A smart approach to ESG can pay dividends

8th September 2021

The role of financial markets in supporting progress on crucial Environmental, Social and Governance (ESG) issues is increasingly in the spotlight. Every company looking to attract money from investors faces intense scrutiny across issues such as their approach to Net Zero, reducing community inequalities or fostering a diverse corporate leadership. The investment decisions of the world’s biggest institutional investors – the organisations that allocate your pension and rainy-day funds – are having both direct and indirect impacts on corporate responsibility. Recent research by Morningstar suggests that a big transition is now underway with more than £3 trillion of savers’ cash allocated to uniquely sustainable investing strategies. Whilst in a global investment market worth in excess of £140 trillion this remains a small minority, this proportion has doubled over the last twelve months alone.

Despite this rapid growth rate there are significant pockets of scepticism on whether this approach accelerates progress towards a more sustainable economy. Whilst a direct link is hard to establish, companies without a clear ESG strategy are rapidly becoming uninvestable for a wide range of pension funds and wealth managers. For example, the high-profile floatation of the online delivery company, Deliveroo, earlier in the year – London’s biggest Initial Public Offering (IPO) in a decade – was made more challenging by some major UK investors snubbing the company and holding back invested capital. These institutions – which included high profile UK operators Legal & General and Aviva – publicly cited ESG concerns such as the legal, litigation and regulatory risks around the employment status of Deliveroo riders as an insurmountable barrier. Whilst this did not stop the Deliveroo floatation completing, it did send a loud signal to similar companies active in the “gig economy” that are eyeing investment. Often the most powerful shift in behaviour occurs outside the public glare. Advisors reassess – following such public actions – which companies are acceptable to stock market investors. This progress is real – even if its impact is never directly observed as these companies fail to attract interest at an earlier stage than going public.

This pattern is not confined to companies coming to the stock market for the first time. The UK stock market has several large oil and gas and tobacco companies that offer annual dividend payments in excess of 8%. Yet their status as ESG pariahs is often sufficient to stop new investors taking advantage of these attractive yields. Whilst there are valid concerns over the long-term viability of these sectors, this is still a clear case of otherwise yield-starved investors choosing to steer clear of sectors with question marks over their environmental and public health footprints. This recent trend follows in a rich history of public markets providing signals of what they will, and will not, support.

The ESG landscape however remains fragmented. This means its measurement and reporting can be open to selective interpretation by company management teams. On the environmental side this has led to accusations of “greenwashing” – a situation where a company reports on the environmental measures that presents it in the most favourable light. Similar criticisms are faced by companies that commit to particularly salient social issues and are selective about their governance standards. And this is where ESG and sustainable investing needs to be allowed to transition from a blunt “invest or divest” approach to something with more nuance. Failure to do so increases the risk of perverse economic incentives that will stifle progress and leave UK savers poorer. In the George Orwell classic, Animal Farm, the untenable nature of the “Four Legs Good, Two Legs Bad” commandment provides a useful literary example of how labelling entities as good or bad using a single characteristic rarely achieves the desired outcome. The risk is that such two-legged companies move to seeking private capital investment where scrutiny is often lower. The shrewdest institutional investors will look to work with companies with underlying environmental, social or governance concerns to improve their future, rather than ostracise their past.

Three areas stand out as requiring investor attention to ensure that public markets, in the UK and globally, continue to allocate socially conscious capital in a way that supports growth and avoids unintended negative consequences.

First is to reject the temptation to standardise ESG assessment and standards. The sustainability challenges faced by a mining company are fundamentally different to those of a technology platform or a fast fashion retailer. Trying to measure excellence across a common framework will lead to savers being left with stakes in companies that have taken time to play the “reporting game” rather than truly looking to improve their ESG performance.

Second, the success of ESG will not be its ongoing growth – but, ultimately, its demise. The cottage industry of advisers, consultants and data aggregators currently bombarding companies with ESG solutions should not become a permanent feature of being a public, or indeed a private company. Rather embedding these issues into the DNA of companies is the more attractive goal.

Third, there need not be a trade-off between company profitability, economic growth and sustainability. So far this has been avoided with my own research signalling no discernible difference between the returns of “good” ESG companies and “bad” ones. But in a stock market that is increasingly passive in the way it allocates capital this is not assured. Active investors perform an important, if more costly role in exposing important nuances that are central to the ESG debate. Should the trend towards passive investing continue then this powerful signal risks being diluted.

Overall, the economic impact of ESG investing is a powerful instrument in achieving the goals ofgovernments, and those widely supported by the general public. Carefully managed over the coming years it can grease the wheels of important transitions in our economy. Bluntly managed it will do more harm than good.

A SMART APPROACH TO ESG CAN PAY DIVIDENDS

Simon French

Managing Director, Head of Research