It’s sometimes argued that including environmental, social or governance (ESG) factors into your investment decisions isn’t an investment strategy in itself. That may be, but when you consider that sometimes as much as 50% of company’s value is made up of non financial data, if you’re not taking ESG into account, then you probably don’t have the complete picture of how the company you are backing is performing now, or in the future.

You can use this tool to check out how your investments on the ASX 300 fair.

According to RIAA, about 50% of institutional investors in Australia use ESG in their investment strategies. Some do it because its a better indicator of long term risk and return. ESG allows others to invest in their view of the future, think solar over for coal for example. Some use it to ensure that they are not investing in business practices that don’t align to their values. For whatever reason, there is plenty of research to indicate that more sustainable companies outperform their less sustainable peers over the long term. Which means having a more complete picture could result in higher returns.

What is ESG?

ESG (environmental, social and governance) is a generic term used in capital markets and by investors to evaluate corporate behaviour and to help determine the future financial performance of companies.

Environment
Assesses key business practices ranging from emissions and carbon intensity, waste management and recycling, to green energy production. By lowering expenses (e.g generating solar power rather than buying energy) and creating efficiencies (e.g lowering packaging cost through recycling), can all have a material impact on bottom line.

Social
Assesses key business practices focussing on workers and human rights. Topics such as diversity, (which at a board level has shown to reduce company risk and increase share price value), supply chain and supplier standards, human rights and justice, community development and even staff happiness (which research suggest has a material impact on productivity and therefore profit).

Governance
Relates to corporate structure, board independence and transparency and even covers a businesses stance on certain practices, such as animal testing. Some consider this a fundamental view of company and management ethics and ethos. Governance is generally considered by investors to be an integral part of assessing corporate risk through understanding how a business is conducting its affairs and can therefore be a lead indicator on assessing the potential risk of any investment decisions. For example some ESG assessors were able to flag transparency and governance issues at VW, which were the precursor to the recent emissions scandal which permeated through the entire business.

Benefits of ESG to risk and return

Capital loss:
At its most basic level, using non financial indicators to identity risk helps to protect the capital you’ve invested and can go a long way to increasing long term returns. For example, if you have a $1 invetsment which loses 50% of its value, you have $0.5. To get back to a dollar you now need a 100% return, not a 50% return. Simple protection of invested capital to increase long term returns is often overlooked by investors and assessing ESG factors can help.

Returns
Whether the link between outperformance and high ESG ratings are casual, or simply correlation, its hard to argue the benefits to a company’s bottom line and share price. One current trend for using ESG is to identify long term investment opportunities. If you are going to invest $1 today for 10 or 20 years, are you going to invest it in mining or solar technology? A growing portion of society and investors would back the long term opportunities in new clean technologies rather than any potential short term return uplifts in higher risk carbon intense assets or practices. A second key trend is investors looking to make money and do good at the same time. ESG help investors understand that these two things do not need to be mutually exclusive.

How can you use ESG to invest?
The positive screen:
Systematically select sectors, companies, and practices based on areas that align to your values. Commons positive categories include recycling and waste reduction, renewable energy and clean tech, protection of natural environment, human rights and employee conditions, community development, diversity and equality, corporate transparency, corporate sustainability policy.

The negative screen:
Systematically excludes industry sectors, companies, practices, or countries based on specific ESG or ethical criteria. This approach is also often referred to as values-based, or ethical screening. Common screens include gaming, alcohol, tobacco, weapons, pornography and animal testing but now expand to things like sugar or fast food.

Best of breed:
Investment in sectors, companies or projects selected for positive ESG or sustainability performance relative to industry peers. Suitable for those investors who want to maintain investments in industries that might otherwise be screened out, but select those that are performing the best from an environment, social and governance perspective.

You can use this tool to check out how your investments on the ASX 300 fair.

*The information in this post and the links provided are for general information only and should not be taken as constituting professional advice from the Author.

Image: Emily Morter