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Looking behind the screens of ESG investing

Interest in environmental, social and governance principles (ESG) has been growing among investors in recent years. However, in pursuing these preferences, they can severely risk compromising their investment goals. As the popularity of investing sustainably gains momentum globally, how do fiduciaries ensure sound investment outcomes are not compromised in pursuing ESG goals?

Naïve and simplistic screening processes, for instance, can leave clients with highly concentrated portfolios that reduce the chances of them reaching their goals.

Client preferences may also differ within the ESG framework. For example, some may care more about reducing the carbon footprint than about land use and bio-diversity. Preferences around social criteria can also vary.

Simple screening processes may not work

A simple, binary screening process may not be able to accommodate the broad range of issues investors really care about. This dilemma was highlighted in the 2016 Investor Report, a landmark survey on ESG investment, published by the independent group Impact Investing Australia in collaboration with the University of Melbourne. The survey of Australian investors, accounting for more than $300 billion of funds under management, found that while more than two thirds expect ESG to grow in significance, many are put off by inadequate investment solutions.

“There appears to be an unmet need from investors for financial services and advice that incorporate social and environmental impact,” the survey found. “[But] lack of reliable research, information and benchmarks and no recognised investment framework are cited as key deterrents to investors entering the market.”

Fortunately, many of those deterrents are gradually being resolved due to greater knowledge of sustainability topics and more availability of data on companies and their sustainability credentials. In terms of benchmarks, some providers have launched ESG indexes over the past year.

More attention is also being paid to clients’ sustainability and social issue considerations, importantly without compromising long-term investment performance.

This means it is now possible to incorporate sustainability preferences in robust, broadly diversified investment solutions. If designed and implemented correctly, investors can simultaneously pursue their sustainability and investment goals.

It also means asset managers can report their portfolios’ sustainability footprint, providing detailed metrics that give investors the transparency they have come to expect from investment performance reporting.

Growth in ESG is undeniable

The amount held in core responsible investment funds rose 62% last year to $51.5 billion, according to the Responsible Investment Association of Australasia’s (RIAA) 2016 benchmark report.

The most popular strategy among the 69 asset managers offering responsible investing products was screening, both positive and negative. To ensure adequate exposure and not compromise on diversification, strategies are now available that shift capital within particular sectors from companies with the lowest sustainability scores to those with the best scores.

Using this scoring framework, issues such as land use and biodiversity, toxic spills, operational waste and waste management can be considered alongside the dominant metric of intensity of greenhouse gas emissions.

A simplistic screening method can also easily overlook potential emissions from fossil fuel reserves. So while companies with large fossil fuel reserves may not have high emissions, those stored reserves are nevertheless a source of future potential emissions and may face risk of devaluation due to governmental action or the increased availability of alternative energy sources.

A final consideration is that sustainability includes more than just emissions. Penalties can also apply to companies linked to intensive factory farming, cluster munitions and mines, child labour practices, and tobacco.

How should ESG work?

The ideal approach should systematically evaluate sustainability metrics among companies across all major industries, excluding or penalising those that rank poorly while emphasising those with higher sustainability scores.

At the same time, the strategy needs to be broadly diversified across countries, industries and companies, while targeting the sources of higher expected returns, minimising turnover and keeping a lid on trading costs.

For fiduciaries, this opens up an avenue of differentiation by allowing them to tailor solutions that satisfy client convictions around ESG issues while delivering on investment outcomes. The client discovery process is important in providing fiduciaries with a sense of each person’s wealth aspirations and requirements, in addition to their non-material goals.

In the meantime, the RIAA has published a framework to help advisers judge best practices in integrating ESG in investment strategies. These include transparency of approach, the use of systematic processes and evidence of active ownership.

Aiding transparency on the company side are regulatory pressures to improve reporting around ESG issues. In November 2016, the Global Reporting Initiative (GRI) released its new sustainability reporting standards. More than 20 stock exchanges, including Australia’s, now reference GRI in their listing requirements.

Sustainable investing has moved from a fringe to a mainstream consideration for many millions of investors worldwide. The challenge is on now for asset managers to deliver solutions that meet those non-material requirements while still meeting clients’ long-term financial goals effectively.

 

Nigel Stewart is Executive Director of the Australian arm of Dimensional, a global funds manager with assets under management of around $600 billion, about 10% of which are in sustainability or ESG strategies.

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