Environmental, social and governance (ESG) investing has been gaining in popularity over the past few years as investors are becoming more and more conscious of these factors in their investments, especially as issues such as climate change, the #metoo movement, and executive pay have all gotten lots of media attention. Nowadays many investors want to see not only financial returns from their investments, but they also want to know that the return was earned through ethical and sustainable means. This new consciousness is creating problems and opportunities for money managers and corporate executives.
Many companies are now more conscientious of the need to address ESG factors. For example, Microsoft (which was the subject of numerous anti-trust lawsuits by the US department of Justice in the 1990s) recently announced that they would go “carbon-negative” by 2030 and would also create a $1 billion fund for capture carbon tech. Nestle said it would spend 2 Billion dollars to develop an easier to recycle plastic packaging. Colgate plans to sell recyclable toothpaste tubes. Meanwhile companies that have had issues with bad behavior, such as Alphabet or Facebook, have lost value in their share price as a result (though perhaps only temporarily). Recently Blackrock, the largest asset manager in the world announced that they would start to consider ESG factors when voting their proxies at corporate meetings and would also divest themselves of all companies with bad ESG ratings.
I think it’s a good idea to define exactly what we mean by ESG factors. As the name would indicate, there are three main components to ESG investing and they are broken out as follows:
Environmental. An investor would assess a company’s operations and their impact on the environment either by energy consumption, carbon emissions, and/or waste. Certain industries are obviously much more carbon intensive such as energy, but many industries are also big consumers of energy such as online streaming services, which would lead to more environmental risks in their business.
Social. Social is a very broad category of factors, but it would include things such as the effects of a company’s products or services on individuals and their communities. This could include impacts on their health and safety, either mental or physical. It could also include concerns over how a company deals with privacy and personal information. Social factors also include workplace health and safety, relations with employees, and workplace diversity.
Governance factors. This would include issues such as executive compensation, quality of management, independence of the board, and diversity of the board.
As you can see, these factors cover a fairly broad area of analysis. As such, it can be difficult to figure out exactly what ESG investing is, and how investors can use it in their own portfolios.
ESG investing has been one of the biggest trends in our industry and hundreds of funds now bear the ESG stamp, signaling that they at least try to incorporate ESG principles in their investing processes. However, despite this trend, the results for investors have been decidedly mixed.
Many funds that brand themselves as ESG funds use a technique that’s called negative screening when they select investments. This means that when selecting investments, the manager screens out companies which don’t meet their criteria. For example, a manager could screen out all oil and gas companies if they are concerned about the environment, or they could screen out weapons manufacturers if they are a pacifist. This type of negative screening can be a blunt instrument as it effectively eliminates large swathes of the investing universe based on high level factors. The individual circumstances are not really considered.
What further complicates this is there are no standardized criteria for what constitutes a good ESG company. As such the criteria is very inconsistent across the industry. This is very bad for consumers as they may think they’re doing the right thing by investing in an ESG fund, but on closer inspection they could find that the criteria used by the fund they selected does not actually match their own ESG concerns. For example, a Financial Post analysis of the 122 active responsible investing funds listed on the Responsible Investment Association found that 45% of those funds still had exposure to at least one stock that is primarily engaged in the production, processing or direct transport of fossil fuels1. This number is probably even a conservative number because 50 of the funds on the list only disclosed their top holdings, which made up as little as 7% of the overall portfolio. Another 18 funds don’t disclose any information at all. The Financial post also found that some funds were invested in things like tobacco and alcohol stocks as well. In some cases, the fund manager didn’t claim to exclude fossil fuels, though in other cases the disclosures were more misleading as they branded themselves as “low CO2” funds. There’s even been a term developed for this type of behavior. It’s called “greenwashing” and its where funds try to portray that they are greener than they actually are. It’s not just environmental issues causing problems however, as a number of funds and ETFs claimed to screen for conflict zones, nuclear energy, and oppressive regimes yet still had investments in their funds which met these criteria, even though they should have been excluded.
Part of the issue is that there is no proper auditing or regulatory oversight of these types of claims as yet, so basically funds are able to claim things which may not be 100% accurate. For amateur investors, it can be a nightmare to try and figure out which ESG fund is right for them, or whether they should even bother with the type of fund at all.
Negative screening is one way of doing ESG investing, but another way is called ESG integration. Instead of simply blacklisting companies based on certain ESG criteria, ESG integration task the fund manager to utilize ESG criteria when conducting due diligence on a potential investment. This allows the fund manager to identify and assess any ESG risks that a company might have. ESG integration does not exclude any particular sector or industry but looks at each unique company and judges the company on its individual merits.
ESG integration is in my preferred method for integrating ESG principles into your investing and I much prefer it to negative screening. I view negative screening as too much of a blunt instrument. All sectors and all companies have ESG considerations, so while ESG definitely applies to sectors like Oil and Gas, it also applies to tech companies like Microsoft and Netflix, who are not usually thought of as companies with ESG concerns (though they are both big consumers of energy). What’s more, I think that a more nuanced approach should be taken when investing.
This is consistent with our approach to investing overall. We’re interested in buying great businesses that are sustainable. As part of being great and sustainable, companies should have great management and provide real value and benefits to society. They should be socially conscious and environmentally aware. If they are carelessly polluting the environment or treating their customers, their neighbours, or their employees badly, they are unlikely to maintain their great business for long, especially in today’s environment. We’ve always analyzed companies on their own individual merits and for me it wouldn’t make sense to then try and look at ESG factors without considering the individual merits and risks of the individual company.
In addition, I think that negative screening can improperly remove companies that are doing some great things. For example, Canadian energy companies have to adhere to some of the highest environmental standards in the world. Since demand for oil and gas is consistently going up, you could certainly make the argument that we should be investing in Canadian energy companies instead of importing oil from other countries where the environmental standards may not be as strict. This is not inconsistent with a desire to reduce overall green house gas emissions, even though it’s often treated as if Canadian energy and the environment are completely opposed to each other.
When we look at a business, part of our own due diligence is to determine what environmental or social impacts a business has, and what are the potential risks to the company from their environmental and social impacts. In my opinion if you’re an investor in Coca Cola, you have to be aware that Soft Drinks are getting an increasingly bad reputation for their effects on consumers health, and that is a risk to their business model. It’s not that we shouldn’t invest in Coca Cola just because they have sugar in their drinks, but it is a risk that an investor needs to be aware of.
This type of analysis is possible when you’re an active manager selecting investments. It would be virtually impossible to make this kind of analysis using a passive fund which is doing negative screening. In my opinion our approach is much more fair, and much more effective.
ESG factors are becoming more and more important and are definitely not going away. Investors who are concerned about these types of factors should make sure that their investments reflect their concerns. They may be surprised to learn that they can be ethical AND earn a good return at the same time.
- Craig White, BA, LL.B., CIM®
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.