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Understanding ESG
Breaking the ESG myths
Time to explore some of the questions that arise when looking at responsible investing
Andrew Parry 8 Mar 2021

With responsible investing and environmental, social and governance (ESG) factors getting more attention now than ever before, it’s important to demystify some of the language involved and explore some of the questions that arise when looking at this area of investing.

Why is ESG investing important?

For a range of reasons. For some it’s because investors want to play their part in building a fairer, more sustainable world – and they understand the importance of ESG issues in creating that. But there’s also an increasing body of evidence that suggests a focus on ESG considerations can boost a fund’s performance. Certainly, it may help avoid exposure to problems that can lead to falls in a company’s value. Just look at corporate scandals – from oil spills to data breaches – to see the damage caused to the share price of their businesses. In some cases, they can even go out of business.

What is an ESG fund?

An ESG fund is an investment portfolio in which environmental, social and governance factors have been integrated into the process used to buy and sell companies (or in the case of bonds, the debt of companies). This means the selections of stocks and companies in the fund have usually passed tests or have been analyzed on how sustainable they are regarding ESG. However, fund management groups don’t all follow the same process so just because a fund has a label denoting it as sustainable or an ESG one, doesn’t mean it has used as vigilant a process as another.

Does an ESG fund mean it’s environmentally friendly? Are they like ethical funds?

Not necessarily. ESG are factors in analyzing companies. They are not moral judgements on what the company does as a business. One fund, for instance, might avoid any company engaged in the oil and gas sector; another might invest in those kinds of companies as long as they’re working towards sustainable solutions. And the environment is just one aspect of ESG. Some companies you may not consider to be environmentally friendly but are well-rated when it comes to their social or governance actions.

Is a fund that invests in, say, renewable energy using ESG?

Perhaps. It is difficult to say. Not all funds use ESG factors as a way to analyze companies. And just because a fund may look as if it is invested in so-called environmental companies, it doesn’t mean they score highly on an ESG basis. For instance, a coal company may be implementing strong social and governance policies whereas a renewable energy group may be employing practices not considered highly through an ESG lens.

What is responsible investment?

Responsible investment is an approach that recognizes and takes into consideration the importance of ESG factors. The latter is a component of the former – if responsible investment was a house, ESG would be a room in it. Investors adopting this approach believe the generation of long-term sustainable returns depends on stable, well-functioning and well governed environmental, social and economic systems. They also show stewardship as they promote active ownership on behalf of the clients.

What is sustainable investing and how does it differ from impact investing?

Back to the house – sustainable investing is often synonymous with responsible investments and just as ESG was a room, so too is impact investing. With impact, the focus is on companies with products and services intentionally designed to tackle an underserved societal need. The aim is to generate a financial return alongside a measurable, beneficial social or environmental impact. A fund labelled ESG or sustainable can hold those companies seen to fall under the definition of impact, but the scope of permissible names is far wider. While impact investing is a growing and popular area, at the moment, measuring the “impact” of a company is often considered more of an art than a science.

What is active engagement?

This is when owners of a company’s shares or bonds – investors – talk with its management to try to persuade the adoption, or cessation of certain actions. In ESG terms, that might mean persuading them to take climate change seriously, or to have more diversity on their boards. It could also mean rejecting a CEO’s pay package or persuading a company to be more open about its working practices. In this way, owners of shares in a company – or owners of its debt – have significant powers to influence behaviours. Think of it as the power to nudge a company to act in a more responsible, sustainable way.

How can I compare one ESG fund with another?

Not easily. You can compare their performance, certainly. But even if they are invested in the exact same market, they may have two completely different approaches to ESG analysis. For instance, one may have an in-house team that specializes in it; another may invest only in those constituents of an ESG index. This would give the two funds far different universes of companies from which to select. However, governments and regulators worldwide are recognising this problem. Work on a common set of standards is underway in many places, which would help investors to get more information and greater transparency.

Is ESG just applicable to developed markets?

Not necessarily. Some managers try and review companies within the context of their market rather than compare them across countries. So, a company in France might be more progressive in its ESG actions than one in, say, Indonesia. But in comparing two similar companies in Indonesia, there is one that might score more highly than the other. Many emerging markets do have less developed institutional frameworks and their political environment may be more complex. They may also have different social norms (such as sharing personal data with governments) and disclosures may vary significantly across markets. This is why investors should look to see the approach being taken in any prospective ESG fund.

What are SDGs? Why do they matter?

Sustainable Development Goals (SDGs) are 17 specific measures of economic development designed to maintain a balance of environmental and social needs and address shortfalls in areas like poverty and gender equality. These United Nations-backed aspirational goals are aimed at making the world a better place by 2030. They include zero hunger, no poverty, affordable and clean energy, and quality education. Today some investment funds have been built around these goals, investing in companies that aim to make the aspirations in the SDGs a reality. Again, as ESG and impact are rooms in the house of responsible investment, so too is SDG.

What is the importance of the Paris agreement?

It is an important international treaty designed to tackle climate change. The agreement came into effect in November 2016. Its central aim, driven by concerns over global warming, is to strengthen the international response to the threat of climate change by keeping a global temperature rise in this century well below two degrees Celsius above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius. The agreement was signed by 197 countries parties and ratified by 187, as of November 2019.

Andrew Parry is the head of sustainable investment at Newton, an affiliate of BNY Mellon Investment.

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