MANY of us are now familiar with shopping for organic food, but there used to be a time when we were confused by the many organic labels and various certifications used.
We went through a period of educating ourselves so that as consumers we would not be misled - and we learnt the difference between non-GMO (genetically modified organism), natural, organic and 100 per cent organic products.
Today, investors looking to invest in ESG products (incorporating environmental, social and good corporate governance factors) are in a similar situation. As interest in sustainable investing grows and more products are launched, concerns about ESG and "greenwashing", the practice of putting spin over substance and including misleading claims, are also growing.
What exactly is ESG washing?
It refers to investment solutions where the investment manager's claims of ESG integration are exaggerated or misleading. Examples include environment funds holding coal companies that do not have a clear transition plan or where the fund manager does not have a clear plan to engage the company stakeholders; ESG funds investing in companies in controversial industries such as tobacco and nuclear weapons; or where the integration of ESG factors is optional.
Research shows that when used well, ESG data can enable better investment decisions.
In a study comparing over 10,000 funds between 2004 and 2018, it was found that sustainable funds provided returns in line with comparable traditional funds while reducing downside risk. It is increasingly costly to ignore ESG risks, as shown in a December 2019 report highlighting that ESG controversies wiped US$500 billion off the value of US companies over the last three years.
As we consider sustainable investments, it is key that we evaluate the credibility of the ESG funds presented to us. Here are some questions investors can ask their financial advisors:
Are certain sectors excluded from the ESG fund and is there thoughtful thinking behind exclusions?
The discussions around exclusions are often personal, and investors have differing opinions. Some investors prefer that their ESG funds not include alcohol, tobacco, fossil fuel and controversial weapons, while others may be comfortable with alcohol companies.
However, we would caution against the complex nature of supply chains when applying exclusions. The key is to know where to draw the line with respect to the nature of business involvement and the companies' materiality thresholds. For example, we may exclude tobacco manufacturers from the ESG funds selected, but not exclude supermarkets and stores distributing cigarettes if the proportion of revenue from cigarettes is less than say 5 per cent of its overall revenues.
As an investor, you should decide on what is important to you.
What is the fund's ESG strategy?
ESG strategies range from thematic ones focused on the environment, water and sustainable foods, to best-in-class integration, where ESG factors are considered alongside financial metrics in the analysis of a company.
For thematic strategies, the fund should be easily understood in terms of how the portfolio companies fit within the ESG story. For example, some managers of environmental funds select companies that contribute towards innovation and reduction of carbon emissions while others may select based on companies' focus on technology and carbon footprint. It is important to understand the manager's intent and whether all other aspects of the due diligence align with and support the strategy.
For best-in-class integration funds, we found that leaders in the space have a strong understanding of how different ESG factors affect their portfolio company and highlight that not all metrics are of equal importance. For instance, environmental factors are more important in the mining sector from a risk management perspective and not so for a bank in financial services, so weighting of these factors should differ. How a manager determines a fund's ESG rating should also be considered, whether there is thoughtfulness behind it and if it makes sense, versus solely relying on an ESG score by rating agencies.
How experienced is the team?
The experience and expertise of the ESG investment team is important. Some fund houses have a large central ESG team while others emphasise portfolio managers and analysts having strong ESG knowledge. Leaders in the space have a good balance of both, and a structured training process alongside systems to ensure effective embedding of ESG decisions. It is usually helpful too if the ESG head reports to senior management and ESG is on the board's agenda.
How is ESG being integrated?
To better understand how ESG factors are integrated, we ask portfolio managers to walk us through examples of companies being selected for inclusion in the fund, of positions being exited, and how ESG factors are considered at each stage of the process.
Leaders in the space have a clear articulation of this, and a systematic, institutionalised way of embedding ESG from the selection of the initial universe of companies through analysis and evaluation. As part of the process, ESG research should contribute significantly towards the eventual decision of including or exiting a company, and not just exist as an optional reference point.
Another huge consideration is active ownership/stewardship activities of the fund houses, specifically how involved they are with proxy voting and engagement with shareholders.
How are you measuring impact?
Finally, for ESG funds marketing themselves as impact funds, we ask for quantitative and qualitative data on how they are measuring impact. Meaningful quantification of impact is not always easy, especially for public companies, since their impact may not be as direct as investments made in the private markets. It is important that fund managers are honest about the challenges faced, and the steps being taken to plug data gaps and provide investors with meaningful reporting.
In the long run, regulation, standardisation and initiatives to better define sustainability like the European Union's Taxonomy, or to improve data on companies' climate-transition risks, like the global Task Force on Climate-Related Financial Disclosures, should help mitigate ESG washing.
In the meantime, for investors exploring ESG investments and who are concerned about ESG washing, asking some of these questions will go some way in helping you better understand the funds presented to you. As Benjamin Franklin wisely said: "An investment in knowledge pays the best interest."
- The writer is head, sustainable investing and engagement strategy, private bank and wealth management, Standard Chartered
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