What is Responsible Investing?
Responsible investment explicitly acknowledges the importance of Environmental, Social and Governance (ESG) factors in the investment decision. There are many ways of investing responsibly and three of the most common approaches are:
- ESG integration: where the key objective is to improve the risk-return characteristics of a portfolio. With this approach ESG factors are explicitly included in investment analysis and investment decisions. The aim is to use ESG information alongside other financial information to improve return and reduce risk. This may not be pure enough for some ethical investors as it can allow investments that would be excluded using an ESG screen.
- Ethical or Values-based investing: where the investor seeks to align their portfolio with their beliefs. This approach typically uses negative screening in selecting investments. Typically, this would exclude ‘sin’ companies such as those engaged in coal mining, the production of controversial weapons, such as cluster weapons, anti- personnel mines or biological and chemical weapons, gambling or tobacco.
- Impact investing: where investors select investments that bring about change for social or environmental purposes, e.g. to accelerate the decarbonization of the economy. The investments need to have a positive impact in a measurable way. Broadly speaking, where ESG integration is focused on the operations of the company, impact investing focuses on the products and services the company is producing. To qualify as an impact company, it has to be producing products and services that help achieve sustainability goals.
What is driving responsible investment?
- What is driving responsible investment?
There is a growing recognition in the financial industry and in academia that ESG factors influence investor returns. High-profile examples of financially material ESG incidents include the 2010 BP Deepwater Horizon oil spill which led to BP paying $53.8 billion to settle, and the 2015 Volkswagen rigging of emissions tests which cost Volkswagen 27.4 billion euros in penalties and fines.
- Investor demand
There is greater awareness by investors that ESG factors can affect the performance of an investment. There is also a greater trend towards aligning the values of the investor with the investment. People are more aware of environmental issues such as climate change, landfill waste, plastic in oceans and vehicle emissions and many want to do something about it in their lives. This could involve greater recycling, cutting down on plastic and switching to an electric car. There are now greater opportunities to follow this through into the investing decision with a greater range of ESG investments available. The availability of ESG funds has moved beyond the negative screened ethical funds that first appeared over 15 years ago to embrace funds that seek positive ESG outcomes.
There is increasing regulation to promote positive behaviour in relation to ESG issues. This ranges from exhaust emission charges in cities to incentives to buy electric vehicles. Companies are being encouraged to disclose more information on their ESG impact and institutional investors are encouraged to follow stewardship codes that encourage a positive approach to ESG matters. An important recent development was the adoption of the Low Carbon Benchmark Regulation along with the Disclosure Regulation by the EU in October 2019. These should bring greater clarity on the construction of ESG benchmarks and bring greater disclosure of how investment managers have considered sustainability in their decisions.
Does responsible investment lead to lower returns?
There is a misconception that responsible investing means sacrificing returns. Some early studies suggested that responsible investment, particularly with funds that use a negative screen for selecting companies, had lower returns on average than funds that did not consider ESG factors. However, the balance of evidence has shifted in recent years. There is now growing evidence that returns from responsible investment are, on average, at least as high as from conventional investing, and probably higher. Some examples of this evidence is presented below:
George Sarafeim of Harvard University shows the benefits of companies reducing their costs by cutting waste and pollution and increasing their income through innovating around sustainability. Companies with good sustainability practices had average returns 4.8% per year higher than those with poor sustainability.
Analysis by Bank of America Merrill Lynch in 2016 shows higher returns from responsible investment portfolios (those with high ESG ratings) and lower risk. The analysis created 4 categories for ESG scores and found significantly higher average returns for those investments in the top two quartiles. The impact on risk was even stronger, showing far lower downside risk and bankruptcies from companies rated highly for responsible management.
- Thursday, January 23, 2020