02 Mar Will ESG investing decrease my returns?
As published in BusinessLive.co.za on 28 February, 2021 by Kyle Wales
Environmental, Social and Governance or “ESG” issues are becoming increasingly relevant investment considerations. The rise of ESG investing has accompanied the rise in general social appreciation of the various environmental, social and governance issues facing society. This has also gravitated to the political stage: in many countries “Green Parties” have become major political forces, and activists taking a stand on ESG issues, like Greta Thunberg, have become household names.
Some notable investors have also advanced this trend. Norway’s sovereign wealth fund is one of these. It owns on average 1.5 percent of most of the large listed business in the world and has forced many of the companies in which it is invested to improve their ESG track records, especially with regards to environmental issues. Ironically, oil – which carries a high environmental impact – accounts for between 40 to 70 percent of Norway’s exports, which a cynic might interpret as Norway being principled on these issues when it suits them, and overlooking them when it doesn’t.
Being alert to ESG issues makes investment sense. While the “MSCI World ESG Leaders Index” had performed in line with the MSCI World as at 28 February 2020, holding shares in many companies with poor ESG records can prove to be disastrous, regardless of whether this relates to the “E” part, the “S” part or the “G” part. Three examples illustrate this.
- Firstly, companies, especially miners, which have poor environmental track records can accrue massive environmental liabilities further down the road. This is a real-world financial impact; which shareholders need to value correctly.
- Secondly, a poor track record with regard to social matters can also destroy shareholder value by causing labour unrest or through punitive regulatory changes.
- Finally, we would be remiss to forget about issues relating to governance. South African companies have fared poorly with respect to such matters recently and millions of Rands of shareholder value has been destroyed as a result. Who can forget what happened at Steinhoff, EOH and Tongaat Hulett?
ESG on a global stage
Global ESG failures have been even more extreme than the South African examples that readers will be more familiar with. Wirecard, a German financial technology company, misrepresented profits, forged contracts and inflated billions of euros in cash balances. Theranos, a health technology company, falsely claimed to have devised blood tests that required very small amounts of blood and could be performed very rapidly using small self-developed devices. Nikola, a US truck manufacturer, made a string of misrepresentations of its technology, including a 2016 promotional video that purported to show an operational Nikola freight truck but was in fact staged by rolling the truck down a long hill.
In many cases of this nature, even when justice is metered out, it is not sufficient to compensate the victims of the fraud. This makes ESG investing vitally important.
Two types of ESG investing
There are two broad approaches to ESG investing. The first approach is negative (or exclusionary) screening whereby companies are excluded from an investment universe because they are in sectors which are deemed undesirable. On this basis, oil companies would be excluded because they have a detrimental impact on the environment, no matter how hard they try to reduce their impact.
The second type is inclusionary (or best in class) approach. This approach might allow an investment in an oil company that was trying hard to reduce its environmental impact by diversifying into renewables, and being more ambitious on the “S” and “G” fronts.
Are there unintended costs with ESG investing?
While ESG’s impact on the world has been overwhelmingly positive, investors should be aware of unintended consequence. As more capital crowds into ESG compliant sectors at the expense of non-compliant sectors, the returns from the former will decline. The more rigid one’s ESG policy, the more this effect will be felt.
An example of this crowding effect can be seen in the energy sector, where exclusionary ESG policies that favour solar and wind projects have flooded this sector with capital. This will ultimately dampen the expected returns from the sector as a whole.
A fund manager’s role
Defining the role of the fund manager in ESG matters is complex, and they enjoy considerable discretion in the application of ESG policies. Because there is no such thing as a ‘standard’ ESG policy, two investors can both have ‘strict’ ESG policies but invest in entirely different companies.
There are a few things that we believe can assist investors in deciding how they should choose a manager in light of their ESG beliefs.
Firstly, a manager must have a well-constructed and properly communicated ESG policy in place. This policy must authentically represent what the fund manager believes to be appropriate conduct for companies to adhere to along environmental, social or governance lines, and must create a bar by which to measure the investments that are conducted by the manager.
Secondly, a manager must convincingly show that the ESG policy he or she follows will still allow him to deliver the returns his clients expect. This is an area that many managers need to look closely at. It may well be that a manager has succeeded in constructing a very strict ESG policy, but this impedes his or her ability to deliver on the fund’s performance outcomes.
We evaluate ESG issues on the basis of current and past company disclosures and spend our research efforts scouring for evidence of ESG infractions. We penalize companies with surmountable ESG shortcoming, making it harder for them to enter the portfolio, but will only eliminate companies as potential investment opportunities when these ESG concerns are material, or getting progressively worse.
Unfortunately, fund managers cannot eliminate the risk of stepping into ESG pitfalls entirely, especially when it relates to governance, because fraud often involves the collusion of multiple insiders and fund managers are only able to assess risk on the basis of information that is in the public domain. If the auditors who do have access to this information are sometimes unable to detect fraud, there will always be a risk that a fund manager who doesn’t will not be able to.