Sorting the wheat from the chaff in ESG investments
Navigating the Environmental, Social and Governance (“ESG”) landscape in 2022 is no mean feat for investors. While it seems that the world is embracing ESG factors and addressing long-term sustainability challenges, the asset management industry, as well as investee companies, still have a long way to go.
There is an increased focus on making sustainable choices in our daily lives, such as recycling household waste and switching to more environmentally and socially conscious products and brands. Big brand names are also joining in, such as Formula 1 who introduced regulations to support sustainable fuel and has committed to achieving a net-zero carbon footprint by 2030.
Naturally, this push towards sustainability is influencing decisions regarding investments, as investors look for ways in which their investments can make a positive impact. While it’s easy to get excited and jump on the ESG bandwagon, it’s essential for investors to make informed decisions before committing their capital. With greenwashing an ever-present risk, as companies face pressure to adhere to rising ESG trends and expectations, the vital question is – how can you, as an investor, ensure that you are investing in genuine ESG investments and not funds simply masquerading as “ESG friendly”?
To be able to answer this, investors need to understand the different types of ESG investments available, and the long-term sustainable outcomes that they aim to achieve.
Impact investing looks to have a measurable impact on society. This would include renewable energy or infrastructure projects that invest in building solar farms, wind turbines, schools, healthcare, and housing – to name a few. At Prescient, we have developed funds that provide debt financing to clean energy and infrastructure projects within South Africa. These Funds give us the opportunity to make a proactive, measurable, and lasting contribution to communities. The Funds’ impact on the community is tangible; based on jobs created, community spend, projects supported, and power added to the grid.
Before choosing an ESG Fund, impact measurement – in the form of reporting and disclosure – is a key consideration to determine whether the investment aims to deliver positive environmental, social and governance outcomes.
Aside from impact investing, investors may use an ESG screening method, which identifies ESG risks in investee companies based on specified criteria, and assigns an ESG score. Based on these scores, investors are able to make informed decisions on whether to increase or reduce exposure to, or exclude, investments that showcase increasing risks.
From a financial risk perspective, this makes sense – a well-managed company that adheres to environmental, social and governance regulations is less likely to face litigation, or incur the higher costs associated with the management and disposal of hazardous waste, labour unrest and regulatory fines – to name a few. The benefit of using an ESG scoring methodology is that it allows investors to easily integrate ESG into their overall investment process.
However, the accuracy of an ESG score is heavily reliant on the input data and therefore ESG scores are only useful when the input data is unbiased and robust. Transparency in how the ESG score is derived is essential – an investor should be able to take a deep dive into the scoring methodology and easily understand the decision-making process.
Some ESG factors may be more topical or easier to measure (such as carbon emissions), which could result in a tendency to overlook other factors, such as governance or social impact. Conflicting ESG priorities can be managed by looking at companies from a holistic point of view and taking the E, S and G factors equally into account.
Consider a company that has a greater environmental impact, that is required to adhere to environmental regulations and thus scores highly on the “E” factor. The same company may still have “S” or “G” risks. Therefore, it is important for investors to consider all three factors to assess potential risks and shortfalls in order to make informed investment decisions on the overall ESG assessment.
Being a leading provider of trusted, exceptional investment expertise, we, at Prescient, have adopted a systematic approach to ensure ESG screening is done free of biases through our in-house ESG-scoring tool. The Prescient ESG scorecard is quantitative and data-driven, and accounts for industry materiality and company size biases. This allows us to integrate ESG across our entire investment process, by providing an in-depth measure of each pillar. As part of our credit process, for example, we are able to integrate ESG by adjusting companies’ credit ratings based on the derived ESG score.
The greenwashing effect
With asset managers under pressure to meet demand for ESG products, they may over amplify their ESG practices, via marketing and PR tactics, in an effort to attract investors. This “greenwashing”, whether inadvertent or not, presents a potential risk to investors who may, as a result, invest in companies that are not aligned to their ESG goals or expectations. Companies should be transparent in disclosing ESG strategies that directly translate into their investment philosophy and process as a form of best practice.
It is also important that companies show how the strategy aligns to their specific financial and ESG goals. In this way, investors can assess the extent to which companies are reporting progress and holding themselves accountable.
Current ESG stumbling blocks
The lack of global standards for the regulation of ESG investments continues to pose significant challenges in the asset management industry. Without standardised and consistent disclosures across investee companies, it becomes challenging to eliminate greenwashing and address conflicting ESG priorities. As part of our approach at Prescient, we engage with policy makers and industry bodies to encourage greater transparency and consistent disclosure that will improve the financial markets and, in turn, allow investors to make better, informed investment decisions.
Internally, companies can establish their own ESG guidelines or “regulations” by implementing formal ESG policies and facilitating internal and external awareness training to staff and stakeholders. Externally, companies can pledge support for and adopt recognised, well-established frameworks, which provide guidelines to support the integration of sustainable investment practices.
An example is the United Nations Principles for Responsible Investment which promotes the incorporation of ESG decision-making processes and ownership practices to better align companies’ objectives with the environment and society as a whole. There is also the Task Force on Climate-Related Disclosures which focuses on climate change regulation and provides recommendations on climate related disclosures.
For now, these frameworks are voluntary, and a “one-size-fits-all” approach may not facilitate the best disclosure for certain companies or industries. But global sustainability regulation is evolving rapidly, and the increased transparency that will ultimately be achieved will greatly benefit investors. Until such time, investors should protect their interests by staying informed and approaching potential investment opportunities with scrutiny.
We, at Prescient, remain consistent and transparent in our evidence-based approach, and will keep striving to preserve our clients’ capital by deploying it in a manner that promotes sustainability and delivers on our goal to achieve superior risk-adjusted returns.
We view ESG integration as a core input into the investment process and believe this enables us to play a pivotal role in shaping the ESG landscape in our country. We continuously look for ways to improve our overall ESG impact and believe that incorporating ESG principles into our process not only perfectly complements our already trusted and well-tested process, but also allows us to be active participants in the advancement of the broader sustainable finance goals. DM/BM
Author: Natalie Anderson, Business Development and ESG committee member at Prescient Investment Management.
- Prescient Investment Management (Pty) Ltd is an authorised financial services provider (FSP 612).
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