CONSIDERING RISK AND ESG

When IFA Magazine hosted an ESG roundtable back in the autumn, the discussion turned inevitably to the risk implications of ESG investment.

When IFA Magazine hosted an ESG roundtable back in the autumn, the discussion turned inevitably to the risk implications of ESG investment.

When you ask clients if they’re interested in ethical investments, they want to know the trade off, either added risk or reduced performance. It’s a difficult conversation to have with them and get them to understand if they’re taking on extra risk.

Julian Barnard, Principal at Barnard Lee Associates, noted that it’s something Mark Carney, Governor of the Bank of England has been talking about.

“From a risk profile, if companies haven’t embraced some sort of positivity towards it, they’ll have to in the future. From my perceptive, I’d always put impact investing as riskier than ESG, that’s because you’re screening out a whole lot more stuff, you’re probably going into smaller companies and into a bigger risk dynamic. Belinda Thomas, partner at Triple Point, commented that Triple Point approach impact investing through their EIS product, as such “this entails investing in smaller companies to be eligible for the associated tax breaks.”

“Of course, it’s a different risk profile than investing in the equity of a FTSE 100 stock, but as advisors you have the ability to step outside only investing in large cap equities and look at other ways of fulfilling the investment needs of your clients, such as using EIS for the private equity part of a portfolio.

“When we are targeting smaller businesses, as part of our Impact EIS Service, we target both financial reward and impact. The higher return the more impact created; if they don’t make a return then they won’t have a good level of impact.”

Julia Dreblow, Founder of SRI Services, also focused on impact. “A lot of impact funds do invest in smaller companies and sometimes they will do better than other funds, sometimes they may do worse. What matters most is what the client wants. If they are happy with mid-sized companies, for example, that’s fine – but you need to keep the bigger picture in mind. Rules and regulations are changing particularly in relation to climate change. Investors have the choice of being ahead of the curve or behind it, but keep in mind that all other factors being equal those ahead of it should prosper as they are better equipped to deal with growing challenges and emerging opportunities.”

Ben Constable-Maxwell, Head of Sustainable & Impact Investing at M&G, noted that “ESG focuses on the material environmental, social and governance risks and on how individual companies are managing those risks and related opportunities. ESG investing can improve the risk profile of your investment; with a long-term mindset you want to know how companies that you invest in are managing those risks. We think that a company with high ESG characteristics can have lower volatility and produce higher returns than the overall market. We think ESG investing is a sensible way of thinking about risks. It's not about what you're excluding, it's about investing in quality companies. Impact investing is different. With impact, you're investing in and how their business helps address climate change or improve societal outcomes. I think these companies, when selected carefully, are not necessarily higher risk and are really exciting to invest for the long term. ”

Julian Barnard added a note of caution; “How you define risk isn’t the way the FCA does. If I’ve got a medium risk client and I put them in there, I’m immediately at risk myself. Secondly, where the risk is amplified, say you want to go into a managed fund, there are plenty of ethical funds as good as its counterpart. You get a much smaller pool and putting together a portfolio, you start to find it hard to be able to find ethical funds in those spaces and it makes it more difficult to put together a portfolio that’s completely ethical. That’s where the risk is amplified.” “ESG investing doesn’t exclude the majority of the market, it just focuses on better performing businesses and reduces the long-term volatility risk”, was Constable-Maxwell’s view.

“Across ESG there’s a famous example of an auto manufacturer that had flawed governance standards, with an all-powerful board with very ambitious goals. It was because of governance deficiencies that Dieselgate materialised with huge negative financial outcomes. There are examples of companies that are not managing their cyber secutrity risk and the ownership of data properly and are being fined millions on those companies.”

On the question of risk, Michael Daniels, Director at Kingswood Consultants, suggested that political risk is often the most significant factor.

Wayne Bishop, CEO of King & Shaxson Ethical Investing, pointed out that 30 or 40 years ago, no one thought the tobacco companies would be sued the way they were. “There are lawsuits going out against oil companies, drug companies who used opiates and I think it will persist. The FCA are saying you have to take climate change risk into consideration, and you can’t ignore it anymore. Risk to me is the risk of losing money. That can happen after bad management, having the wrong product and it also comes from not reading which way the wind is blowing. In environmental areas, we know which way it is blowing. We have no fossil fuel exposure, we’ve replaced it with wind and solar. Although they have their own risks, George Osborne changed the risk profile, but we know which way the wind is blowing, quite literally. The risks are getting higher and higher for oil and coal, and this trend will keep growing into the future. There are lots of reasons to see risks building up. I have respect for the regulators but they’re very reactionary, whereas money isn’t reactionary, and your client’s wealth isn’t, so there needs to be more focus on what the future risks will be.”

The discussion then moved to ESG in practice, which is covered in the next article.