Investing sustainably
05 September 2022
By Damian Payiatakis, London UK, Head of Sustainable & Impact Investing
Avoiding environmental, social, and governance factors when making investment decisions can be costly. Their use in asset management is becoming standard practice. As global growth splutters and long-term megatrends reshape society, can environmental, social, and governance (ESG) help guide investors in the right direction?
Recent criticisms of environmental, social, and governance may make some, less familiar, investors question its role and value.
But don’t be fooled by these distractions. Investing using such considerations is becoming conventional.
ESG data provides information about how a company operates on non-financial metrics.
Organised into three general categories, ESG metrics span numerous topics, such as carbon emissions, labour practices, and corporate governance structures. These metrics apply to any, and every, business. However, their financial relevance or materiality varies by industry and time.
Investment managers are using the data to assess and make comparisons of these internal operating practices to gain insight into how well an organisation is run. In actual usage, it’s primarily a risk mitigation tool.
As such, it should be clear what it isn’t. Incorporating ESG considerations is:
Instead, it’s an innovative, and still evolving, improvement to current investing doctrine. Below are three reasons investors should expect its use by their investment managers – with the aim to improve investment outcomes.
Effective investment decision-making requires making a judgement using available data and information. Prior to the arrival of ESG data, investment managers relied only on financial data. They may have had views about topics such as governance, or culture. But there was minimal data to inform or support their views.
Now managers have this data, even if not perfect, to improve their analysis. Moreover, it’s sensible for them to assess the risks for a company of, say, climate change in relation to its potential physical effects from extreme weather, preparedness for regulatory changes, or changes in customer preferences.
These are material issues where a changing world has an impact on a company’s profits and losses1.
Any rational investor would want their manager to have, and to use, this additional data to inform their decisions. The alternative? Ignoring it, would disadvantage them in terms of information asymmetry.
As a fiduciary, investment managers are required to act for the benefit of their clients. More specifically, their fiduciary role expects:
A duty of prudence, to operate with due care, skill and diligence
A duty of loyalty, to act solely in the interest of beneficiaries, operating impartially and avoiding conflicts of interest
In 2005, the law firm Freshfields Bruckhaus Deringer was asked to determine the relationship between ESG and fiduciary duty. Their report2, A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment, concluded that “integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.” [emphasis added]
Since that time, this practice has become widespread, growing empirical and academic evidence is highlighting when and how ESG factors are financially material, and regulatory frameworks around the world have enshrined, and driven further, consideration of them.
At this point, a manager failing to include ESG factors to assess long-term investment value would be failing in their fiduciary duty.
Investment managers face, simultaneously, the current period of a deteriorating macroeconomic backdrop while megatrends are driving deeper societal changes. Economic signals and indicators are divergent both in direction and by location.
Managers are looking at significantly different circumstances than they have seen in decades. Markets are reacting with uncertainty and volatility. Here, ESG factors can provide a framework to make sense of wider market conditions and deeper questions being raised. For example:
As noted before, investing in this manner does not seek to solve the above issues directly. It can decarbonise an investor’s portfolio from climate risks, but does not decarbonise the planet. Nonetheless, ESG factors and data can provide greater visibility into wider trends as well as how historically-accepted externalities will be dealt with by companies, citizens, and governments.
Investors are expecting managers to navigate their portfolios through the rough times ahead. ESG factors can’t steer the boat. But they serve as tell tales and horizon scans of conditions for savvy managers.
The above reasons should remind investors why they should want their managers to use ESG analysis on their behalf. That said, using such considerations doesn’t automatically guarantee outperformance for an investment manager.
Consider giving the same violin to a six-year-old and a Royal Philharmonic’s first chair. You don’t blame the instrument for the quality of the music produced. Exceptional performance in this case, as well as in investing, is driven by the talent and skill in using their instruments.
In the end, the real question for investors shouldn’t be 'Does the investment manager incorporate ESG considerations?', but 'How, and how well, do they?'
Welcome to the latest edition of “Market Perspectives”, the monthly investment strategy update from Barclays Private Bank. With the Russia-Ukraine war raging on, inflation surging, and the risk of recession rearing its ugly head once again, financial markets are grappling with much uncertainty. This month’s report attempts to make sense of it all, providing insight and context behind the major trends at play.