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04/08/2021

Making Cents: Your guide to ESG investing (part 1)

Making Cents: Your guide to ESG investing (part 1)

Green funds in particular, ones which emphasize climate, environmental, and renewable energy have become a popular choice for investors

IN the first of two articles, this week I’m going to look at the rise in sustainable investing, which are investments that take into account environmental, social and governance factors alongside financial factors when making investment decisions.

And next week, I’ll post a second article because you might want to consider implementing your own ESG investment strategy, which is why I’ll look at specific ESG investments, and give you 2 examples of ESG mutual funds, 2 ESG ETF’s and 4 ESG companies.

What exactly is ESG investing?

It’s basically an investment strategy that takes into account environmental, social and governance factors alongside financial factors when making investment decisions. It falls under the ‘sustainable investing’ umbrella.

Below is a breakdown of factors relating to a company’s impact on the environment and society and the way a company is governed:

Environmental (E): climate change, greenhouse gas emissions, recycling practices, water usage, usage of renewable energy, raw material sourcing, etc.

Social (S): employee health and safety, fair wages, employee training and development, ethical supply chain sourcing, privacy and data security, etc.

Governance (G): board diversity, executive pay, business ethics, transparency, political contributions, etc.

ESG investing has become increasingly more popular with one report from the Forum for Sustainable and Responsible Investing suggesting that last year, more than $17 trillion of assets under management were held in sustainable funds, which is about one third of all assets under management.

So, sustainable investing isn’t a new phenomenon, and it looks like they’re taking over, based on the volumes of new monies being invested in them. Investors are beginning to take money out of traditional equity funds, ones that don’t have a clear and obvious sustainability objective or use environmental, social and governance measures, and are pumping them into sustainable funds.

Green funds in particular, ones which emphasize climate, environmental, and renewable energy are the most popular choices. Four of the top ten sustainable funds with the biggest inflows last year came from those focusing on renewable energy.

And values of what have become known as green stocks, have in some cases increased three and even four-fold. Just look at electric car maker, Tesla. This time last year they were trading at $162.26 and at the time of writing this, they were at $625.22, which is an increase of 285%.

Last year, some $50 billion was invested in sustainable funds, which was more than double what was invested in the previous year.

And there are very good reasons why this is happening.

In 2017, a study conducted by Morgan Stanley Capital International (MSCI) found that companies with higher ESG ratings were associated with higher profitability, lower tail risk and lower systematic risk.

In 2019, the International Monetary Fund (IMF) published a report that suggested, when investors make investment portfolios that prioritise ESG values, returns are not sacrificed.

In February 2020, the European Securities and Markets Authority (ESMA) published a report on trends, risks and vulnerability which looked at ESG investing. It also looked at the performance of the EURO STOXX ESG Leaders 50 index with its corresponding benchmark index, the EURO STOXX 50. And over a two-year timeframe from 2017 to 2019, the EURO STOXX ESG Leaders 50 was the clear winner.

And in March 2020, Bloomberg reported that 59% of US ESG ETFs outperformed the S&P 500 index and 60% of European ESG ETFs beat the MSCI Europe Index in the first quarter. However, it was also noted that six of the ten largest ESG-focused US mutual funds performed worse than the S&P 500 during the same timeframe. So, it’s important to note that ESG investments are not outperforming across the board.

It’s quite revealing that some leading investment management companies are now centring their investment strategies around ESG. For example, BlackRock, the world’s largest asset manager, announced in January 2020 that it would be shifting its strategy towards investments related to climate change issues.

Which all means that integrating ESG into investment strategies has grown with momentum. And MSCI, cited three main reasons for this growth:

New challenges: Issues such as rising sea levels and personal data leaks, for example, are more prevalent in today’s day in age and introduce new risks to investors. Therefore, an investor may evaluate investment strategies according to these new risks.

New investors: There is a new generation of investors that do not only consider the bottom line in their investments. Interest is growing in strategies that follow ESG standards.

Availability of data and analytics: There is more research and data from companies regarding ESG available, which investors can use in making their decisions.

ESG Scoring Models

With its growing popularity, data providers have created scoring criteria upon which they can rank ESG investments, allowing socially responsible investors to make informed decisions when choosing companies, ETF’s or mutual funds.

Companies like MSCI, Standard & Poors and Blackrock have developed their own ESG scoring models.

The world’s largest index provider, MSCI, for example, has a rating system where it rates companies on a ‘AAA to CCC’ scale and based on a company’s rating, it is classified as laggard, average or leader.

The parameters they use to determine ratings falling under environment factors in things like a company’s contribution to climate change, pollution and waste management, use of green technologies and renewable energy. And under social, they look at, health safety and human capital development, product and consumer safety, community relations and under governance they assess corporate governance and fairness and accountability and transparency and ethics.

Companies are given a score from zero to ten in each area, with zero indicating virtually no exposure and ten being very a very high exposure to a particular ESG risk. Scores are then aggregated, weighted, and scaled to the relevant industry sector to arrive at a letter-based grade, which is very similar to what credit ratings use for banks and countries.

A score between 8.5 and 10 will receive a AAA designation and considered a leader. Between 7.143 and 8.4 the letter score is AA and between 5.7 and 7.142 is A.

Letter scores that attract a BB or BBB rating are considered average and B and CCC ratings are considered laggards, which means they trail their industry and has a high exposure to failing to manage significant ESG risks.

Tesla for example has an MSCI ESG rating of A, which is at the lower end of the leader leaderboard.

It excels in corporate governance and environmental risks (it has a relatively small carbon footprint) and invests heavily in green technologies. It would receive a higher rating if it didn’t fall down on product quality and safety (exploding batteries, poor crash text ratings, and accidents involving their cars autopilot feature) but what really impacts it’s rating is its labour management practices. It has been found to be in violation of labour laws for blocking unionisation and has come under severe criticism for keeping plants open during C19, with several of its employees coming down with the illness.

Okay, next week, I’ll post a second, follow up article where I’ll look at specific ESG investments, and give you those 2 examples of ESG mutual funds, 2 ESG ETF’s and 4 ESG companies.

Liam Croke is MD of Harmonics Financial Ltd, based in Plassey. He can be contacted at liam@harmonics.ie or via harmonics.ie

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