Even the most casual investors can’t have helped but notice the rise of Environmental, Social and Governance (ESG) investing over the last few years. According to the Global Sustainable Investment Alliance, sustainable investing assets in the five major global markets stood at $30.7 trillion at the start of 2018, a 34% increase from 2016.
Responsible investment now commands a sizable share of professionally managed assets in each region, ranging from 18% in Japan to 63% in Australia and New Zealand, and shows no sign of slowing down.
Investing in ESG funds and companies is seen by some as a potential answer to the dangers presented by climate change. But can responsible investing really help to slow or even eradicate the human-induced warming of the planet’s average temperature?
What is ESG investing and how does it work?
First, let’s break down what ESG investing actually means, starting with the E.
The Environmental component refers to a company’s impact on the Earth, whether that be positive or negative. If you’re looking to invest in equities that are green, a company that’s actively works for the betterment of the environment, or at least not to its detriment, might be worthy of your investment.
When doing research into companies and their environmental impact, pay special attention to:
- Climate change policies and plans.
- Greenhouse gas emissions goals.
- Carbon footprint.
- Water-related issues and goals, such as usage, conservation, sustainable fishing and waste disposal.
- Usage of renewable energy.
- Recycling and safe disposal practices.
- Environmental benefits for employees such as cycling programs and environmental-based incentives.
To help you get started with this research, look for sustainability reports that adhere to respected sustainability standards. Corporate websites with sustainability pages can be useful for budding ESG investors, but keep an eye out for those that seem light on actual quantifiable data. Its all well and good a company saying that they are committed to recycling, but that alone would not merit a tick in the “E” category. Concrete numbers and metrics that demonstrate real progress are much better.
The social component (S) refers to people-related elements, such as the company culture and issues that impact employees, customers, consumers and suppliers, including:
- Employee pay, treatment, and benefits.
- Staff turnover.
- Employee training and development.
- Diversity and inclusion hiring practices.
- Public stance on social issues and lobbying practices.
Sustainability reports are, again, a good place to look for information on this but you should also look out for ‘Best place to work’ lists and rankings from respected publications, as well as Glassdoor.com reviews.
Finally, the G stands for corporate governance; how management and the board relates to different stakeholders, how the business is run and if the corporate incentives align with the business’s success. This information can often be found in a company’s proxy statements and annual meetings, and you should be looking out for:
- Executive compensation and ‘golden parachutes’.
- Dual or multiple class stock structures.
- Transparency in dealing with shareholders.
- Diversity of the board of directors and management team.
- Compensation tied to long-term business value, rather than short-term growth.
So how does it work? Once you’ve identified companies or funds that promote sustainability, start investing. Socially conscious investors practice ESG investing not only for moral or environmental reasons but also because they believe that rewarding companies with these kinds of values will support their long-term performance. They’re investing in sustainability itself.
You could also make the case that it’s a risk management move. Investing significantly in a company with notoriously unsafe workplace practices or a history of causing environmental disasters won’t pay off in the end.
To help you get started with impact investing, many stock brokers have pulled together lists of companies or funds that you can invest in. The Share Centre, for example, have a ‘Responsible investing‘ section of their website where you can invest in companies that are categorised by different themes. So your investments can match your values.
Can ESG investing really help combat climate change?
For many ESG investors, climate change is the highest priority issue they face. With emissions on the rise since 2015, we are losing the battle to hold the increase in the global average temperature to well below 2°C above pre-industrial levels. As such, urgent, immediate action is required.
The body of research providing evidence of global trends in climate change has led investors – pension funds, holders of insurance reserves – to begin to screen investments in terms of their impact on the perceived factors of climate change.
In the UK, investment policies were particularly affected by the conclusions of the Stern Review in 2006, a report commissioned by the British government to provide an economic analysis of the issues associated with climate change. Its conclusions pointed towards the necessity of including considerations of climate change and environmental issues in all financial calculations and that the benefits of early action on climate change would outweigh its costs.
So, in the face of inconsistent global regulatory action, businesses have taken the initiative and investors have started preparing for the risks by calculating how exposed their investments are to changes in global temperatures.
These risks can be grouped into 4 key categories; Physical, Indirect, Policy and Transition.
Physical risks:
The physical investment risks around climate change include damage to companies and assets due to volatile and extreme weather events. This includes floods, droughts, heat waves, rising sea levels and storms.
Indirect risks:
The indirect risks are as a result of the knock on effects of extreme weather. This includes outcomes like lower crop yields, disruption to supply chains, political instability and conflicts.
Policy risks:
Policy risks refer to the financial impact of changes in regulation, including caps on emissions, the withdrawal of subsidies or the support of renewable alternatives.
Transition risks:
Transition risks include the impact of changing valuations to businesses or assets as economies shift to renewable energy sources. This also includes stranded asset risk, whereby assets or businesses are written down to zero because of the transition.
Investors have also become increasingly active when it comes to engaging with investee companies on these issues. And this changing in attitude is becoming apparent when we look at the success of some companies involved in climate-related industries.
The rise of Tesla and their electric cars is one of the great business success stories of the century so far, but there are others. Bulb, a renewable energy supplier, saw their turnover rocket from £10 million in the previous period to £182.8 million in its latest financial year.
More established companies are also following suit. IKEA sources close to 50 per cent of its wood from sustainable foresters and 100 per cent of its cotton from farms that meet the Better Cotton standards, which mandate reduced user of water, energy and chemical fertilisers and pesticides. They also use over 700,000 solar panels to power their stores and aim to start selling them to customers soon.
Nike is another company who have changed their approach in the face of growing climate concerns. Historically not the strongest when it came to corporate responsibility (to say the least), Nike has made a huge effort to reduce their carbon footprint.
Key to their success is the company’s robust disclosure about its supply chain and production practices. They’re also making it easier for designers to make green choices with an app that helps you compare the environmental footprint of different fabrics.
As the investment market for climate friendly companies accelerates and more companies are rewarded for their ESG efforts through investments, it creates a self-fulfilling prophecy about the impact this behaviour has on environment. As these companies succeed because of their environmental practices, so more companies will follow suit and push those that are not ESG conscious out of the market.