – is this true? In a sense, has sustainable investing perhaps worked a little too well?
We would suggest that the evidence would point to that argument being largely fallacious. First, the International Energy Agency (IEA) notes that there is no government in the world today that wishes they had more fossil fuels. The wish of all governments is that they have higher renewable penetration in their grids to ameliorate the impacts of the current energy crisis.
Second, empirical research highlights that 95 per cent of capital being deployed by energy companies is being deployed into fossil fuels, not renewables.
What’s more effective: engaging with companies as a shareholder, or divesting from them completely?
They rank equally – we do not have a distinct shareholder engagement team that is siloed away from the investment team. If you just have a portfolio that is principally comprised of companies that score very well on a given set of ESG scores, you’re removing a larger part of the investment landscape.
Our philosophy is to think about the sustainable returns that can be generated by the portfolio. And that’s really where shareholder engagement helps. We include some companies that rank poorly on ESG scores if we have comfort that their management teams and boards are diligently trying to change the sort of risks they face.
What about moral ambiguity – for example, should nuclear energy be classed as green? You’ll get a different answer in France than in Germany!
There’s a clear moral ambiguity around nuclear. We know that the cost of electricity produced from nuclear is demonstrably higher than from renewables. We also know that the trajectory (and continued expectation) of renewable energy costs is falling. Subsequently, there is an inherent risk with deploying capital towards the nuclear sector.
However, the offset to that narrative is that we need a high level of baseload generation in the electricity grid, having removed so-called dispatchable energy such as coal. We need baseload electricity provision from sources such as nuclear, which intermittent supplies including offshore wind and solar cannot provide.
Nuclear has a very low carbon and environmental degradation footprint compared to many other energy sources too. While it is morally ambiguous the argument suggests that we probably need more nuclear.
Will there ever be a universally accepted standard for what constitutes an ESG-compliant fund?
We would be particularly surprised if there were ever a binary approach to determining whether anything is ESG-aligned at a top level for a fund. But we certainly think we will start to see more demonstrable frameworks from financial regulators.
Sustainable investment funds enjoyed a halcyon run until just recently. How much of this was down to the quality of the companies? How much was just a little bubble of popularity?
There has been a perception in some areas of the capital markets that scarcity of value leads to sustainable competitive advantage. Over the past 12 to 18 months that perspective has been reframed. As more capital has been deployed into the electric vehicle market and the renewable energy markets, for instance, investors are realising that scarcity does not necessarily last for an extended period.
The key is to discover firms that can generate a sustainable competitive advantage over time. There’s no doubt that this has become more challenging. We spend a lot of time thinking about the competitive advantage that firms can generate – not just over the next 12 months, but over the forthcoming decades.
If you have any questions on ESG or would like to know more, please contact your Private Banker who will be only too glad to help.
Please note that the value of investments can go down as well as up, and you may get back less than you originally invested.