As with any investment, capital is at risk.
Late at night, a police officer finds a man crawling around under a streetlight. The man tells the officer he is looking for his wallet.
“Where did you drop it?” asks the officer. “Across the street,” the man replies. “Then why are you looking over here?” says the officer. “Because the light’s better here,” explains the man.
In some ways, this is analogous to our industry’s current approach to environmental, social and governance (ESG) issues. Are we focusing our efforts on those areas where it’s easiest to take metrics and score companies, rather than where our actions could be most valuable?
Before delving into that question, some context. The appetite for sustainable investing is growing among defined contribution (DC) schemes and members.
The Financial Conduct Authority found that 80 per cent of respondents to its Financial Lives survey “consider environmental issues important and believe that businesses have a wider responsibility than simply to make a profit”.
Accordingly, there has been an explosion in ESG investing. Morningstar estimates that, as of 2023, the assets allocated in this category had grown to $2.96tn across 7,400 funds.
Clearly, there is momentum. But it’s worthwhile stopping to consider whether we are heading in the right direction.
Opaque definitions
ESG is a nuanced field – observing good practices goes to the heart of a business and its operations, encompassing how it treats the environment, manages relations with its employees and upholds human rights in its supply chain.
If companies are under pressure to achieve certain data points, they may focus on factors that improve their scores but ultimately turn out to be costly, unhelpful distractions.
But solving real ESG issues seems unreachable when we can’t even agree on a simple meaning.
Definitions remain inconsistent and change depending on who’s talking. Some consider ESG as behaving ethically regardless of the financial consequences, others consider it only as a mechanism for financial risk management.
This lack of consensus makes it difficult to evaluate and compare different organisations’ ESG performance. It doesn’t help that the different bodies involved use different processes.
For instance, asset manager Legal and General (L&G) uses 30 indicators to score 17,000 companies, while London Stock Exchange subsidiary FTSE Russell uses three pillars and 14 themes to score 7,200 companies. They are not doing the same thing.
Several studies have found little or no correlation between the ESG scores that the major data providers have given to the same companies. That is because they evaluate different attributes, use different indicators to do so and give each factor a different weight.
This can lead to some surprising results. For example, according to one well-known ratings agency, British American Tobacco has a higher ESG score than wind turbine company Vestas and pharmaceutical firm Moderna. Rating agencies are clear their scores are primarily about financial management, but for many defined contribution (DC) pension scheme clients, the promise of ESG lies beyond this. It’s important for them to invest in a manner that aligns with their values.
Joining the dots
How can we resolve the discrepancy? For some, the answer is to standardise ESG reporting, making it mandatory and pushing for greater quality and availability of data.
This, they contend, would lead to more consistent and comparable reporting. The regulators seem to agree.
However, recent research into ESG ratings by professors from Harvard Business School found that more data disclosure made the divergence worse, not better. Thus, we would argue that the emphasis on quantitative scoring disregards the complexity of the issues it claims to address.
What’s our answer, then? Our starting point as long-term investors is to think about the companies we invest in holistically. We look not just at their long-term potential but also at the impacts, positive and negative, they have on the broader system.
We integrate ESG research with investment research and try to avoid static, box-ticking approaches to measuring performance. We place emphasis on qualitative, forward-looking factors.
That includes considering whether a business strategy has the potential to reduce emissions, benefit society or lead to improved governance. And we explore different scenarios – hypothetical stories about the future – to test our assumptions and anticipate when an investment case might change.
This should lead to better investment decisions than solely relying on backwards-looking numerical data.
Our five-year-plus time horizon gives us an edge here. Engagement is a critical part of the process. We speak to management to understand, support and challenge our holdings. And by building up these relationships over time, we can build influence and push for change where necessary.
The right direction
Our approach to ESG is resource intensive, but we believe it’s worthwhile.
Certainly, it would be much easier to look where the light’s better and measure ESG with third-party data that’s already at hand.
But, perhaps counterintuitively, we believe the right direction takes us towards the hazy world of qualitative measuring. Perhaps we can shed some light of our own here.
What’s our reward? Opportunity. Much is spoken about ESG as a way of managing downside risk. While this is valid, our long-term outlook means it’s equally a source of immense potential.
Consider the energy transition or advances in healthcare. At their core, these sectors rely on, and should propagate, sustainability and positive social outcomes. ESG factors will shape their progress.
To help companies achieve their potential, address some of society's biggest issues and deliver long-term growth, we need to go further than simple data analysis – I think that’s what the pensioners we invest on behalf of expect.
Risk factors
The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in March 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
Potential for profit and loss
All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.
This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.
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The images used in this communication are for illustrative purposes only.
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