We embarked on this project because the two are often used together, creating some confusion about concepts that are new to many investors. So, we thought explaining the difference could be helpful, hopefully leading to the conclusion that sustainable investing as an investment style, may not be for everyone, but ESG as an analysis tool should be integrated, in some capacity, into every investment decision.
ESG analysis is about considering and managing the environmental, social and governance risks and opportunities in a company and/or portfolio. In essence, it is using more information than traditional research to make a more informed investment decision — a very important point.
ESG analysis does not necessarily preclude an investor from investing in anything. Let me reiterate that … ESG analysis is not a negative or positive screen.
So, what are environmental, social and governance risks?
“E” explains how a company approaches the environment, i.e., Is it managing its biodiversity impact? How does it approach water and waste management? Does it have a large carbon footprint? And is it exposed to carbon pricing? The “S” is how it treats its workforce and society: Will it retain key staff? Does it have modern slavery or supply chain risks? The “G” is the board independent — Do they have appropriate remuneration structures? Is the board diverse enough?
These factors are often used in conjunction with traditional company valuation metrics to formulate an investment view that can affect risk and return if not managed appropriately. ESG analysis is a subjective process, relying on an analyst’s view about what is material to the business. It is an active investment tool; it doesn’t tell an investor what to invest in, but identifies the non-financial risks.
ESG analysis will help identify sources of carbon risk, whether a company risks losing employees, whether a company faces modern slavery issues within its supply chain, whether a company lacks diversity, remunerates its executives appropriately, and more. These factors, despite being termed “non-financial”, can have a meaningful effect on a company’s share price if ESG controversies should arise.
It is not unreasonable to assume these considerations should be integrated into every investment decision. Certainly, they are at the top of board members’ agendas as they respond to the weight of ESG capital and institutional investor pressure. At the same time, companies are navigating a difficult economic environment with supply chain delays, inflationary pressures, rising interest rates and a slowing economy, with ESG sceptics possibly thinking this is enough for companies to stop thinking about ESG and directing their attention to solving the issues at hand. We disagree, arguing that a continued focus on ESG can support a business through these periods.
Take, for example, the social agenda that is gathering pace under the Labor government. Social initiatives include investing in childcare for greater female participation in the workforce and progressing initiatives for Indigenous inclusion, including accepting the Uluru statement in full.
From an investment perspective, we understand that ESG is still a major discussion point for listed boards. We are still experiencing inbound ESG queries from corporates and seeing progression on ESG reporting initiatives.
Other ESG issues include cyber security, managing a company’s carbon footprint, ensuring a board is independent and that executives are appropriately remunerated and aligned with long-term shareholder outcomes.
So, how is this different from sustainable investment?
Sustainable investment looks at the intentionality of a company — Does its business purpose solve a sustainability challenge? Is it helping decarbonise the economy? Is it providing a healthcare outcome? Is it proliferating educational software?
These companies are often in industries such as renewable energy, resource efficiency, healthcare, education, social outcomes, environmental services, water, and waste treatment, and more. The business purpose of the company is largely independent of its ESG metrics.
Let’s compare Company A and Company B within a purely hypothetical scenario.
Company A conducts its business in a polluting industry. Yet it has great staff retention, pays staff well, has strong diversity and good board governance.
Company B displaces fossil fuels within, say, the automotive industry. While it is solving a sustainability challenge, it has poor staff retention, bad working conditions, and a CEO who is also the chairman making all the decisions (poor governance).
There are many other factors outside this hypothetical scenario, and while this isn’t exactly how Perennial considers ESG analysis, it is possible that with traditional ESG scoring methodologies, Company A has a better ESG rating than Company B. ESG analysis doesn’t necessarily look at the business purpose of the company; it looks at how the company deals with their non-financial risks.
While ESG analysis is not the same as sustainable investment, they are often best used in unison because companies that integrate ESG essentially understand how sustainably they conduct themselves. Combining both can have a powerful effect. If a company is positively contributing to society or the environment, while conducting itself sustainably, one can assume it will benefit from financial and non-financial tailwinds.
To conclude, ESG analysis assesses real-world impacts on a company, while sustainable investment is the impact of the company on the world — and they should never be confused. It is important to remember that ESG analysis uses more information to make a more informed decision, and it is not an investment style. ESG analysis does not narrow the investible inverse.
An investor may not wish to access sustainable investments, but all investors should use as much information as possible to make the most informed investment decision they can. This is why we believe ESG analysis should be integrated into all portfolios.
George Whiting, head of distribution for sustainable funds, Perennial Better Future Trust
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