What is ESG – and is it here to stay?
2 December 2019
Ben Constable-Maxwell, head of Sustainable and Impact Investing at M&GPrudential looks at the fundamentals of ESG investing and what it offers investors.
Environmental, Social and Governance (ESG), is a framework that investors use to take account of the extra-financial and non-financial issues that affect their investments, alongside traditional financial analysis.
This framework outlines the environmental, social and governance risks and opportunities that companies face, and that investors really need to take into consideration.
Why? Because those issues can have material impacts on the long-term performance of those businesses, both operationally and financially.
ESG, though, is not a one-size-fits-all, and there is a broad range of ESG strategies that investors can implement.
At one end of this range are exclusionary approaches, for example, screening out so-called ‘sin sectors’ like tobacco or gambling. As strategies increase in sophistication, investors can adopt more meaningful approaches, including ESG integration and engagement, which is where we at M&GPrudential think you really start to add value as an investor.
The upper end of this spectrum culminates in pure sustainability themes or impact investment. It is at that end of the range where investors have more of a primary focus on delivering real outcomes to society or the environment, as well as financial returns, rather than thinking about ESG just as a risk framework for portfolio management.
Driving forces – why ESG is here to stay
We believe that the focus on ESG is not simply a fad that will eventually fall out of vogue – quite the opposite, we think it represents a long-term structural trend, with a number of different drivers behind it.
One major impetus is a fundamental shift in societal expectations around what investors have a responsibility to focus on, particularly given the problems the world is facing, whether environmental or social.
We believe that legislation and policy are increasingly reflecting this shift in expectations and, thus, are also important elements behind the transition to an ESG mindset. The world’s policymakers, governments and regulatory authorities are all focusing on environmental, social and governance issues as potential major risks, not just to companies and sectors, but to the whole global economy and the financial system itself. This has translated into heavily increased scrutiny on ESG practices, which investors have to respond to.
A final element, which we think is one of the most compelling for us as investors, is that the evidence is increasingly showing that taking an ESG-focused approach may result in better returns over the long term, and at the very least does not lead to worse returns.
This means that investors who consider ESG issues are likely to have a better risk-return profile, with increased expectations for the long-term delivery of financial returns.
If we drill down into some of the specific issues, in ESG terms, that we look at as investors, on the environmental side, climate change is really at the top of the agenda. This is a major, potentially existential issue, that companies across sectors are going to have to deal with over time.
But it’s not just climate change, with other environmental challenges, from pollution to natural resource scarcity, very much forming part of our environmental considerations.
The social side also represents a broad range of issues and really requires thinking about a company’s range of stakeholders, including its employees, its customers and the local communities in which it operates. Here we have to consider the ways in which a company is carrying out its responsibilities towards those stakeholders.
Governance, meanwhile, is arguably the most fundamental element in the equation. This is about ensuring the right people are managing a business and leading it forward with an effective strategy, and also that those people are incentivised to manage the business responsibly in the interest of shareholders, as well as in the interest of the wider society in which it operates.