ESG – The what, why and how?
What do we mean by the term ESG?
In investing circles, ESG refers to investments that consider Environmental, Social and Governance issues as part of their process. For example, a fund might exclude companies with poor environmental credentials such as fossil fuels polluting the environment or tobacco and gambling businesses that profit from the legal but harmful products and services that they provide to the public.
Why would you invest in ESG products?
- Investors have multiple reasons for choosing ESG products. It could be:
- Aligning with ethical or moral concerns such as avoiding companies that employ child labour in developing countries, profit from fossil fuels or environmental damage as an example.
- Aligning with religious beliefs.
- Trying to make a direct impact by funding businesses or projects that “make a difference” e.g. green bonds that fund projects with a positive environmental impact1 such as encouraging households to purchase solar panels.
This movement towards ESG-based investments is now one of the fastest areas of growth in the asset management business. PwC is forecasting that ESG-oriented assets under management (AUM) will more than double from US$4.5 trillion in 2021 to US$10.5 trillion in 2026 while in the Asia-Pacific it is expected to triple off a lower base to reach $3.3 trillion in 20262. In their base case it will be taking an increasing share of total investments as shown below with private markets (private equity, venture capital and the like) expected to lag public markets for stocks and bonds given its relatively smaller size.
Figure 1: ESG growth forecast by asset type and region (2015-2026)
Source: PwC Global ESG and AWM Market Research Centre analysis, Lipper, Preqin, ESG Global
How would you invest?
As climate change and social issues have become more charged in recent years, we have seen a material shift with investors highlighted above with growing demand for products with an ESG-focus. In some cases, these may “just” be aligned to environmental goals and in others, more broad-based e.g. factoring in broader social ambitions and targets.
Today the typical Australian investor has a range of options before them. These usually fall in one of two camps:
- Negative screening
- Impact investing
Negative screening is the process of removing potential investments due to ESG concerns. For example, take a benchmark index such as the S&P/ASX 200 and remove businesses that are involved in gambling or alcohol sales. A fund manager following this index would then exclude companies such as Endeavour Group (owner of Dan Murphys and a range of pubs across the country) or Tabcorp (gambling operator with brands including TAB and Keno) from the portfolio.
The goal here is twofold;
- by avoiding these businesses investors know they have limited exposure to damaging business practices; and
- by reducing demand for these stocks enough they will tend to trade at more depressed valuations versus the broader market making it more difficult for them to raise capital and grow in the future.
The second point is seemingly indirect, what does a depressed valuation matter if you’re still making money? It can be a powerful deterrent to expanding operations however as it makes more ambitious projects that require equity injections from shareholders increasingly expensive and at times prohibitively so. If broader society buys into the approach, e.g. bank lenders with ESG targets then in some cases an entire industry can become increasingly sidelined.
This has arguably become the case with the domestic coal sector with a range of operators increasingly isolated from equity and debt markets as a source of capital in recent years. Just this year we saw Commonwealth Bank promise to no longer finance new thermal coal mines and reduce its existing lending to zero by 2030 . Mine operators in this scenario will have to increasingly rely on the few lenders left (at potentially higher rates) or self-fund their operations and expansion if they even can do so.
These negative screening solutions tend to be more “benchmark-like” in nature and are commonly offered to clients as a benchmark index such as the S&P/ASX 200 less a range of unsatisfactory businesses in an ETF (listed index fund) or managed fund structure.
Impact investing is more direct and “hands on” with managers actively looking to engage and promote stronger ESG outcomes in their investments. Examples include;
- investor activism to encourage divesting environmentally damaging business divisions e.g. a conglomerate that also owns an oil field;
- encourage investing in the business itself to achieve net zero greenhouse gas emissions; or
- private markets (private equity, property etc) funds aiming to deliver social goods such as affordable childcare or housing.
These tend to be less benchmark-aware approaches as they are targeting a specific set of outcomes in listed equity markets or bond markets for instance. They tend to be more suitable for investors with concrete ESG goals that have a higher risk tolerance and ability to handle returns deviating materially from traditional benchmarks such as the S&P/ASX 200 or the S&P 500 indices.
Conclusion
ESG investing is now a powerful movement across the asset management industry and is only expected to grow more important over time. Its influence has already started to impact the broader economy with certain business practices becoming increasingly uninvestable such as thermal coal. There are a range of investment options available to meet investor preferences and a particular choice will depend on the strength of their ESG preferences and ability to handle potentially higher levels of risk.
If this article has sparked an interest in ESG investments, we encourage you to reach out to your adviser and express your interest. Not only do they have access to extensive external research, but they also have the broader investment team to draw upon and we are confident that we can find solutions to meet your ESG.
