A Beginners Guide to ESG Investing
If you read the general or financial press, you are sure to have come across the term "ESG". And you might already know that this three-letter acronym stands for Environmental, Social and Governance – but what does that mean? And what does ESG have to do with investing?
In this article we will examine these questions, look at ESG investing and provide you with some ideas on how you can incorporate it into your own trading and investing strategies.
What Is ESG?
ESG combines Environmental, Social and Governance criteria into investors' decision making. Most ESG investors first determine whether a company's activities and the way it operates merit a high, or at least a "good enough" ESG status. Only then do they go on to look at the financial trends and fundamentals of the filtered group of companies and decide whether or not to invest in them.
Environmental factors obviously examine whether a company is polluting the air, land or water; and what it is doing to become more "green".
The Social aspect is less obvious and more wide ranging, examining policies and behaviour in areas such as:
- Diversity and equal opportunities
- Employee exploitation and slave labour – including in its supply chain
- Consumer protection and
- Animal welfare
Governance focuses on how well a company's executive management is controlled and how responsibly it acts. Good governance is evidenced by integrity, transparency and controls on a company's behaviour and that of its management.
A Brief History
Investor concerns about ESG issues date back to the 1960s and 70s but the issues have evolved
Initially, "ethical investors" were simply keen to avoid "sin stocks"; the shares of companies involved in areas like tobacco, alcohol, gambling and arms.
As concerns about the environment grew, investors became keen to avoid polluters (oil companies being the most cited example) and also to reward companies that invested in ways that reduce their environmental footprint – by for example recycling, switching to clean energy or reducing their use of water.
The last 15 years have seen an explosion of interest in companies' "good behaviour" in other areas and the evolution of broader and more rounded frameworks with which filter potential investments, culminating in the ESG movement and ESG investing.
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The Development of ESG in Finance
The first ESG index was introduced in 1990. Known then as the Domini 400 Social Index, it is "a market cap-weighted stock index of 400 publicly-traded companies that have met certain standards of social and environmental excellence". The index has since been renamed as the MSCI KLD 400 Social Index.
As the importance of the subject grew, the financial industry moved to create products that catered for this interest and the first ESG ETF was created in 2002. ESG ETFs have proved to be a popular product and, now, there are hundreds with a total of $240bn estimated to be invested in the sector.
In April 2006 the UN launched its Principles for Responsible Investment (PRI), a set of six aspirational principles drawn up between the UN and a group of 90 investors and industry advisors and experts. The UN's PRI received a lot of publicity during and immediately after the 2008 financial crisis increasing the number of signatories committing to implement the principles. By April 2019 the number of signatories stood at 2,350.
The ESG movement received another boost when in 2014 the Law Commission of England and Wales confirmed that there was no issue with pension trustees and others from taking account of ESG factors when making investment decisions and that there was no conflict with their fiduciary responsibilities.
Criticisms
Supporters believe that ESG investors can "do well by doing good"; i.e., that ESG investing can help investors make money whilst helping the world become a better place. Detractors cast doubt on this and point out a number of other difficulties.
Some see the ESG initiatives as "box ticking" exercises that often do not do any real good but are done primarily to improve the image of corporations and of ESG investors. More specifically, some organisations have been accused of "greenwashing" their image by heavily promoting small green initiatives, whilst mostly carrying on with traditional activities which continue to harm the environment.
Others criticise the "alphabet soup" in the field, referring to the immense number of acronyms of competing standards and bodies created to promote and police them. As well as ESG and PRI, these include GRI (the Global Reporting Initiative), SASB (Sustainability Accounting Standards Board), TCFD (the Task Force on Climate-related Financial Disclosures), the CDP (Carbon Disclosure Project), the GRI (Global Reporting Initiative) and so on.
This all points to another problem; the fact that there is no dominant or widely agreed standard that companies and ESG investors can look to.
For example, there are several rating agencies awarding ESG ratings but each uses different frameworks, examines different factors and weighs them in different ways. Sometimes what is rated high by one agency is rated low by another, stoking confusion and cynicism.
Even worse, there have been cases of highly rated companies later being found to be careless, if not deceitful.
One recent example was the once admired retailer Boohoo, who was found by a newspaper investigation to be inadvertently fostering unacceptable working conditions at some of its suppliers.
Boohoo's shares quickly lost 46% of their value in mid-July 2020, when the Sunday Times published its findings.
A more controversial example was, highly-rated, electric truck maker Nikola who, among other issues, was discovered to have rolled a truck down a hill to make it look like it was moving under its own power when making a promotional video.
Even with the best will in the world, summarising ESG impact into one score is a huge challenge full of subjective judgements and practical difficulties – so the above criticisms are likely to be with us for some time yet.
The Current State of ESG Play
Despite the reservations the ESG movement continues to gather momentum.
In July 2020, industry publication Pensions & Investments reported that ESG assets under management had "almost doubled over four years" to reach $40.5 trillion.
In November 2020 Rishi Sunak, Britain's Chancellor of The Exchequer, announced the country's first "green gilt", a green sovereign bond issued specifically to fund low carbon infrastructure projects.
Also in November 2020, UK fund manager Scottish Widows announced that they would be selling £440m-worth of shares in companies that failed to meet their ESG standards.
So can traders and investors benefit from the growing interest in ESG?
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ESG Investing
Despite scepticism from some, there does appear to be a positive case for ESG investing.
A study by Deutsche Asset and Wealth Management and the University of Hamburg in 2015 looked at 2,250 academic studies going back to the 1970s. It found that 62.6% of the studies showed a positive relationship between the implementation of ESG policies by a company and its financial performance. Only 10% of the studies found a negative relationship.
The study also found there was no difference in financial performance whether the policies were focused on the E, the S or the G – but it did find that diluting your efforts too broadly "seemed to reduce the rate of positive results between ESG and CFP (Corporate Financial Performance)" implying that more focused initiatives work better.
It makes intuitive sense that companies that score highly for ESG are, on average, run more efficiently, have more motivated employees and customers and exert more control on its management to do the right thing – whilst also avoiding expensive mistakes related to, for example, the pollution of the environment, the mistreatment of employees or suppliers, or the misbehaviour of its management.
Such companies are also likely, on average, to enjoy better reputations among their customers and, because of their popularity among ESG investors, lower costs of capital.
Trading and Investing in ESG
So, as an ESG investor, how can you benefit from these current trends? Here are some ideas.
Niche Suppliers
The most obvious way to attempt to profit from ESG is to invest in the shares of companies that will make money directly from servicing some of these new market needs.
In the financial industry, corporates, banks and professional investors will have to spend more money with specialist suppliers of data, indices, ratings and analysis covering ESG. The growing list of companies providing these services includes:
S&P Global, for example, supplies ESG data, ratings and profits from the S&P and the Dow Jones brands in the index world – both of which have several well established indices aimed at this market.
Clean Energy
Clean energy, and the replacement of fossil fuels, is at the heart of the ESG movement, To benefit from this, ESG investors could invest in the shares of clean energy suppliers like NextEra Energy.
The company owns two utility companies in Florida, which provide it with very stable revenues; and owns a third subsidiary that focuses on the generation of clean energy. NextEra claims to be "the world's largest generator of renewable energy from the wind and sun and a world leader in battery storage".
Cleaner Manufacturing
Another alternative for the ESG investor is to buy shares in companies that are focused on supplying traditional products in cleaner and more environmentally friendly ways, for example:
- Electric car leader Tesla
- Conscientious mining company Polymetal
- Or, closer to home, Unilever, which is aiming to become carbon negative by 2030.
Polymetal, a member of the Dow Jones Sustainability Index since 2018, operates eight mines and processing plants in Kazakhstan and Russia. According to the FT, the company adopted ESG principles long before they became fashionable and "has won plaudits from investors for its approach to ESG".
FTSE100 constituent Unilever, the maker of a wide range of every-day consumer goods, is on a drive to become carbon-negative by 2030, something anticipated to be popular among customers of some of its brands, like Ben & Jerry's ice cream.
Fossil Fuel
A different strategy could involve shorting the less popular shares of fossil fuel companies, including:
- Shell
- Exxon
Major oil companies are typically painted as the "bad boys" by the ESG community and one way of shorting their shares is by using Contracts for Difference (CFDs).
ETFs and Funds
There is a growing list of Funds and ETFs focused on selecting companies that meet ESG criteria. One US-based example is iShares' MSCI USA ESG Select ETF.
As the chart shows, this ETF has been on a fairly steady rise, more or less doubling its price between 2013 and 2018 – though it has become more volatile since.
A different strategy related to ETFs and Funds is to look at the shares most commonly held by ESG funds.
Top of the list is Microsoft, which has been carbon neutral since 2012 and is aiming to be carbon negative by 2030.
The second most commonly held share by ESG funds is Thermo Fisher Scientific Inc.
With annual sales exceeding $25bn, this company develops and manufactures high end scientific and laboratory equipment.
Conclusion
As you can see, the ESG movement seems to be gathering pace and becoming increasingly mainstream.
There seems to be strong logic behind the assertion that ESG investors can "do well by doing good" and the above ideas should help to make a strong start in this growing area of investing.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
