ESG: Investing for a better tomorrow

Research suggests that firms which incorporate a strong ESG culture in the management of their business can enhance investment returns by allocating capital to more sustainable opportunities (renewables, waste reduction, etc.).⁸ Furthermore, it can help firms avoid investments that may not be beneficial economically in the long run due to environmental concerns. It is anticipated that new regulations enacted on carbon intensive industries will likely introduce new constraints on existing and future lines of business. For this reason, firms are repurposing assets today, to get ahead of the curve.

Strong corporate governance is widely recognized as a risk-mitigation tool that is in the best interest of all stakeholders. Strong governance promotes accountability and long-term focus by providing transparency and a clear link between robust value creation and compensation. Regarding social risks, companies that offer safer working conditions and better compensation can attract and retain superior talent and often achieve better productivity from their workers. Moreover, firms that are environmentally conscious not only attract more capital, but also reduce the risk of property damage from their operations and litigations that may arise from environmental damage. These are just a few examples of how ESG considerations can reduce risk while potentially adding value to a firm and therefore, shareholders as well.

Companies with a strong ESG focus understand the relationship between business, its stakeholders and society at large. Moreover, creating long-term sustainable value should be part of their core purpose while being transparent in their reporting of their ESG performance.

Sustainable investment drivers

Incorporating ESG into your personal portfolio begins by defining your values and beliefs, which can then inform your investment policy statement. Implementation decisions require alignment between your objectives (Are they broad based, or do you have targeted interests, such as “clean tech”?) and specific approaches adopted from the various investment managers. There are typically four approaches that investment managers employ to incorporate ESG into their process:
 

1. ESG integration: The process of including broad-based ESG factors into the investment decision-making process for security selection. This is a holistic approach to investment analysis in which both ESG and traditional financial factors are assessed to make investment decisions. 
2. Stewardship: Shareholder democracy is one way to leverage an investment manager’s influence on a company’s policies through proxy voting or direct engagement with their management or Board of Directors. 
3. Investment: Allocate funds to sustainability themes or impact investments for new opportunities.
4. Screening: Negative screening is one of the most commonly used ESG approaches. It involves excluding specific industries or companies that do not align with specific beliefs (e.g., drugs, alcohol, weapons, etc.). Positive screening, on the other hand, involves the inclusion of companies that align with specific beliefs. 

ESG integration and stewardship approaches are considered more active relative screening approaches that are more passive. Active ownership is an important component of sustainable investing as it promotes engagement with company management in a proactive and cooperative manner to achieve ESG objectives. Engagement is viewed as a more effective method as it broadens the universe of investment options by recognizing firms that are making progress on ESG initiatives rather than simply divesting away from companies that are not performing well on this front. Passive approaches aim to replicate an index or use an algorithm to select securities, which is less effective than engagement in advancing ESG performance at the company level.

A review of the ESG Global ETF universe reveals that the screening approach (the simplest) represents 44% of available options, while the integration approach — whereby managers seek best-in-class companies — makes up roughly 41% (a good balance between active and passive approaches). However, when considering asset size, the 24 largest US-based equity ETFs adopt the integration approach and collectively represent $25 billion. Only 3% of ESG ETFs follow an impact approach — focusing on investments that provide solutions to ESG issues — which in part is reflective of the complexity and resources necessary to pursue this route. In recent years, however, investment products have started to isolate universes of public securities linked to positive impacts with explicit references to applicable United Nations Sustainable Development Goals — the 17 goals listed by the United Nations with the intention of promoting prosperity while protecting the planet.

As of Dec. 31, 2020
Source: MSCI LLC ESG Research (Feb. 2021)

Today, ESG performance is becoming more measurable, allowing agencies to better assess the sustainability of companies and provide an ESG rating. That rating measures a company’s exposure to ESG issues and serves as a complement to financial analysis. A stronger ESG rating means a company is managing its ESG risk more effectively, relative to its peers. Conversely, a poor ESG rating simply means that a company has a high, unmanaged exposure to ESG risks relative to its peers. The most widely referenced ESG rating system is the MSCI ESG score, which measures risk across 10 categories of environment, social and governance areas.

At Mercer, we have a team of ESG specialist researchers that work alongside our dedicated team of global investment manager researchers that provide an in-depth assessment on an investment manager’s capabilities. Our process rates managers on four criteria:
 

1. Idea generation: The effort made by managers, and their ability, to integrate ESG factors into active security selection. 
2. Portfolio construction: Efforts to integrate ESG-driven views into portfolio construction.
3. Implementation: Engagement, proxy voting activities and ability to implement ESG views effectively.
4. Business management: Firm-level support for ESG integration, engagement activities and transparency.

Based on these criteria, Mercer assigns a rating on a 1–4 scale (1 being the best and 4 being the worst). 

Mercer’s ESG rating scale

With the increasing popularity of sustainable investing, investment managers are capitalizing on that momentum but don’t always go far enough in their security selection process; this is referred to as “greenwashing.” The most common criticism of ESG investing is that no investment can be considered 100% sustainable. Tariq Fancy, the former CIO for sustainable investing at BlackRock once dismissed it as “marketing hype.” The issue with ESG investing is that there is no one set of regulations or definitions that make an investment “sustainable.” Investors need to understand that ESG ratings are a points system, and as long as companies rank high enough, they can be ESG approved. For example, an oil company that recently made their board of directors more diverse and compensated employees better, could score a high enough ranking to be placed in an ESG fund that follows an index or uses a negative screening approach. Thankfully some investment managers favour active management that incorporates ESG integration and stewardship approaches. It is also worth noting that in some cases, the “fossil fuel” producers can also be part of the long-term solution if they are working towards incorporating more sustainable business practices, like investing in new technologies such as carbon capture and storage to remove carbon dioxide.

Companies have also attempted to increase their ESG rating and their ability to sell ESG bonds or equity by making commitments to be carbon neutral at some future date. We caution investors on this point, as essentially it provides funding to a firm with unsustainable operations that promises to clean up later. Some public companies offload their less sustainable business lines to the private sector in an attempt to appear more ESG sensitive. From a corporate perspective, they may be doing the right thing but this does not immediately make any significant difference to the common good as there is much less oversight in the private sector. This further emphasizes the point that divestment does relatively little by itself; it is engagement and making specific changes to business lines that will have a more lasting impact.

In order to minimize instances of greenwashing, regulators are further scrutinizing these business practices. Earlier this year, the Canadian Securities Administrators published their guidance for investment funds in the hope of ensuring that sales communications for ESG-related funds are not misleading. 

Currently, investors have to do some of their own due diligence to determine the sustainability of their investments — a challenge for even the most sophisticated investor. If ESG investing is important to you, we suggest looking into a fund’s prospectus, which would explain its investment objectives and more importantly, its approach to sustainable investment. If an asset manager’s approach to ESG investing is detailed and disclosed, it is less likely to be a marketing ploy.

For individual companies, look at their reporting over time. Has the company followed through on their commitments in prior periods? Has the executive team been involved in the decision-making around ESG issues? Lastly, ESG investing is not intended to be an overnight fix to the world’s issues. It is part of a process working towards incorporating ESG considerations into investment decisions to promote long-term sustainability.