Does it pay to go green?

by Camilla Ritchie, 7IM and Clare Reid, 7IM

With the overnight popularity of Greta Thunberg, the devastating wildfires in Australia and Boris Johnson recently setting out his climate change vision, there has perhaps never been more interest and awareness around the impact our actions have on the environment.

Indeed, investors are increasingly looking to align their personal values with their investment decisions. And it’s not just millennials who are leading the charge as even the Church of England, which is rarely acknowledged for being ahead of the curve, has an ethical investment advisory group in place to ensure that all its £8.3 billion in assets is invested sustainably. As a result, in just ten years, the number of Environmental, Social and Governance (ESG) investments has more than doubled (see infographic).

What exactly is ESG investing? Despite the momentum behind ESG funds, what’s still not immediately clear to many is what is exactly meant by sustainable or ESG investing. At the heart of it, ESG investing involves assessing environmental, social and governance factors in determining what assets to invest in. This means not just looking at investment returns, but assessing how these returns are made. For example, does the investment or the company have a detrimental effect on the environment, on its employees and other stakeholders, and is it governed well? Does it operate in areas generally viewed to be unethical? Or do they present a reputational risk for an investor, such as adult entertainment, gambling or tobacco?

However, defining ESG investing is not that straightforward as there are different approaches to building a sustainable or ESG portfolio.

At one end of the spectrum there is so called ‘dark green ethics’ based investing. This approach ranks companies on their environmental, social and governance scores and invests in those which perform better. Then there’s ‘thematic sustainable investing’ which looks to invest in areas expected to grow faster than the global average and have sustainable characteristics. Finally, there is ‘impact investing’, where the outputs of companies are assessed against the UN Sustainable Development Goals.

66

1990 1995

30 years of growth in ESG

Source: Bloomberg, 7IM 1960

470 768

2005

2000 2010 1080

2015

Not all ESG funds are green as they may seem To compound and complicate matters, not all ESG investments are as green as you may think and there are cases of ‘greenwashing’ – a process whereby companies make statements or policies that make an investment appear more aligned to ESG objectives. Most notably, the ‘greenness’ of many green bonds has been questioned. The EU published guidance on green bond standards in June, but there is no legally binding definition – i.e. a bond is deemed green pretty much because the company says so.

There have also been cases of high-profile index trackers not excluding attributes they claim to have removed, due to definitional ambiguity. For example, an Exchange-Traded Fund (ETF) might exclude companies that ‘own fossil fuel reserves’, but keep investing in oil services or refiners – not exactly in the spirit of ESG.

It therefore pays to look under the bonnet of your ESG investments.

Will I sacrifice returns to invest sustainably? There has been lots of debate on the merits of ESG as an investment strategy. Excluding certain companies (such as tobacco or oil producers) makes your potential investment universe smaller, and theoretically lowers the chance to outperform. However, a number of academic studies suggest that incorporating ESG factors makes little difference to returns, while some argue that ESG actually improves returns (simply put, ‘good’ companies are well run and so outperform peers).

It has also been found that sustainable funds – those that have an ESG focus – have lower downside risk, a conclusion which is supported by research from Morgan Stanley, looking at the data on nearly 11,000 mutual funds and ETFs from 2004 to 2018*. This does make some sense: when you incorporate a focus on company practices (especially governance) into your investment process, you are more likely to avoid the worst blow-ups.

How do I incorporate ESG objectives into my portfolio? Most fund managers already make use of ESG factors, to some extent. No good manager is going to ignore the governance of a company when choosing whether or not to invest, or buy an energy company without looking at potential future regulation that might impact its revenues. But a focus on ESG – to have a portfolio with the objective of investing in companies that benefit society – is a personal investor decision. The good news is that the scope to do so is constantly expanding, and the advice around it is becoming more readily available.

If you think you’d like to incorporate an ESG focus into your investment portfolio, get in touch with your Private Client Manager, or call 020 3823 8678.

* Source: Morgan Stanley, Sustainable Reality, 2019

Camilla Ritchie is one of our Senior Investment Managers.

Clare Reid is one of our Business Development Managers. 2020