November 27, 2022

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esg investment thesis: How ESG should impact your investment thesis

4 min read
Global ESG assets are on track to exceed $53 trillion by 2025, representing more than a third of the projected total assets under management. Do we see a mirroring of large-scale environmental and social change that reflect this capital movement? ESG impact comes from having a long-term strategy here we discuss the elements of discipline.

Environment, Social and Governance (ESG) has been tasked with the lofty goals of decarbonizing a global economy that is fuelling climate change, solving for income inequality and supporting the theory of stakeholder capitalism via ethical businesses. Unfortunately, ESG has been subject to a moral binary when in reality it is a complex web of interconnectedness that cannot be unpicked solely based on disclosures.

The 2021 International Labour Organization (ILO) estimates indicate that everyday 50 million people are in situations of modern slavery. According to the Credit Suisse Global Wealth Report, the world’s richest 1 percent, those with more than $1 million, own 45.8 percent of the world’s wealth. In addition, global stranded assets as present value of future lost profits in the upstream oil and gas sector exceed US$1 trillion under plausible changes in expectations about the effects of climate policy.

The ESG industry is in many ways at the crossroads in terms of what value it really creates. Behind the frameworks, metrics, ratings, sustainability claims, fund labels, urgent hires and regulatory scrutiny, a mature version of ESG is making its way to its mainstream audience. One that promises to measure and act on the basis of real-world impact. Alex Edmans, Professor of Finance at London Business School, recently wrote, “ESG is both extremely important and nothing special.” pointing towards the inevitability of the value relevance of ESG analysis and its role in generating long-term value, signalling the mainstreaming of ESG… “Because any practitioner should care about the drivers of long-term value, particularly (for practitioners who are investors) ones that are mispriced by the stock market”.

The market is demanding ESG discipline from all practitioners; companies and their value chain, consumers, investors, and regulators. All practitioners want companies to be responsible for their impacts. What are the tenets of discipline and real world impact from the point of view of an investor?

  • Less is more: ESG is not endless; the subjective open-endedness of the term can be a big flaw. Having a set of focus areas are extremely important in defining any analysis framework. Climate action and diversity were at the top of investor’s lists as areas of concern. However, new risks, such as energy security and humanitarian concerns are now broadening the scope. Typically, companies can have between 4-8 sector specific material issues. The art of knowing where to look is half the battle won. Investors having either risk management, returns enhancement or impact strategies understand attributes A, B, C and D are crucial to their investment thesis, some of which are mispriced, and that’s where all efforts should be directed.
  • Exclusions with caution: Exclusionary preferences are set to get longer and go further down the value chain. There is a consensus that absolute exclusions are equivalent to passing the buck. Exclusions fail to materially address the scale of the problem. Policy changes are much more likely to have desired outcomes when it comes to nuclear, tobacco, palm oil, gambling, alcohol and weapons exposure. Remarkably, nuclear energy, which has been on the exclusion preference lists of many fund managers, was added to the EU taxonomy as an environmentally sustainable economic activity.
  • Investors must refrain from micromanagement: Multiyear engagements lead to impact. For a risk-based approach, use your voice to highlight areas of concerns. From an opportunities perspective, investors influence behaviours and drive positive impact on relevant issues. It is important to note that investors are currently facing pressure to credibly measure and disclose the concrete outcomes on engagement activities. Regardless, being overly doctrinaire in demanding action puts a negative rhetoric in engagement outcomes.
  • Going beyond numbers: As investors, we love to pack data neatly and bring structure and objectivity to an investment thesis however, emphasis on ratings and superficial screens can take away from what it means to truly integrate ESG. In reality, ESG factors are suitably described as intangibles and numbers do not do it justice. MSCI, ISS and Sustainalytics dominate the ratings industry. However, there is a strong signal of moving away from short term rating actions and the welcoming of alternative data supporting ESG analysis. The next generation of data providers will not only have minutiae on customer perceptions, corruption probabilities and intellectual property, but also understand the application of these KPIs going beyond peer set comparisons and year over year reductions/appreciations.

The scope of ESG has evolved. It is a necessary response to market demand; solutions that generate impact will thrive and improve, creating a virtuous cycle. ESG need not be subject to culture wars, be politicized, divisive or represent binary ideology. Even so, let us not forget ESG is a grassroots movement expressing solutions to systemic challenges that matter to investors, consumers and employees. It is all about impact.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)

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