A beginner’s guide to ESG
Environmental, Social and Governance (ESG) has become the catch-all name for a dizzying array of terminology coined over the decades. Among the jargon bandied about by the investment industry are: ethical, socially responsible, stewardship, green, sustainable and impact investing. Many of these idioms represent a particular spin on the general theme.
ESG has the benefit of covering all the most important bases. What’s more, the broad sweep offered by ESG provides greater potential to analyse how companies shape up based on the issues that really matter to their specific industries.
Here’s a brief rundown of key considerations for investors when assessing each letter of the acronym along with some data from supportive research (there has been research that’s not so supportive, too).
Gimme an E
Environmental issues are rising fast up the public agenda. Millennials, who stand to inherit vast amounts of wealth in coming decades, put particular significance on these issues. They are by no means alone, though. Even with Brexit dominating headlines, YouGov surveys have found the percentage of Brits considering the environment to be one of the most important issues facing the country has risen from 13 per cent to 28 per cent in the year to July.
When assessing the E of ESG, analysts consider the environmental impact of a company’s operations and what is being done to manage and lower it. Increasingly, this analysis goes beyond the immediate environmental impact of a company’s business and extends throughout the lifecycle of its products, delving both into supply chains and in the other direction to post-sales emissions, disposal and recycling.
...but does it really matter?
Recent research from CDP (formerly known as Carbon Disclosure Project) found the STOXX Global Climate Change Leaders Index – an index based on the 2 per cent of 6,800 companies that receive an A rating from CDP – outperformed the STOXX Global 1800 by 5.4 per cent a year from December 2011 to July 2018.
Gimme an S
Social factors consider how companies engage with people and communities. This is increasingly thought to have a significant impact on financial returns, particularly through productivity improvements. This includes considering how: a company treats its employees; relationships with and the behaviour of suppliers and customers; and a company’s relations and communications with communities affected by its business.
...but does it really matter?
FTSE Russell found between 1998 and 2016 shares in companies on the Fortune 100 Best Companies To Work For list delivered an average annual return of 11.7 per cent compared with 6.7 per cent from US Large Cap Russell 1000 index.
Gimme a G
Governance considers issues of leadership and both external and internal management controls and safeguards. While this is the final letter in the ESG acronym, many believe it is of primary importance. “Governance is so key to both the social and environmental,” says Lauren Peacock of Share Action.
The point of good governance is to increase the likelihood that management will make sensible and balanced long-term decisions about risks and opportunities when allocating capital. Naturally, these risks and opportunities include environmental (E) and social (S) issues.
Key governance considerations include: the make-up of the board – spanning issues of diversity to the presence of genuinely independent non-executives with truly relevant experience; the level of executive pay and ownership; and the relationship with external auditors as well as the scope and content of both internal and external audit reports.
...but does it really matter?
From the perspective of governance best practice, family-controlled companies are not always leading lights. However, they do make a great proxy for the central idea that lies behind focusing on good governance: long-term, prudent management based on a multi-generational perspective for capital allocation. So it’s a testament to the benefits of having boards aligned with the long-term good of a company that Credit Suisse has found shares in its top 1,000 family companies – where the founding family and descendants control over a fifth of voting rights – outperformed broader equity markets by an average of 3.4 per cent a year from 2006 to 2018.
