ESG investing: room for improvement

By Harry Hill, Hottinger Investment Management 

1,130:

The number of people arrested in London during the protests in April 2019.

£7.5 million:

The additional cost to the police force over the same period.

2025:

The deadline for net zero greenhouse gas emissions demanded by Extinction Rebellion[i].

For many, 2019 will be considered as the year the world at large woke up to climate change. From Extinction Rebellion and Greta Thunberg to David Attenborough’s 2019 documentary ‘Seven Worlds, One Planet’, the theme has now become an all-too-dismal feature of the everyday.

The last four years have been the hottest four on record, with winter temperatures in the Arctic having climbed by 3°C since 1990, sea levels rising, coral reefs dying, and the number of natural disasters indisputably on the rise[ii]. Ten million people were displaced from their homes between January and July in 2019[iii] alone, according to a report by the International Displacement Monitoring Centre. Any efforts to curb the consequences of global warming will require change not just from governments and corporations but also from investors and consumers.

Unlike Extinction Rebellion, the concept of ESG investing (investing with environmental, social and governance issues in mind) has been around for more than a decade. In January 2004, UN Secretary General Kofi Annan asked 50 CEOs of major financial institutions to participate in a joint initiative under the auspices of the UN Global Compact. The aim of the initiative was to encourage the integration of ESG factors into capital markets. The year following, Ivo Knoepfel released a report entitled “Who Cares Wins”[iv] which outlined environmental, social and governance factors in capital markets and set a benchmark to encourage more sustainable markets and better societies. According to KPMG[v], over the course of 2015-2017, ESG integrated investments grew 25% to US$23 trillion, accounting for around a quarter of all professionally-managed investments globally. Whilst progress has been encouraging, there remain inefficiencies surrounding ethical investing, as well as broader misconceptions about the different strategies available and how best to bring about change within society to the benefit of future generations.

Investment strategies typically fall into three categories, with slight overlap between each. (1) ESG, which refers to environmental, social and governance practices. Although there is an overlay of social consciousness, the objective of ESG is to incorporate additional factors into the existing investment process. (2) Socially responsible investing (SRI) employs negative and positive screening to eliminate investments that don’t meet certain ethical guidelines. (3) Environmental impact investing, on the other hand, proactively seeks investments that have a positive impact. Each strategy should be considered as a variation on a broader theme to ensure a better future society, but each will result in different portfolios with potentially large discrepancies in their ability to combat climate change and address social issues. The CFA Institute has expressed[vi] its concern that too many funds are claiming to be ESG managers without any standards of practice attached. A set of harmonised standards will improve investors’ ability to select the funds that really make a difference.

For some investors, wanting to invest with a conscience does not necessarily mean investing entirely in ESG-labelled funds. According to the investment philosophy of hedge fund TCI, the most effective strategy to invest ethically is to take a long-term activist approach by remaining a holder of shares regardless of their carbon footprint and using engagement to bring about change from within. TCI will actively vote against company directors if they fail to meet reduction targets and demands such as disclosing carbon dioxide emissions[vii]. It is still relatively rare for company directors to be challenged in such a manner. Bill Gates is quoted as saying, “Divestment, to date, probably has reduced about zero tonnes of emissions… It’s not like you’ve capital-starved (the) people making steel and gasoline.” As stated by Sarasin & Partners[viii] the directors of the world’s biggest fossil fuel groups were reappointed with an average of 97% investor support. This may leave the higher polluters, stocks in need of scrutiny from investors, neglected, with little incentive to change. Managers of many conventional funds do not vote for change as their investors do not demand it, and managers of ESG funds may vote for change within a portfolio of companies that are already actively tackling climate change. Clients looking to implement an ESG screen to their portfolios may wish to diversify across a variety of strategies using different philosophies.

Finally, there is a need for further transparency through more frequent and accurate disclosures. Organisations such as the Global Reporting Initiative (GRI) and Governance and Accountability Institute (GAI) acknowledge the abundance of poor quality ESG information from which asset managers are making their decisions. According to the CFA Institute, governance factors can run across more than 150 variables, yet the ability to distil data down to a few relevant factors remains disjointed. As more data becomes available and with greater transparency, the ability to correlate governance factors and climate factors to returns will improve investment strategies.

Following the UN 2019 Climate Summit in New York, it is evident that there is an urgent need to address the mounting challenges faced by global warming. To reduce greenhouse gasses by 45% over the next decade and to net zero emissions by 2050 will require drastic changes in all areas of society and by all parties. The opportunities for investment whilst allocating capital to the benefit of future generations might require a more activist form of investing aided by more transparent and accurate data.

[i] BBC: What is Extinction Rebellion and what does it want?

[ii] United Nations: Climate Action

[iii] Internal Displacements: Mid-Year Figures

[iv] Forbes: The Remarkable Rise of ESG

[v] KPMG: The Rise of Responsible Investment

[vi] CFA: Enterprising Investor

[vii] FT: TCI does more on climate action than ethical green funds

[viii] Sarasin Asset Management: Environment, Social and Governance issues