Environmental, social & governance (ESG) issues are becoming increasingly relevant investment considerations.

The rise of ESG investing has accompanied the rise in general social appreciation of the various ESG issues facing society. This has also gravitated to the political stage: in many countries “green” parties have become major political forces, and activists such as Greta Thunberg taking a stand on ESG issues have become household names.

Some notable investors have also advanced this trend. Norway’s sovereign wealth fund is one of these. It owns on average 1.5% of most of the world’s large listed businesses and has forced many of the companies in which it is invested to improve their ESG track records, especially regarding environmental issues. Ironically, oil, which carries a high environmental impact, accounts for 40%-70% of Norway’s exports, which a cynic might interpret as Norway being principled on these issues when it suits it, and overlooking them when it doesn’t.

Being alert to ESG issues makes investment sense. While the MSCI World ESG Leaders Index had performed in line with the MSCI World as at February 28 2020, holding shares in many companies with poor ESG records can prove disastrous, regardless of whether this relates to the “E” part, the “S” part or the “G” part. The following examples illustrate this:

  • Companies, especially miners, that have poor environmental track records can accrue huge environmental liabilities further down the road. This is a real-world financial impact that shareholders need to value correctly.
  • A poor track record regarding social matters can also destroy shareholder value by causing labour unrest or through punitive regulatory changes.
  • We would be remiss to ignore issues relating to governance. SA companies have fared poorly regarding such matters recently, and millions of rand of shareholder value has been thus destroyed. Who can forget Steinhoff, EOH and Tongaat Hulett?

Global ESG failures have been even more extreme than the SA examples readers will be more familiar with. Wirecard, a German financial technology company, misrepresented profits, forged contracts and inflated billions of euros in cash balances. Theranos, a health technology company, falsely claimed to have devised blood tests that required very small amounts of blood and could be performed rapidly using small self-developed devices. Nikola, a US truck manufacturer, made a string of misrepresentations of its technology, including a 2016 promotional video that purported to show an operational Nikola freight truck but was in fact staged by rolling the truck down a long hill.

In many cases of this nature even when justice is meted out it is insufficient to compensate the victims of the fraud. This makes ESG investing vital.

The following are broad approaches:

  • In negative (or exclusionary) screening, companies are excluded from an investment universe because they are in sectors that are deemed undesirable. On this basis oil companies would be excluded because they have a detrimental impact on the environment, no matter how hard they try to reduce their impact.
  • The inclusionary (or best in class) approach might allow an investment in an oil company that is trying hard to reduce its environmental impact by diversifying into renewables and being more ambitious on the “S” and “G” fronts.

While ESG’s impact on the world has been overwhelmingly positive, investors should be aware of unintended consequences. As more capital crowds into ESG-compliant sectors at the expense of noncompliant sectors, the returns from the former will decline. The more rigid one’s ESG policy, the more this effect will be felt.

An example of this crowding effect can be seen in the energy sector, where exclusionary ESG policies that favour solar and wind projects have flooded the sector with capital. This will ultimately dampen the expected returns from the sector as a whole.

Defining the role of fund managers in ESG matters is complex, and they enjoy considerable discretion in the application of ESG policies. Because there is no such thing as a standard ESG policy, two investors can both have strict ESG policies but invest in different companies.

The following can assist investors in deciding how they should choose a manager in light of their ESG beliefs:

  • Managers must have a well-constructed and properly communicated ESG policy in place. This must authentically represent what they believe to be appropriate conduct for companies to adhere to along environmental, social or governance lines, and must create a bar by which to measure the investments that are conducted by the manager.
  • Managers must convincingly show the ESG policy they follow will still allow them to deliver the returns clients expect. This is an area many managers need to study. It may well be that a manager has succeeded in constructing a strict ESG policy, but this impedes their ability to deliver on the fund’s performance outcomes.

We evaluate ESG issues on the basis of current and past company disclosures and spend our research efforts scouring for evidence of ESG infractions. We penalise companies with surmountable ESG shortcomings, making it harder for them to enter the portfolio, but will only eliminate companies as potential investment opportunities when these ESG concerns are material or getting progressively worse.

Fund managers cannot eliminate the risk of stepping into ESG pitfalls entirely, especially when it relates to governance, because fraud often involves the collusion of multiple insiders, and fund managers are only able to assess risk on the basis of information that is in the public domain. If the auditors, who do have access to this information, are sometimes unable to detect fraud, there will always be a risk that a fund manager who doesn’t will not be able to.

• Wales is global portfolio manager at Flagship Asset Management.


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