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Responsible Investing

guide to esg investing

Demystifying sustainable investing

April 2019

There's much more to responsible investing than avoiding "sin" stocks. And it can make financial sense, too.

How well do you know your investments? Most people invest to protect their future and that of their families. And yet we don’t always take into account how the companies we invest in might impact that future. Are they considerate of the environment, of society, of their workers, or their shareholders?

That’s where environmental, social and corporate governance consideration come in – or ESG for short. For big institutional investors, such as pension funds and insurers, incorporating ESG into the investment process is now a basic requirement. Increasingly, this is also becoming a consideration for individuals.

Looking after our planet and our society is important. But the benefits of responsible investment go far beyond an ethical halo. Applying an ESG filter can open up new investment opportunities, highlight corporate problems before they appear on the financial bottom line and future-proof investment returns over a long-term horizon as regulation and consumption habits evolve.

Taking the high road – with a choice of routes

So how does it work in practice? Broadly speaking, there are four distinct approaches to sustainable investing. All of these are available to individual investors through the choice of funds they invest in, or asset managers to whom they trust their money. 

The first is screening. This is the oldest and best-known form of responsible investment – the avoidance of potentially controversial products like tobacco, weapons, gambling and alcohol. Charities, foundations and religious faith groups are among the investors who tend to favour this approach and take it very seriously.

Another route is stewardship – or the extent to which their investment managers engage with the companies they invest in to drive positive change. 

four routes to responsible investment
Four routes to sustainable investing
Source: Mercer

The third route is the integration of material ESG considerations in decision-making and investment analysis. It’s not necessarily about excluding companies but about being aware of their sustainability characteristics and of making the investment decision with that knowledge in mind.

The fourth approach is arguably the most direct and can come without the addition of moral or any other dimensions. It centres on investing in sustainability-related themes, such as low carbon energy, health or water, which have a long-term potential to deliver attractive returns. 

There are many interesting investment strategies within this area and they are no longer just limited to listed stocks but include infrastructure, private equity and fixed income. Clean and renewable energy in particular is now attracting a lot of attention given institutional investors’ growing desire to “decarbonise” their portfolios.

Bracing for climate change

Today, climate change is an issue that is never far from the front page. It is a good example of both the opportunities that an ESG approach can present and the risks that it can help avoid. On the face of it, this seems like a crusade more suited to politicians than pension schemes.

So why should investors care? The policy measures required to address climate change – which will be felt sooner than the physical impacts – will undoubtedly create material economic impacts, and by extension will be felt by investors via their portfolios.

investing for the future
Key areas of thematic sustainable investment
Key areas of thematic sustainable investment
Source: Mercer

Under the Paris Agreement1, 196 nations pledged to keep global warming to no more than two degrees Celcius (2DC) between now and 2100 – a threshold seen as the tipping point beyond which climate change could have serious consequences for our planet. Given that the world population is projected to grow from 7 billion to 10 or even 12 billion in that time – and more people implies greater energy and material needs – this clearly presents a big challenge in terms of stopping or even reducing carbon dioxide (CO2)
emissions. To meet the 2DC target will require a lot of new policies and regulations, alongside new and improved (i.e. lower carbon) ways of generating energy. Research by consultancy Mercer shows that investment returns are likely to be impacted under two, three and four degree scenarios – and that asset class and sector level impacts are particularly important for investors to understand2.

For example, under a 2DC scenario, developed equities in general – and Energy and Utility sectors in particular – are likely to suffer because of the significant restrictions that will be placed on “high carbon” industries. Emerging market equities, on the other hand, are likely to benefit from injections of capital to help them transition to a lower carbon economy. For real assets like infrastructure and property, incentives will be needed to make new assets “green” from the outset and to “decarbonise” existing assets.

It’s not all about risk, though. There are opportunities to make money from solving the challenges created by climate change. We are seeing this through growing investor interest in sustainability-themed strategies, but also through a quiet shift of focus in many traditional industries such as autos and energy. By being aware of ESG, investors can benefit.