All the rage: ESG and the inevitable backlash
- Published
If you’ve been reading the business pages lately you would be forgiven for thinking that ESG investing – or Environmental, Social and Governance investing – is in the midst of a backlash. Depending on who you ask, this has either been a long time coming or it is an unfair characterisation of a part of the finance industry which is increasingly mainstream. In this month’s newsletter, we thought it would be helpful to demystify ESG (and terms like responsible and sustainable investing which are also used interchangeably) and outline how ESG fits in to investment management at Paradice.
ESG and responsible investing – what’s the difference?
Responsible investment or investing is best thought of as an umbrella term for investment strategies which consider ESG-related factors including associated activities such as long-term investing, engagement and voting. Confusingly, though, terms which refer to a specific investment strategy will be used interchangeably with ‘responsible investment’, or ‘ESG’ will be used as a catch-all, adding to lack of clarity on its meaning.
We find it helpful to think of ESG as an information set (relating to environmental, social or corporate governance matters) which can be variously applied within different investment strategies, depending on an investor’s priorities. For example, in many cases an investor’s focus is to generate risk-adjusted returns. In this case ESG information will be relevant where it may affect a company’s earnings, reputation or liabilities, or other such financially material impacts. A key question in this approach is how does the ESG issue impact the company?
However, for some investors, they may have additional considerations they would like included in investment decision making. Whether this is motivated by religious beliefs, personal preference or a sense of social responsibility (i.e. values), these investors will look for financial products which in some shape or form limit the investment universe ultimately through the use of ESG-related information. This can be achieved by using such information to either avoid certain types of investments (e.g. products identified as causing social harm such as tobacco), or to actively seek out investments that meet certain characteristics (e.g. a company offering climate solutions or a company whose operations are best-in-class). In contrast to the above, the key question is how does the company impact society or the environment?
Key responsible investment strategies
The most common strategy in this area is ‘ESG Integration’ and refers to the consideration of financially material ESG factors – both risks and opportunities – within the investment process. The key criteria being that the ESG information is financially material – if it isn’t, it will largely be ignored in investment decision making. For instance, even though climate change may present risks for many companies (and some investors may rightly want to be part of the solution), an investment manager applying an ESG integration approach would only meaningfully consider a company’s greenhouse gas emissions if these were significant enough to present a financial risk. Generally, this will be highly relevant for the energy and heavy industrials sectors, and much less so for professional services and IT as an example.
If ESG Integration is the strategy which focuses on protecting or enhancing value, the three other core responsible investing strategy types variously incorporate values-based considerations, alongside financial ones. In simplified form, these are:
- Ethical investing: avoiding certain sectors/business activities in line with ethical considerations (e.g. through formal exclusions).
- Sustainable investing: targeting companies with sustainable business practices and/or more sustainable products/services. There is a broad range within this category, with some products much more focused on outcomes with others more aligning to structural trends.
- Impact investing: seeking to achieve targeted and measurable environmental and/or social outcomes (in addition to financial returns). Ideally investments deliver outcomes that wouldn’t otherwise have occurred.
To add to the confusion, many products will apply more than one strategy at a time. For example, it is common to practice ESG Integration, however this can be supplemented with additional layers of investment decision making such as ethical or sustainable factors. These supplementary layers of decision making may be rules-based (e.g. exclusions), through a structured framework or at the Portfolio Manager’s discretion.
In our view, common misunderstandings across the market about the nuances of investing for value or to align with values has fuelled some of the current backlash. One outcome has been greater scrutiny of ‘greenwashing’ among stakeholders, and a move for regulators to provide more specific guidelines. We think this will only be positive for the industry, as consumers’ expectations will be better met and true responsible investors will rise to the challenge.
What we do at Paradice
Paradice strives to be a responsible investor in that we believe it’s important to consider the full range of risks or opportunities that may be financially material to a company and as such we also look to relevant ESG information. In short, Paradice practices ESG Integration in all of our strategies as we strongly believe this helps us to achieve superior risk-adjusted returns for our clients. Besides firm-wide exclusions (tobacco and controversial weapons), currently we do not offer any investment strategies which apply values-based considerations.
Another reason we consider ourselves to be responsible investors is that we take a longer-term view when investing in portfolio companies. The longer the investment horizon, the more relevant it is to consider ESG information as such issues can often play out over extended time periods. For example, a company cutting corners on safety today will not see this reflected in the share price tomorrow, however, as time passes and safety processes weaken, the greater likelihood a business-disrupting failing will occur. We also see an active approach to company engagement and proxy voting as integral to our active investment management style.
Disclaimer:
This material (or any contribution to it) is not intended to constitute advertising or advice (including legal, tax or investment advice or security recommendation) of any kind. It is of a general nature only and was current only at the time of initial publication. The information and opinions contained herein are not necessarily all-inclusive and, as such, no representation or warranty, express or implied, is made as to the accuracy, completeness or reasonableness of any assumption contained herein and no responsibility arising for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Paradice, its officers, employees or agents. It may contain certain forward looking statements, opinions and projections that are based on the assumptions and judgments of Paradice with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond the control of Paradice. Because of the significant uncertainties inherent in these assumptions, opinions and judgments, you should not place undue reliance on these forward looking statements. You should consider your own needs and objectives and consult with a licensed financial adviser. For the avoidance of doubt, any such forward looking statements, opinions, assumptions and/or judgments made by Paradice may not prove to be accurate or correct. References to securities may or may not represent the holdings of the Paradice Funds. The content of this publication is current as at the date of its publication and is subject to change at any time. It does not reflect any events or changes in circumstances occurring after the date of publication.
