ESG investing: Can you be both a good investor and a good person?

How does it work?

ESG is a term that was launched in 2005 as an evolution of SRI (Socially Responsible Investing). Think of it as SRI 2.0. But while SRI is investor-specific—because what’s abhorrent to one type of investor may be perfectly okay to another—ESG works for all investors. SRI screens out companies that profit from undesirable activities (alcohol, tobacco, munitions, fossil fuels, etc.); ESG screens in companies who score well on environmental, social, and governmental criteria.

Contrary to popular opinion, ESG investments do not hamper financial returns. Rather, companies that engage in unsustainable practices prove less profitable over time.

Why ESG is here to stay

Here are seven key reasons why the future of investing is in ESG:

1. Planet panic: The planet is under enormous stress from increased levels of plastic and CO2 pollution causing climate change, the extinction of species, environmental refugees, and geopolitical instability. And though you may not give much thought to African tree frogs or Arctic polar bears, you should give some thought to your bottom line: As natural resources become depleted they’ll become much more expensive, leading to stalled economic growth and reduced living standards. Sustainable business practices that aim to slow down the depletion of natural resources are a rational response.

2. Changing of the guard: In 1964, Bob Dylan sang, “The times they are a-changin’.” Now, 55 years later, women, millennials and Gen Z are in the vanguard. And that means social change.

   For the first time in history, women generate and control large amounts of capital and, rather than being purely driven by profit motives, they’re investing in ways that better align with their values. The large inter-generational wealth transfer from boomers to millennials—estimated at $30 trillion over the next several decades—is a tail wind for ESG investments. Millennials and Gen Z have grown up during a period when evidence of climate change is all around them—from losses in biodiversity and global warming to an island of plastic debris floating around the Pacific that is now 3-times the size of France—so sustainable investing is top-of-mind among the majority of them.

3. Follow the money: As demand grows for ESG options, financial companies are keen to provide supply. Today, over $20 trillion (USD)—around a quarter of all investable equity funds—is professionally managed under the ESG mandate.

   According to a 2018 report from the Responsible Investment Association, Canadian investors contribute over $2 trillion to funds with a responsible investing approach, representing over 50% of all funds under management. Last year, Canadian ETFs with socially responsible mandates saw in-flows of $334-million, and RBC, in partnership with iShares (RBCiShares), just launched six new broad-based funds for investors seeking ESG factors. In the fixed income area, “Green Bonds”, where companies promise to spend the money they raise in debt markets on environmentally sustainable projects, reached $136 billion (USD) in 2018.

4. Tech crunch: Thanks to technological advancements, it’s easier to collect and process relevant company data to screen for ESG factors. Artificial intelligence (AI) and big data lead to greater transparency because they can sift through “non-conventional” data to understand context, instead of only searching for ESG-related keywords.

5. Risk reduction: Research shows that companies that score well on ESG factors, particularly governance, are less risky. Recent examples from Canadian companies such as SNC-Lavalin and Bombardier, whose poor governance has led to a destruction of their share prices, are Exhibit A that poor governance and long-term growth in shareholder value do not compute.

6. Fiduciary duty: Portfolio managers are considered fiduciaries and are legally obligated to put their clients’ interests first. Historically, those interests have been narrowly defined as financial interests only. (“Make me the most money”). But the concept of “best interests” is increasingly being expanded to include sustainable investing.

7. Many happy returns: Contrary to popular opinion, ESG investments do not hamper financial returns. Rather, companies that engage in unsustainable practices prove less profitable over time.

   A study conducted at Carleton University in Ottawa showed that responsible investing strategies outperform their benchmarks 63% of the time and with less risk. Another study conducted by Harvard Business School compared the performance of high vs. low-sustainability businesses over an 18-year period and found that one of the reasons that the former outperformed was because they were perceived as lower risk and less likely to default on loans, thus giving them easier and cheaper access to the credit and equity markets.

ESG obstacles

Greenwashing

Greenwashing is a marketing strategy used by corporations to falsely give the appearance of doing business in an environmentally-sustainable way. For example, British Petroleum redesigned its logo with the initials BP inside a green flower. Coca-Cola launched a green aluminum can to tout its water preservation efforts, despite the fact that they use 35 litres of water to produce 0.5 litres of Coke.

Deficient data

Data collection is the trickiest part of ESG investing for a number of reasons:

• There is no standardization for how companies report ESG information, and much of it is self-reported.
• ESG is a relatively new metric. Smaller companies or those in emerging markets may not have accumulated enough meaningful data about their ESG practices and how it impacts their profitability.
• ESG rating agencies use different algorithms and weightings on ESG factors, which leads to “aggregate confusion.”
• There are time lags between initiating ESG programs and reporting on them.
• Some ESG indices are back-filled with new data, thus re-writing a company’s history.
• The “S”, or social, aspect is the least standardized and is therefore the most confusing, since it includes everything from non-discrimination to child labour and indigenous rights.

Cost

As more investors seek products with an ESG mandate, there’s been a corresponding rise in the number of indices that track these strategies (growing by 60 percent in 2018 alone). The cost of buying ESG data has increased over 300 percent since 2014; some of these costs may be passed to consumers.

Is it “ESG” enough?

Some ESG ETFs and mutual funds may include controversial companies, such as pipelines and bitumen producers. Alliance Bernstein, a global asset management company, recently released a damning critique of ESG, saying “As it is currently practiced, we think a significant part of ESG investing is morally feeble (how much change does it cause?); intellectually weak (simple screening and poor data)…” They went on to say that there is a “ludicrous super-abundance of ESG indices (10,000 and counting).”

How to invest in ESG

You can go the DIY route and cherry pick your own portfolio of ESG ETFs.

Or if you prefer automated investing, some Canadian robo-advisors have predesigned, socially responsible portfolios: