ESG: The Growing Influence of Sustainable Investing
Now that you’re all grown up and busy adulting, you may have been thinking about other mature things like money management, pensions, or retirement. These new-to-you concepts might also have you considering investing. If you’re a parent, you’re already invested. There are many ways to approach investing and to the uninitiated, it can appear daunting…just like parenthood. Not only will you have to decide who will handle it—from a certified broker or financial institution guiding you, to venturing into direct stock purchasing yourself—you also have to decide where your money will go.
There are no “sure bets” (unless you invest in T-bills or GICs), but one option that is gaining traction is ethical investing. That is, putting your money (and faith) in companies that are striving to do business, one way or another, in a more pro-social, health-minded, and/or environmentally friendly way. There has been good progress in the realm of ethical investing, and if you are interested in putting your money somewhere that aligns with your values, understanding the basics of it will help you in your decision.
Ethical investing for fiscal greenhorns
Ethical investing can be understood through the lens of ESG: Environmental, Social, and Governance. This is simply a term used to evaluate corporate behaviour in terms of sustainability and ethical impact and to offer investors a longer-term-horizon view of investment decisions. According to Robeco, an asset management company:
Environmental factors include the contribution a company or government makes to climate change through greenhouse gas emissions, along with waste management and energy efficiency.
Social includes human rights, labour standards in the supply chain, any exposure to illegal child labour, and more routine issues such as adherence to workplace health and safety. A social score also rises if a company is well integrated with its local community and therefore has a ‘social license’ to operate with consent.
Governance refers to a set of rules or principles defining rights, responsibilities and expectations between different stakeholders in the governance of corporations.
Making a portion of a company’s trading value qualitative rather than quantitative makes investing less daunting … because it emphasizes social values as markers of good business practice rather than forcing us to acquire complex financial expertise.
Building on the “Socially Responsible Investment” (SRI) of earlier years, ESG is still something of an art form in that it cannot be understood through math and numbers alone. Although it places morality squarely within the investment debate, it distinguishes itself from SRI in that it is not primarily driven by that morality. Initially, responsible investing largely consisted of shunning what are known as “sin stocks”—tobacco, weapons, and investments in American jails. Many large investors, pension funds for example, now no longer hold positions in tobacco companies as a standard policy of their investing mandates; however, ESG concerns itself less with being puritanical and instead strives for an evolved way of working with companies together to elicit positive change.
Making a portion of a company’s trading value qualitative rather than quantitative makes investing less daunting for those of us who think of ourselves as financial investing luddites because it emphasizes social values as markers of good business practice rather than forcing us to acquire complex financial expertise. It is becoming an integral part of the way business now operates, rather than focusing on profit alone. ESG involves creativity, cross-disciplinary thinking, and planning. It goes beyond traditional asset classes (from stocks, bonds, cash, gold, and real estate, to community bonds, green bonds, and microfinancing) and conventional financial metrics (price to earnings, debt to equity, earnings growth rates). Tim Nash, the “Sustainable Economist”, says that traditional sectors such as industrial, technology, media, and banks have transitioned into such areas as “energy efficiency, water, and peer-to-peer lending.”
The Sustainable Economist’s Tips for Starting a Socially Responsible RESP
There’s good reason a Registered Education Savings Plan (RESP) is a great way to save for your children’s education. But how do you choose one that lines up with your values and comfort level?
There are two main reasons why the RESP is a great savings vehicle:
- The federal government tops up contributions by 20%, up to a maximum of $500 each year. Parents who can contribute $2500 each year will get the maximum grant.
- The RESP is a tax shelter so investments can compound tax-free until their child is ready for post-secondary education.
Name your sin
Socially responsible investment options avoid “sin sectors” like tobacco, military, gambling, and those that have low sustainability ratings. Everyone has a different definition of “socially responsible” or “sustainable,” so make sure the companies inside the portfolio line up with yours.
Mind the fees
Make sure you understand the fee structure before you invest, as some companies prey on parents’ and grandparents’ naïveté. Exchange-traded funds (ETFs) offer much lower fees than plans and mutual funds, especially if purchased directly with an online brokerage account. Robo-advisors are more expensive but make it simpler for parents who prefer their investments be controlled automatically.
The exciting news is that more and more studies are piling up indicating that companies ranked high in ESG terms are also garnering slightly better returns compared to regular asset classes.
Growing a mindful financial identity
The three ESG factors are overlaid in the analysis of companies in a non-financial way to evaluate which ones are excelling and which ones are not. In the last few years—most recently in North America—it has grown in sophistication as an effective tool for building a less vulnerable portfolio with a stronger potential to insulate value. Women and millennials have been the driving force behind bringing ESG to the mainstream, which makes it an excellent fit for not only the growing eco-minded set but for many traditional institutions, foundations, and government leaders and banks, who all must answer the demands of these newer investors.
The exciting news is that more and more studies are piling up indicating that companies ranked high in ESG terms are also garnering slightly better returns compared to regular asset classes. Not only is the return marginally better, but ESG investments are lower risk, possibly because they may be inherently better at managing risk and opportunities, finding themselves less likely to end up engaged in debacles like Volkswagon’s “dieselgate” and BP’s “Deepwater Horizon”. The best part is that there are measurable positive social and environmental outcomes from these sustainable investment strategies.
Though ESG-rating practices are widely used, they have not been rigidly standardized among agencies—one reason why ESG itself has been notoriously difficult to define. Generally, ESG measures its assessment of a company by assigning a score which can move up or down according to improvements or deterioration in practices. The investment research firm MSCI (Morgan Stanley) measures an investor’s portfolio content for the ESG risks, opportunities, and ability to manage those risks relative to peers with a rating from AAA down to CCC with content and descriptive detail as to why they received that rating. The three factors are incorporated by institutional investors and integrated into their decision-making process in the evaluation of stocks and bonds too, across all major asset classes, promoting greater transparency or else risk tangible drops in confidence and dropping lower in the rating system.
Eighty-nine percent of asset managers in Continental Europe have signed the United Nations Principles for Responsible Investment (PRI), versus 52 percent in Canada and 56 percent in the United States, according to a recent survey by Russell Investments.
Catching on in the big green leagues
Investing in mutual or exchange-traded funds (ETFs) works by spreading your money under a few different “shells” that work together to diversify risk and those shells can include ethical investments. In fact, this type of investing is becoming so normalized you can build an entire portfolio of ESG funds as long as you diversify across asset classes and geographic regions.
Within asset managers an increase in rebranding of funds over to ESG seems to be happening, in some cases to capitalize on the coolness factor, or simply in attempts to satisfy increased requests from investors for ESG product. In Canada, the last two years have seen an incredible boom in ESG-directed investments, and the trend is growing. European markets are ahead of the curve but North America will continue to narrow the gap as global banks become more aligned on their ESG commitments. Eighty-nine percent of asset managers in Continental Europe have signed the United Nations Principles for Responsible Investment (PRI), versus 52 percent in Canada and 56 percent in the United States, according to a recent survey by Russell Investments. The survey also found roughly one third of firms said their primary motivation for integrating ESG is seeking superior risk-adjusted returns (a less risky investment that makes more money).
Even the indexes that describe market conditions based on selected stocks are paying attention. The MSCI KLD 400 Social Index provides exposure for companies with outstanding ESG ratings and excludes companies whose products have negative social or environmental impacts. Launched in 1990, it was one of the first Socially Responsible Investing (SRI) Indexes and over that time has outperformed stocks included in the well-known S&P 500, with annual returns of 11.2 per cent versus S&P’s 10.7 per cent. (To see how MSCI breaks down ESG factors into sub-themes and issues in order to choose their stocks, search, “MSCI ESG ratings methodology”.) Another index, State Street Global's Gender Diversity Index ETF (known on the ticker as SHE), tracks companies that support the presence of women on their boards and within their management teams.
Regulation has become more robust, and several large international banks have signed agreements together vowing to dedicate their billions of dollars under management away from certain non-ESG investments.
Turning green investment into gold
Depending on their nature, companies looking for ESG cred can do a number of things to achieve it. Cosmetics companies can commit to eliminating animal testing and oil companies may increase their ratings as they commit to carbon-reduction targets. Some soft-drink companies are gaining ESG ground simply by disclosing health and marketing information, and political involvements. In contrast, Facebook experienced a reduction in ESG rating due to its association with privacy concerns—an ethical issue traditional financial analysis would be unlikely to account for in revenue forecasts, as “privacy concerns” would have been a challenge to incorporate into traditional (and mathematical) analysis and earnings projections. ESG helps mitigate such a risk by providing transparency of–beyond straight financial data—or insight into ethical considerations that could impact the company down the road.
A permanent reformation seems underway and some of the framework hinges on new and evolving regulation. In light of unprecedented forest fires, climate change has spurred California to factor climate-related financial risk into some of their pension funds, and other places have integrated ESG into a corporate trustee’s fiduciary duty to redefine how businesses are run and evaluated. Regulation has become more robust, and several large international banks have signed agreements together vowing to dedicate their billions of dollars under management away from certain non-ESG investments. Corporations seeking loans, for instance, could receive preferential rates on interest if they meet ESG standards. They also could be penalized and open to legal consequences if they fail to identify an ESG risk component that turns out to be material down the line, as all material risk factors have a duty to be disclosed once a year by public corporations on their Annual Information Statement.Finally, you may have heard some negative comments about ethical investing in your travels. It’s true that a financial version of greenwashing exists as brokers feel the growing expectation to recognize these factors in their portfolio analyses, compounded by some larger investment companies’ lax or ambiguous definition of ESG. Nash encourages investors to seek out some of the smaller funds who are “pushing the boundaries” with more vigour and authentic commitment to the burgeoning green sector. Nash and colleagues have developed the Green Transition Scoreboard, a report which tracks sector growth in green economies and it is a heartening look at the viability of the movement.
The world of sustainable investing continues to evolve, however, to underscore why ESG is the right direction to take we need to look no further than the younger generation at the kitchen table. When we invest ethically, we begin to ensure they are left with something at least preserved in value, if not a little better than when we arrived. We are investing in a sustainable future together as a conscious generation.
Written with assistance from Tim Nash, Liza Oulton and Phil Gow
Sustainable investing resources
- The RESP Book by Mike Holman