Investing with an ESG lens that categorizes binary outcomes as “good” or “bad” can be counterproductive. It undermines the market research and independent financial analysis that guides actively managed portfolios while distracting from the social objectives it hopes to achieve.
Companies are increasingly looking to improve their environmental, social and governance (ESG) footprint while investors are pursuing more purpose-driven opportunities. Incorporating ESG engagement and analysis into the decision-making process can strengthen the investment process. This is not about taking a moral high ground but rather linking a process to think objectively by identifying how stakeholder issues can impact valuations and financial assets around the world.
In this evolving landscape, investors are asking a revised set of questions to company executives. ESG-focused inquiries like “how are different business units prepared for rising sea levels?” or “what actions are being taken to incorporate a potential carbon tax?” now complement traditional analysis, like asking about a company’s pricing strategy or debt-level covenants.
Why Investors Should Ask Better Questions
Screening potential investments on a “yes” or “no” basis overlooks incremental achievements of companies that are working to improve their ESG credentials, be it investing into energy efficiency technology or expanding diversity on its management board.
Gaining true insight into material ESG issues requires engagement with company management. Since asset managers are judged by their fund’s ability to generate alpha—the excess return of an investment relative to a benchmark—engagement focused around sustainability reinforces client interests to drive long-term value creation, rather than thwart it.
The view is shared throughout the industry. Deeper analysis incorporating investments through an ESG lens more accurately evaluates the sustainability issues that impact future cash flows underlining a company’s value. Over time, portfolio managers that don’t embed these variables will weaken the financial analysis that upholds their fiduciary responsibilities, in our view.
We believe that the coronavirus pandemic has sharpened the urgency for integrating ESG issues into the investment approach. With inequality rising across the world, we expect new regulations will soon reshape investment policies. Potential new taxes or labor laws bring risks for companies, possibly increasing the cost to operate a business in the future.
In preparation for the decades ahead, meaningful discussion is taking place now. The United Nations Sustainable Development Goals (UN SDGs) have identified 17 areas that demand a call to action, including deeper investments related to climate, health and empowerment. The preliminary cost is expected to reach $90 trillion over the next fifteen years.
To meet these challenges, a collaborative approach is required, with the daunting task of identifying, maintaining and strengthening overlapping goals among company executives, investors and local communities to improve returns without burdening excess social costs in the future.
For companies, we believe ESG engagement with investors provides operational insight into financial performance that supports immediate and longer-term success. It’s not only in the equity universe, but also fixed income as well. Green bonds support environment-related projects while responsible investors appreciate that a company’s efforts to mitigate ESG risks can help lower a company’s cost of capital.
Because climate change is unlikely to reverse, ESG integration is becoming more important. Since investors are leading the process, regulators are establishing ESG standards and frameworks to ensure that best practices become more commonly accepted.
However, we do not believe that regulators alone should be responsible for explaining what reported data is material. Instead, we view a collaboration with capital producers and consumers is essential to produce more meaningful outcomes that unlocks greater value across portfolio holdings.
That is why using an integrated ESG approach, along with sound fundamental analysis, in our view is key to managing risk better. Investors should look for high quality companies without relying on a binary lens that classifies companies as “good” or “bad” actors. Instead, thinking objectively about how stakeholder and shareholder interests are aligned alongside committed ESG engagement initiatives can foster real improvements in company behavior that support stronger long-term returns.