ESG: investing in sustainability, not scores

It’s a positive development that environmental, social and governance considerations are climbing the agenda. At Baillie Gifford, we’ve long believed that a company’s business practices and broader impact are inseparable from its long-term prospects.

But as ESG becomes ubiquitous, is the broader investment industry making progress or a counter-productive mistake?

Death by data

The explosion of interest in ESG has been accompanied by efforts to measure and quantify it. That’s given rise to a new industry that tries to distil good and bad into numerical risk scores.

The inevitable danger is that the focus becomes risk and where a company is today rather than what might happen tomorrow and the opportunity that presents.

That isn’t to say that metrics are irrelevant or that poor environmental or social practices don’t threaten a company’s prospects. It’s just that when thinking about investing for the long term, looking forward matters more than looking back.

Quantitative methods tend to distract from the importance of qualitative assessment. They gloss over the complexity of the real world and the impossibility of applying one-size-fits-all policies to global portfolios.

Moreover, the obsession with risk tends to obscure the possibility that a company’s environmental or social impact might be the platform upon which it builds long-term success.

Recapturing ESG

There’s a natural alignment between a company’s sustainable activities, its long-term prospects and the long-term investment returns it provides to its capital providers. At Baillie Gifford, we believe in looking for those opportunities rather than obsessing on the risk.

One opportunity is to identify companies whose contributions to delivering a more sustainable future are intrinsically linked to their outsized growth potential. For example:

• Tesla revolutionising the world’s perspective on automotive electrification.
• MercadoLibre promoting financial inclusion in Latin America.
• Coursera improving access to education for elements of society left behind by traditional education structures.

Another opportunity is identifying companies such as ASML, the sole equipment maker capable of producing the world’s most advanced computer chips. Its sense of purpose and genuine appreciation of the long term are critical to its enduring success.

Look after your staff, and they’ll tend to work harder. Operate within the spirit rather than the letter of the law, and regulatory change is less likely to shock when loopholes close. Think carefully about the indirect consequences of your actions, and you are more likely to avoid scandals and reputational damage. Take a chance on long-term innovation that challenges the status quo, and you are more likely to lead your industry and deliver transformational growth.

These benefits may not be easily measurable when costs are first incurred. But they tend to become significant if you stretch your time horizon.

The final opportunity is engaging with ESG laggards. The cement manufacturer that needs to accelerate investment in zero-emission technologies, perhaps, or the clothing manufacturer that needs to improve oversight of its supply chain.

To use climate change jargon: it’s not just about ‘solution providers’ but also ‘transition companies’. Businesses that may have a substantial emissions footprint but could transform their prospects by playing a vital role in reducing the impact of industries where behavioural inertia is hard to overcome and practical alternatives difficult to identify.

Making our impact count

One ESG challenge levelled at listed equity investors is the question of additionality. What can we add via our investment in and engagement with a company?

We believe that engagement should be a genuine two-way process by which management and shareholders work together to overcome difficult, long-term challenges.

Such an approach facilitates higher-quality conversations with senior executives and board directors, increasing our influence. With that influence, we aim to help companies make better strategic and operational decisions that result in better long-term outcomes for shareholders and all stakeholders. This is undoubtedly what sustainable investing and the incorporation of ESG should be about.

Not every company relationship will be as impactful as the other. As in investing, it is in the extremes that we are likely to add the most value.

Where we do make a difference, however, it is unlikely to occur because we bombarded the company with requests that sought to minimise our clients’ exposure to every potential ESG ‘risk’ highlighted by third-party data providers. In our experience, the outliers that make the greatest impact are seldom slaves to orthodoxy and custom.

It’s better to help our clients understand real-world impact than to fob them off with box-ticking, however much easier that might be.

Conclusion

As the investment industry scrabbles to look good in the age of ESG, the quickest fix is to focus on rating agencies’ scores and tweaking portfolios to make yourself look good.

Will such an approach make the world a better place? Will it guarantee attractive investment returns? We think not.

Data will matter over time to demonstrate progress – how else can we prove we are making headway if we have no reference points? Nonetheless, we’d rather drive while looking forwards rather than exclusively focus on the rear-view mirror.

The opportunity is not in playing the numbers. It is about meaningfully engaging with the issues, understanding why they matter and seeing the risks and possibilities they present.

If there is any chance of avoiding climate disaster or delivering sustained and meaningful improvements to financial and social inclusion across the globe, that’s what it will take.

Tom Walsh is a partner at Baillie Gifford

Important Information

As with any investment, capital is at risk. This article does not constitute, and is not subject to the protections afforded to, independent research. Baillie Gifford and its staff may have dealt in the investments concerned. The views expressed are not statements of fact and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA).