With each passing day, reports regarding the state of our environment are becoming increasingly alarming - we are all well aware of this. Ultimately, the catalyst for the wider public to demand climate change action from our Government and each other will either be the related and apparent catastrophic loss of life, or the ability to achieve a material financial benefit from sustainable activity.
The great news is that environmentally-conscious investing is available today and it makes financial sense. As it turns out, we can have our cake and eat it too. In fact, it’s likely that we will soon reach a turning point where ignoring the environmental consequences of our actions will not only impact the world, but also our success in investing.
Enter ESG investing
Responsible investing is commonly referred to as ESG investing i.e. introducing Environmental, Social and Governance (ESG) criteria into the portfolio construction process (e.g. avoiding businesses involved in guns, tobacco, nuclear power, etc.) It has been slow to gain traction historically, but as it’s becoming progressively more evident that ESG issues have financial implications, this trend has experienced considerable growth in parts of the world, particularly the U.S. and Europe, but also slowly in Australia.
Traditionally, ESG factors have not been part of fundamental financial valuation, however they are impacting businesses, their revenues and the wider economy in unanticipated ways. An example of this is how the major Australian banks were subject to significant scrutiny during the Royal Commission (governance issues), forcing them to drastically tighten their lending practices. This, in turn, directly impacted their margins/revenue and share prices, whilst having a broader knock-on effect onto the Australian housing market, as the banks were unable to lend money to borrowers as quickly or freely.
Climate change in particular is the ESG factor receiving the most attention, given that the consequences are on our doorstep and the economic costs range in the billions of dollars. For example, the automotive-vehicle industry is currently going through a phase of substantial disruption as several countries and over a dozen cities and states around the world have recently announced their intentions to at first phase out, and then entirely ban fossil fuel based vehicles. In December 2017, Paris, Madrid, Athens and Mexico City said they would remove diesel cars and vans by 2025. Norway will phase out conventional cars by 2025, followed by France and the United Kingdom in 2040 and 2050, respectively (Coren, M. J., 2018).
The response of the auto-industry has been significant, with a renewed focus on the research and development of all-electric and hybrid vehicles. Almost all of the major producers (e.g. VW, GM, Volvo etc.) have announced new electric vehicle ranges or intentions to move entirely to electric in the near future (Coren, M. J., 2018). This illustrates how financial implications affect real change and that businesses must be prepared to adapt in order to survive (as must investment managers), with ESG considerations a key part of this.
Renowned quantitative fund manager Georg Kell (2018, para. 10) writes that, “The rise of ESG investing can also be understood as a proxy for how markets and societies are changing and how concepts of valuation are adapting to these changes. The big challenge for most corporations is to adapt to a new environment that favours smarter, cleaner and healthier products and services, and to leave behind the dogmas of the industrial era when pollution was free, labour was just a cost factor and scale and scope was the dominant strategy.”
Is there an opportunity cost?
If you were to put this into the context of your retirement and your children’s future, then the opportunity cost of not taking an ESG approach is immeasurable. Financially, it is difficult, if not impossible to definitively determine if ESG strategies will result in reduced (or improved) investment returns in the short to medium-term. This is due to a number of factors including screening processes, economic trends, the available strategy options, potential legislative changes, the subjectivity of ESG investment selection, etc.
Importantly, there are a number of different ESG investment strategies currently available that have been extremely successful and therefore generating positive investment returns through an ESG approach is certainly achievable. In fact, research by the Responsible Investment Association Australasia (2019, p5) found that the average returns of international ESG equity funds outperformed the Morningstar average mainstream international share fund over every time horizon, as did ESG diversified funds against the mainstream diversified growth fund average.
Longer-term, ESG strategies will undoubtedly lead the market and we expect that there will be a paradigm shift in favour of ESG investing, or, more likely, businesses that have positive ESG practices are likely to consistently outperform non-ESG businesses due to the relevant economic and social trends. However, it’s unclear as to when this shift will occur e.g. in the next two years, five years, or longer?
Regardless, there is no doubt we are experiencing firsthand the beginnings of a third industrial revolution in this space, driven partly out of necessity, but predominantly by the financial benefits yielded. At a consumer level for example, there is widespread adoption of solar panels on our roofs, which can power our homes and charge our electric cars at no ongoing cost (with a single car charge now lasting around 500 kms). Now, consider the longer-term implications of this technology for fossil fuel companies, utilities providers, our electricity infrastructure networks, the jobs in those industries, and the list goes on. It won’t be long before the biggest names on the ASX aren’t resource companies and banks, but instead sustainable businesses - BHP’s days are numbered!
Any investment manager with their finger on the pulse, not just in relation to market trends, but also the seismic shifts that the third industrial revolution will bring, is already factoring ESG considerations into their investment processes, as these trends can directly impact earnings prospects and long-term returns. Dedicated ESG investment options are increasingly being brought to market and there are now many available to investors through either actively invested managed funds, or passively managed market indexes, although the quality of these managers/indexes and their returns vary greatly.
At BDO, we can provide guidance to our clients around different ESG strategies, depending on their personal philosophical beliefs and conviction. These can include:
- An active approach where only investments that promote positive ESG practices are included within the investable universe;
- A ‘neutral’ approach that filters out ‘sin’ companies; or,
- A transitional approach that builds and evolves the ESG exposure over time (and as markets mature in this space).
If you would like to explore ESG investing further, please contact a member of the Private Wealth team.
Sources / additional information
Coren, M. J. (2018). ‘Nine countries say they’ll ban internal combustion engines. So far, it’s just words’. Retrieved from - https://qz.com/1341155/nine-countries-say-they-will-ban-internal-combustion-engines-none-have-a-law-to-do-so/
Kell, G. (2018). ‘The Remarkable Rise of ESG’. Retrieved from https://www.forbes.com/sites/georgkell/2018/07/11/the-remarkable-rise-of-esg/#46ea231c1695
Responsible Investment Association Australasia (2019). ‘Responsible Investment Benchmark Report: 2019 Australia’. Retrieved from https://responsibleinvestment.org/wp-content/uploads/2019/07/RIAA-RI-Benchmark-Report-Australia-2019-2.pdf
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