Sustainability and Responsible Investing

Tiziana Maida, Head of Research, 26th May 2020

Responsibility has long been a fashionable by-word to most investment portfolios. Some date its start back to the 70s, with the Quakers’ movement prescribing exclusion of “sinful” companies (arms, oil and gas), others point to South Africa’s apartheid period as a pivotal moment, when investors began divesting in the region on the basis of moral and ethical consideration. More recently sustainability has entered the financial lexicon and we now have ESG investing.

Adopting an ESG philosophy means putting such considerations into Environmental, Social and Corporate Governance. The Environmental component typically revolves around a company’s carbon footprint and climate change awareness, Social refers to workers’ rights and supply chain management, and Governance assesses the quality and diversity of management and internal policies.

It is worth remarking that despite similar investment outcomes, Ethical and ESG investing diverge significantly from a philosophical point of view. While Ethical trading works to bypass those controversial companies that are not aligned to investors’ beliefs and morals, ESG investing aims to include new types of risk that can significantly impact the economic performance of a company, whether financial or otherwise. Consider, as an example, a firm with severe supply chain issues or extremely poor governance standards. Such a company is much more likely to be penalised for its conduct and face punishments, potentially leading to onerous fines and even delisting, resulting in a highly undesirable outcome for investors.

According to Morningstar, assets under management in ESG products have doubled over the past five years, from £17bn in 2014 to £35bn in 2019. Today thousands of investment professionals hold the title ESG analyst, and sustainable investing is frequently discussed in major financial news outlets. The term ESG has come to encompass a variety of investment styles, from the more benchmark-aware exclusion based processes that ban companies whose products harm societies or the environment, such as

Most sustainable investors rely on exclusion, while impact investing has only recently started to gain momentum. This is largely due to the fact that to qualify as an impact investor a manager must demonstrate intentionality, i.e. the targeted sustainable goal must be stated in the company’s mission, and ensure measurability of impact. It is intuitive that this kind of investment offering is easiest to find in private markets, where the of the impactful contribution is easier to quantify.

To better illustrate this point take Adidas; the company is one of the major holdings of a retail friendly global equity impact fund that came to our attention recently. Adidas has improved its environmental impact in the last few years by using more recycled materials and transitioning to less polluting production processes, . Nevertheless, we think labelling it as an impactful company is a misnomer, especially due to the lack of a pivotal tenet of impact investing, i.e. intentionality. Despite this obvious exclusion, we are continuing to find Adidas and other companies like it, included in funds branded as ESG, creating a problem for the industry and a lack of clarity for investors. So, what can be done to change this?

What emerges is that despite the existence of a broad framework, there is still a lack of uniformity in how different managers translate definitions into their specific ESG strategy, while terms like sustainability, impact and environmentally friendly can be distorted and misinterpreted, causing confusion among investors.

Regulators have acknowledged this issue and they’ve tried to offer more clarity via a unifying framework of disclosure, especially on carbon footprint and environmental externalities. Since the establishment of the Sustainability Accounting Standard Board (SASB) in 2011, these efforts have intensified, with the issue in 2018 of 77 criteria based around sustainability issues that are considered financially material to investors.

The European Union has also contributed to these aspirations, by developing a new taxonomy which is due to transform the space quite significantly by posing a threat to so called The objective is to make ESG investing criteria directly applicable to law and no longer open to interpretation.