ESGs - The Future of Greener Asset Investing

Environmental, social, and governance (ESG) the strategy of considering ethical values alongside financial values when evaluating investments. ESG standards help socially conscious investors gauge a company’s commitment to ethical business practices. While no single ESG rating system is used industry-wide, popular ESG data-providers include MSCI, Morningstar, Bloomberg, Sustainalytics, and more. Interest in environmental, social, and governance-related funds sky-rocketed this year, with total investment topping $1trn (£778bn) for the first time on record, according to data from Morningstar.

One of the biggest concerns about ESG is that it excludes parts of the investment universe, hurting returns. The good news is that funds that market themselves on their ESG credentials do not just focus on companies fighting global warming, with many of them incorporating technology stocks.

“If you are expecting ESG funds to be investing in small and innovative renewable energy companies, you might want to think again.”

Separate data from Refinitiv also shows that out of the top 10 performing funds that it labeled ESG in the year to June 30, 19 percent of assets were in Faang stocks — Facebook, Amazon, Apple, Netflix, and Google — or Microsoft.

• ESG stocks can include tech stocks.
• ESG stocks have to be sustainable.
• Greenwashing has become more prevalent.

Technology companies tend not to have a reputation as carbon emitters and therefore seem like a safe bet if your clients’ investment goal is focused on climate.

They have also been some of the best-performing investments over the past decade, in some cases quadrupling returns for investors. So, it is easy to understand why so many fund managers are keen to have them in their ESG portfolios.

The Bottom-Line of ESGs & Impact Investing

Impact investing could encourage more people to get involved in efforts that have been traditionally relegated to philanthropy or charitable contributions. With the potential to achieve at least some return, more dollars may be directed towards companies that are trying to address society’s problems. Admittedly, impact investments tend to generate lower returns than the stock market as a whole. A 2017 study by the Global Impact Investing Network (GIIN) of 71 private equity impact funds found their average net return rate to be 5.8% (well below the S&P 500’s average rate of return).

To be clear, this financial give-up only applies to impact investing in the strictest sense. If by “impact investing,” you actually mean ESG investing, you can expect much better returns. Multiple studies have shown that investors can build ESG-focused portfolios without compromising returns. In fact, Morningstar found that in 2019, US-based. ESG funds actually outperformed their conventional fund peers.

A recent ruling from the US Department of Labor may eliminate impact investing vehicles from 410(k) or corporate pension plans. The rule prohibits fiduciary financial advisors from selecting investments based on any goals other than achieving the highest possible return for their clients. The rule doesn’t specifically call out ESG or impact investing. Still, any investments that have a below-average anticipated rate of return (as many impact investments do) could be eliminated from employer-sponsored retirement plans moving forward.

The Future Variables Impacting ESGs

Public Policies & Disclosure Issues: -

A Biden administration is likely to push for green investments, either via explicit green linked fiscal stimulus, subsidies, and/or via regulation. Hence, electric cars, pollution abatement, biofuels, energy storage and the like are likely to do well. Scrutiny related to whether green investments actually employ the funds raised for stated purposes and whether such investments lead to measurable better environmental outcomes will increase.

The Climate Deal new administration will push for some kind of carbon tax deal, a cut on carbon emissions, or at the very least, mandatory disclosure of carbon emissions. European firms routinely disclose such data. It’s hard to determine whether carbon emissions are correlated with future stock returns partly because ratios of scope 1 and 2 emissions divided by revenue are highly clustered by industries. Predictably, energy has high emissions per unit of revenue, and energy stocks have not done well of late. Technology on the other hand has low emissions per unit of revenue and technology stocks have been on a tear. However, there is some evidence linking emissions per unit of revenue to higher operating efficiency.

The actual price per unit of carbon charged will matter a lot. For example, Sweden charges $119 per ton of carbon relative to $49 in France, $22 in the U.K. but only $0.08 in Poland. Meanwhile, the U.K. charges a carbon tax for electricity plants and manufacturing locations for large businesses and that too for emissions, is in excess of the allowance given to such businesses. Given the complexity involved and the room for bureaucratic and lobbyist wrangling, I do not foresee a carbon tax in the U.S. for at least the next four years especially given the need to dig out of the COVID-related economic fallout.

The E&S metrics in Europe despite the legislation and social pressure in Europe, these disclosures are barely comparable across firms in the same industry. For instance, SAP in Germany provides perhaps the most quantitative ESG reports Forbes reports have seen covering metrics such as women in management, employee engagement index, business health culture index, leadership trust index, net promoter score of the firm from the customer’s perspective, net GHG emissions, total energy consumption, and data center electricity usage. Most of these data are absent in other large German firms or such disclosures are not comparable. For instance, SAP claims an employee engagement of 93% in 2019 while Siemens reports that the average approval among employees for aspects of innovation, diversity, openness, and leadership was 70%. So, Forbes asks, did SAP consider the same aspects in its employee engagement survey? That’s impossible to answer. But the solution, for now, is to rely on primary sources of data such as federal filings as opposed to potentially biased self-reported metrics.

The Financial Takeaway

If you’re just getting started with socially conscious investing, you may want to start with ESG ETFs and mutual funds. As publicly traded assets, they are easy to buy (or sell) and generally earn solid returns as well. But if you have a net worth that’s on the high side or considerable investment expertise, you may be willing to deal with less liquidity and lower returns in exchange for making a bigger difference. And, in that case, it could be highly rewarding to invest in private funds and firms that are wholly focused on making a positive impact in the world.