ESG Investing: What is sustainable for you?

ESG INVESTING: WHAT IS SUSTAINABLE FOR YOU?

If you were to realize that Philip Morris, the leading tobacco company, is part of your ESG portfolio, how would you react? Would you call up your investment manager asking to get rid of the stock ASAP or would you be happy to hold one of the most sustainable companies in the tobacco industry?

Let’s be honest now. ESG screening is prone to sector bias. Mining, tobacco are in most cases automatically kicked out of ESG indices because of the nature of their activities. However, this does not mean that they are not complying with the best environmental and social standards in their own industry. In other words, they might be the best in class.

And after all, – continues the investment manager – we do need heating for our houses, fuel for our cars, a glass of wine from time to time. Therefore, why not target maximum portfolio diversification and also include companies that have made clear steps to align their business model with new regulations, that have dedicated a large portion of their R&D budget to adopt cleaner technologies regardless of their sector, and that have made clear improvements in their business practices?

“But these are clearly NOT sustainable companies! This is not what I was looking for!” might answer a disappointed investor. Who’s right and who’s wrong?

As index providers involved in the development of ESG strategies, how to effectively integrate ESG standards is a question we have come across many times. Thanks to our collaboration with experts in the field, we have always managed to find solutions satisfying our customers’ requests.

Nevertheless, it is still interesting to investigate the challenges involved in designing ESG strategies. One of the most common issues can be traced back to the fact that there is not a universally agreed definition of ESG. The rule of thumb is to do good to the environment, society and governance. But what does this mean in practice?

To make matters more complex, there is also no universally agreed approach to integrate ESG criteria. The composition of ESG indices or ETFs can differ depending on the chosen definition and screening approaches. Systematic sector exclusions can give quite a different outcome from best-in-class approaches. And in the end, this can result in companies with questionable sustainability records being included in ESG indices.

In addition, nonfinancial performance can be difficult to gauge and, even when you think you’ve done a pretty good job assessing it, mistakes can always happen. There have indeed been examples of high-profile companies that seemed to be ESG leaders in their sectors that then fell from grace due to scandals of mismanagement. BP’s “Beyond Petroleum” campaign, designed to promote the company as environmentally-friendly, culminated in the Deepwater Horizon Oil Spill in 2010.  In 2015, the Volkswagen Group, formerly considered an industry leader in clean-diesel technology, was hit by the carbon emissions scandal.  More recently, a number of tech giants – usually top components in ESG indices – have been accused of poor labor conditions in China.

In order to neutralize the risk of potential pitfalls, there is an ongoing trend towards transparency and standardization. As environmentally-conscious customers are increasingly demanding more transparency, new regulations are pushing companies to systematically report nonfinancial information.

This is for instance the case in the European Union Non-Financial Reporting Directive requiring large companies to annually report performance on environmental protection, social responsibility and other such matters. Similarly, with the implementation of the Gender Pay Gap Regulations in 2017, companies in Great Britain are obliged to publish gender pay information on an annual basis.  This regulation has already exposed large gender pay gaps in some of the biggest firms active in the UK.

ESG INVESTING IS HERE TO STAY.

The concept of ESG is not static but is evolving, influenced by new regulation, consumer expectations, and increased information. If initially the movement was mainly about protecting the environment, responsible investment has now expanded to embrace a more comprehensive definition, with themes such as gender equality gaining increasing importance. Improvements in transparency & reporting will make ESG screening more effective. Nevertheless, mistakes in judgement can always happen and it’s important that investors are aware of the limitations of the different screening approaches.