ESG is a set of minimum standards, benchmarks and acceptable industries that a fund manager will abide by in making investment decisions. Essentially its purpose is to screen out certain investments, be they bonds or shares, loans or property holdings that do not meet what the fund manager sets out in its ESG policy.
There is no universally agreed standard of what may or may not be included. Each manager determines this. It is not compulsory for a manager to have a written guide or follow an ESG policy. The United Nations (UN) has created ESG standards and processes that fund managers can follow and be audited against.
Environmental criteria considers how a company performs as a steward of nature.
Social criteria examines how a business manages relationships with employees, suppliers, customers and the communities where it operates.
Governance deals with a company’s leadership, executive pay, audits, internal controls and shareholder rights.
Here are some key points investors should keep in mind when it comes to ESG investing.
- Its not a ‘cure-all’ guarantee that all investments held will be as pure as the driven snow.
- Some funds may not follow formal ESG rules yet exceed the scores of many ESG funds.
- Larger companies can be both ‘good’ and ‘bad’ across their varying business interests.
- You can ask for your fund managers’ ESG policy (if there is one). In many cases they are scored by external research firms.
- Be aware of 'Green washing'. Some managers use ESG primarily as a marketing tool and appear to be doing good but only loosely so.
- ESG may exclude you from generating better returns and lowering risk that you may need.
- Conversely, it may push managers towards firms with less certain returns and increased risks.
- ESG is subjective and ethically debatable. Individuals may disagree with definitions and determinations on issues where no outright correct answer exists.
This last point is where it can get tricky. Here is some food for thought with real world examples that point to why its not as clear-cut a thing to do:
Whilst it might sound good to exclude weapons manufacturing, can we sit in our homes and enjoy our nation with the assumed silent protection of no weapons within our police, border and defence forces?
Here's another: A aeronautics corporation providing the planes you fly in and also delivers life-saving cancer diagnoses from their MRI scanners, yet also produces key components in nuclear ballistic missile systems.
How about a large food production business feeding millions whilst relying on GM altered food and mono-culture cropping?
Perhaps a carbon energy business that has commenced the shift towards renewable energy, yet carbon will remain a significant component of its business (and in your life) over the next 15 years.
These can be companies that touch almost every aspect of your everyday life and household. They can be a few steps removed from you, yet are essential to you. It is a challenge to be against them yet use the goods, services and outcomes you need.
How does one decide the ‘line’ on these businesses? Is it right to do it at the investment fund level, or via laws, or lobbying, or a mix of them all? Yes a few are easy; smoking and child labour. However, much like the rest of life, it is the shades of grey that predominate and provide the challenge.
Consider this approach as an investor: Don’t aim for absolutes. Like most things in life, moderation is better. Avoid aiming to solve everything and focus on just some of the things you would like to make a stand on. Accept that some issues may best be solved by other means. For example leveraging the proceeds from your investment. Why not donate some of your returns to an NGO (Non-Government Organisation) dedicated to solving the issue of most concern to you?
Compromise makes the world turn but it is good to at least be aware of the ESG situation in your larger investments and perhaps even consider an ESG fund. The world is a better place for them and what they support. Be part of ‘good change’ within moderation.
Impact investing. This differs from ESG. It is focused on allocating capital to companies that are attempting to do direct good in the world. Thus, it targets specific businesses improving the world as opposed to deploying a set of restrictions across all business opportunities. An example is renewable energy. Next month we will take a deeper look at this form of investment.