"ESG" is a familiar acronym increasingly making it's away across headlines over the last few years. Many wealth and investment firms, as well as banks and insurers, use it to promote investments and new products.
But what is ESG and why should it matter now, during the COVID-19 pandemic?
Sophie, what's the clearest description of ESG?
ESG is the integration of environmental, social and governance factors in the investment decision-making process, as they have the potential to be financially material. We look at ESG from both a risk and an opportunity perspective.
Sustainable investment is about allocating capital to economies to help them thrive. That capital is directly linked to financial returns, in a way that's beneficial to the environment and society.
When we think about the bigger picture, we look at the whole spectrum of capital, from responsible to impact investments, depending on the level of financial returns and environmental or social impact the client is keen to make through their investment portfolio. Sustainable investing is everything between traditional finance and philanthropy. Clients can choose from a range of investment methods from avoiding harm to the environment and society, all the way through to actively contributing to finding solutions to environmental and social problems.
What changes have you seen when discussing ESG with clients?
ESG integration had in the past gained more interest amongst institutional investors, however with more global headlines around climate change, poor corporate behaviour and issues of labour rights in supply chains, more investors are now aware of these issues and want to understand how their investments can drive change.
Whereas in the past Private Banking clients were more focused on ethical exclusions from their investments, we are now seeing that clients wish to invest in a way that is respectful of our environment and society.
In particular, younger investors such as our NextGen clients expect to see more from their investments than just financial returns. They want to do something purposeful with their investments, understanding that they can shape the society and environment we live in. We've seen a lot of reports in the media about students lobbying their universities to divest their endowments from fossil fuels, for example. We want to offer investment solutions for their personal wealth that reflect their sense of purpose in a meaningful way. Their influence is being felt across the industry from family offices, through lobbying foundations, corporate boards, and endowments, to raising awareness and changing investment behaviours across generations.
Sustainable investing plays a role in long-term value creation and preservation. That's why it is so important for Private Banking clients.
As far as the ESG acronym is concerned, where do you see the most potential for interest: environmentalism, society, or governance?
In the past we have seen more interest in environmental issues. The E of ESG is easier to understand and measure and we've seen that reflected more in the media than the S and the G. Social aspects were perhaps harder to define or grasp for investors.
That being said, the COVID-19 pandemic has also brought to light Social Issues and the way the most vulnerable populations have been affected. Many employers have been offering health and job protection to employees, while others have behaved disappointingly in the eyes of many, furloughing their employees when some had the cash reserves to keep them on.
ESG integration is the simple idea that companies which succeed long term, and deliver shareholder returns, are those which create value for all stakeholders - employees, customers, suppliers, the environment and wider society1.
We need to place more emphasis on Social issues. For instance, are workers' rights being respected? Is the lack of health benefits, paid holidays and sick leave putting employees in harm's way? What policies should companies have to protect their workers in this challenging environment and have existing ones been updated? Asking these questions makes sense from a long term return and well-being perspective.
There have been criticisms that too much ESG investing is tilted towards large cap equities because publicly quoted firms disclose more data and are easier to analyse… What are the drawbacks to that for investors coming in, and how do you see it evolving?
On one hand, large cap companies have more resources to put towards ESG disclosure and transparency. On the other, this means they are under more scrutiny in the public eye and under greater pressure from activist shareholders to deliver change.
Public companies are under more scrutiny because their footprint is bigger and they tend to be more in the spotlight: there are more analysts covering them, they have more shareholders, they are better known by the public and are more likely to be the target of NGOs, lobbies and corporate engagement teams.
For example, Climate Action 100+ is an investor initiative targeting the 100 largest corporate greenhouse gas emitters, because to tackle climate change and reduce drastically our Greenhouse Gas emissions, we need to start with the largest emitters.
With more firms going private, what tools exist to analyse such firms from an ESG point of view? And from your vantage point what can public markets learn from private markets on how to screen companies' ESG practices?
We already know that transparency and disclosure is a challenge when integrating ESG into fixed income for instance. Some private companies issuing debt are less transparent than publically listed ones, often because they are simply not required to do so.
For private markets, I would focus rather on impact than ESG integration. Private markets have more flexibility to have impact targets as part of what investors expect from them and they also require new capital. Different objectives can be set more easily beyond maximising shareholder returns. For impact investments to have additionality, meaning bringing new capital to help solve social and environmental challenges, private markets are the most effective option. But it is important to be selective in that space.
Does human bias and behaviour influence ESG investment choices, and to what degree?
Sustainable investing is somewhat subjective because there are as many clients as there are sustainability preferences. This is particularly true regarding negative screening and ethical investing. While some clients want to exclude alcohol or tobacco, others prefer to omit fossil fuels or nuclear energy. These preferences have nothing to do with optimising efficiency by maximising their risk/return profile. You could say, sustainable investing is to a large extent about embedding your values into your investment decisions so, yes, human behaviour does play a large part in sustainable investing.
There is currently a lot of volatility and fear in markets – how can ESG help frame investment and poise through such a period over the medium term?
We believe that ESG will not only survive the bear market, but it will thrive even more so, once we recover from the turmoil. Today's market shows that too many companies and investors fail to price in environmental and social issues, which can lead to careless corporate behaviour towards stakeholders. Since the beginning of the COVID-19 pandemic, our ESG analysts have established that not only have Climate tilted and ESG indices outperformed their broader market peers, but long-term data is even more supportive of ESG integration2.
COVID-19 has brought disruptions to communities and societies around the world – it's highlighted how the most vulnerable are being treated. This crisis will hopefully put our wellbeing and the environment front and centre of our economic system and ESG integration is the most useful tool for investors to achieve that. Sustainable investing plays a role in long-term value creation and preservation, which explains why it makes sense morally and financially. Therefore, we strongly believe ESG will not only be resilient in the current market environment, it will also become more prevalent.
1Adapted from a quote from HSBC Global Research, ESG matters: Climate and ESG outperforming during COVID-19, 25th march 2020