With temperatures hitting record levels this year, it’s been hard not to notice the impact of global warming on our lives. July 2019 was the hottest month ever recorded on Earth, according to preliminary data. A new UK high of 38.7C was set at the Cambridge Botanic Garden, while Paris reached a phenomenal 42.6C.
Policymakers have begun to take notice: Theresa May’s last hurrah was a commitment to net zero UK carbon emissions by 2050, while France also proposed net zero emissions legislation this year. These proposals are in response to climate studies showing that, in order to halt climate change, carbon emissions – carbon dioxide (CO2) produced by the burning of fossil fuels, like coal, oil and natural gas – would have to be cut dramatically.
To achieve ‘net zero’, any emissions produced need to be balanced by absorbing an equivalent amount of carbon from the atmosphere. So emissions have to be either reduced (e.g. via the banning of petrol and diesel cars, or using wind and solar energy sources) or offset (by planting trees).
It has been found that sustainable funds – those that have an ESG focus – have lower downside risk.
Many investors who believe in the importance of addressing climate change, as well as other ‘social’ factors like poverty and equality, would like to incorporate their views into their investments: to put their money into areas they believe in.
The investment industry has woken up to this drive and has been increasingly integrating ESG (Environmental, Social, and Governance) factors into investment products. Over the past couple of years, the number of funds with an ESG focus has soared (see graph), while the issuance of green bonds – debt issued to finance sustainable projects – is also on the rise, hitting an all-time high of US$66.6bn in Q2 this year.
Does ESG pay?
There has been lots of debate on ESG as an investment strategy. On the one side, excluding certain companies (such as tobacco or oil producers) makes your potential investment universe smaller, and theoretically lowers the chance to outperform. However, a number of academic studies suggest that incorporating ESG factors makes little difference to returns, while some argue that ESG actually improves returns (simply put, ‘good’ companies are well run and so outperform peers).
It has also been found that sustainable funds – those that have an ESG focus – have lower downside risk, a conclusion which is supported by research from Morgan Stanley, looking at the data on nearly 11,000 mutual funds and ETFs from 2004 to 2018. This kind of makes sense: when you incorporate a focus on company practices (especially governance) into your investment process, you are more likely to avoid the worst blow-ups.
But ESG investing is not straightforward and there are cases of ‘greenwashing’. Most notably, the ‘greenness’ of many green bonds has been questioned. The EU published guidance on green bond standards in June, but there is no legally binding definition – i.e. a bond is deemed green pretty much because the company says so.
There have also been cases of high-profile index trackers not really excluding attributes they seem to claim to due to definitional ambiguity. For example, an ETF (exchange-traded fund) might exclude companies that ‘own fossil fuel reserves’, but not oil services companies or refiners – not exactly in the spirit of things.
Most fund managers already make use of ESG factors, to some extent. No good manager is going to ignore the governance of a company when choosing whether or not to invest, or buy an energy company without looking at potential future regulation that might impact its revenues. But a focus on ESG – to have a portfolio with the objective of investing in companies that benefit society – is a personal investor decision. The good news is that the scope to do so is constantly increasing.