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Ideas Farm: Which letter matters most in ESG?

Ticking the right ESG boxes is fine, but new research suggests a way to identify companies that are grasping the real opportunities
Ideas Farm: Which letter matters most in ESG?
  • ESG storms home in 2020
  • Why that matters for investors
  • How new research highlights the G comes first
  • Loads of new ideas generating data, including the favourite international shares of top ESG fund managers.

Drum roll please. The results are in. The biggest inflows into UK funds in 2020 went to…ESG!

This will come as little surprise to anyone who has been keeping track of the investment zeitgeist over the last year. As totted up by Refinitiv, UK investors poured £14.9bn into environmental, social and governance (ESG) funds last year, compared with £11.8bn into funds without an ESG badge. Fund fashionistas will probably also not be too surprised that on a more granular level the biggest loser of 2020 was UK Equity Income, which experienced outflows of £6.8bn. 

But turning quickly back to the positives from 2020, what is the significance for equity investors of ESG’s increased popularity? 

One major plus point for companies ticking the right ESG boxes is that the increased flow of money into the area means they should be able to access capital more easily and at lower cost. A lower cost of capital can be a significant positive influence on shareholder returns. That’s as long as the advantage it offers is not competed away. Interestingly, many opportunities in this space, such as green energy, are currently considered so massive that many analysts expect that profitability will hold up even as a flood of capital rushes in. 

Adding to the idea that simply ticking the right ESG boxes is an advantage in and of itself, is the fact that the asset manager that attracted the biggest inflows from UK investors last year was BlackRock – again, this is perhaps not that surprising given the firm is the world’s largest asset manager. BlackRock has been vocal in its support for the ESG cause. In his latest annual letter to CEOs, BlockRock boss Larry Fink pushed for better disclosure on net zero plans and revealed an intention to sell holdings in the worst polluters. While this announcement got a lukewarm, they-should-do-more reception from some, it definitely signposts the direction of travel.

So for those companies judged to be doing the right thing, there should be a virtuous circle created by this unbridled enthusiasm for all things ESG. What’s more, with increased regulation in this area and threats of disinvestment, there is increased risk attached to companies that do not embrace ESG. So far as fund flows help focus companies on the issue, this could head off future upsets.

But for companies wanting to raise the ESG flag, how should they go about it? And more importantly from this magazine's perspective, what should investors watch for? Recently published research from academics at INSEAD, The Wharton School and University of Pennsylvania provide some clues, which helps vindicate what many investors intuitively feel: the G should come first in ESG.

The study found a positive relationship between E&S (environmental & social) ratings and good governance based on: E&S risk oversight and measurement; board-level communications on risks; and E&S-linked executive incentives

But investors can look for more from ESG than simply targeting lower-risk companies that may be able to access cheaper capital thanks to a good rating. The most interesting companies to back in this area are ones targeting opportunities created by the ESG rush. So, it is particularly interesting that the research also found evidence – albeit “modest” – that companies with strong governance mainly benefited by finding opportunities in the E&S space rather than simply mitigating risk.

Governance is hard to measure, and it is also because of this that the study stands out. It took its cues from survey data, compiled by insurer Aon, which provides insights into how management functions internally. Such nuance could offer better insight than more objective measures of governance, such as board composition. 

For private investors who may struggle to get ready access to such a depth boardroom insight, we hope our lists of the biggest bets of top ESG fund managers can provide a shortcut for highlighting companies worthy of further research. This week we are publishing our updated list of top ESG fund managers’ favourite international shares. There are plenty of new names.