ESG Investing For Dummies. Brendan Bradley

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ESG Investing For Dummies - Brendan Bradley


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well by doing good.” Since then, the significance of ESG issues has experienced a meteoric rise. The Principles for Responsible Investment (PRI) network of investors, which was introduced in 2006, has grown from 63 asset manager and owner signatories with US$6.5 trillion in assets under management to more than 3,000 signatories with over US$103 trillion in assets under management. Driven by increased stakeholder attention to corporate environmental impacts and investors realizing that strong ESG performance can safeguard a company’s success, ESG is no longer a niche investment concept.

      

As the world is changing, there is a greater requirement to understand what risks or opportunities a company faces from ESG issues that may determine its long-term prospects. The COVID-19 pandemic has highlighted the need to consider these factors even further, hence the recent surge in investments in this space. Even within this century, the context in which businesses operate has changed radically. Businesses have generally profited from economic growth, globalization, increased consumption, and fossil fuels, and have strengthened and developed their role as the major providers of goods, jobs, and infrastructure worldwide. Consequently, their contribution to essential sustainability issues, such as climate change, biodiversity, social diversity, and inclusion, has also grown. Concurrently, the rise of technology has allowed stakeholders, as well as shareholders, to challenge businesses on how they behave.

      In recent years, the term “ESG” has generally become synonymous with socially responsible investment. However, ESG should be seen as more of a risk management framework for evaluating companies and not as a stand-alone investment strategy. ESG measures the sustainability and societal impact of an investment in a company. These criteria help better determine the future financial performance of companies. Likewise, impact investing is more about the type of investments a manager is targeting, while ESG factors are part of an assessment process to apply non-financial factors to a manager’s analysis in identifying material risks and growth opportunities. Also, impact investing seeks to make a measurable, positive, environmental, or social effect with the investments that a fund manager purchases, whereas ESG is a “means to an end,” serving to identify non-financial risks that may have a material impact on an asset’s value.

      Moreover, ESG is often incorrectly commingled with terms such as corporate sustainability and corporate social responsibility (CSR). While some overlap exists, these terms aren’t interchangeable:

       Corporate sustainability is an umbrella term used to describe the long-term creation of stakeholder value by encompassing opportunities and managing risks resulting from economic, environmental, and social developments. To many companies, corporate sustainability is about “doing good” and doesn’t require any set conditions.

       Corporate social responsibility is an embedded management concept where companies incorporate the concerns of key stakeholders into their operations and activities. In comparison, ESG assesses a company’s ESG practices, together with more traditional financial measures.

      

You may be used to gauging financial ratios when investing in stocks, from the relative price-to-earnings (P/E) ratio to EBITDA margins. (Yes, I’m talking about earnings before interest, taxes, depreciation, and amortization — good thing there’s an acronym to use.) All of those ratios are still relevant, but now you can view the same stocks through an additional lens. The sustainability evaluation of ratings firms is normally blended into a single ESG score, similar to the stock recommendations offered by investment banks and brokers. Just as mainstream research analysts calculate different recommendation valuations for the same companies, using largely the same information, so ESG analysts also differ on their recommended scores. Check out Chapter 2 for an introduction to ESG ratings.

      The following sections look at the different components of ESG, including financially material indicators, how those indicators can differ according to industry sector, and how various ESG strategies can be applied across these factors. These elements can be analyzed in the ESG Cube, which represents the intersections between these factors.

      Defining the breadth of ESG

      Unlike common financial ratios, there aren’t a common set of ratios that neatly define what a good ‘E,’ ‘S,’ or ‘G’ score looks like. And whether you should aggregate the three siblings together or you should consider each one individually depends on your determination of what issues you believe are most relevant from an ESG perspective. Indeed, some of the factors may be more material to some stocks than others. For example, the environmental risks associated with a bank will be less material than those facing a mining company, while such risks may be counterbalanced by more concerns over governance with a bank. Also, to what degree should you be concerned, and what data or methodology will you use to gauge that concern? As you can see, ESG analysis brings an entirely new set of indicators that you need to consider, which can result in a complex analysis that isn’t reasonable for a layperson to calculate.

      Then there is the version for sophisticated investors, including large asset owners such as pension funds and family offices, where that approach won’t pass the “smell test” given the level of fees they are paying for investment management. They expect a much more active management approach, with full consideration of the complex interdependencies that can be analyzed in this process. One way to visualize the approach that an asset manager could take is to consider a matrix, or a three-dimensional cube. An asset owner considers at least three dimensions to be important:

       What are the key industry sectors that exhibit the greatest ESG risks or opportunities?

       Which ESG execution strategy


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