A strategy to avoid common pitfalls of ESG investing

This article is part of
The Guide: Half-year review

A strategy to avoid common pitfalls of ESG investing
ESG failures, such as the BP Macondo oil spill, have had devastating financial implications for firms previously considered sustainable

Most investors recognise that it pays to take heed of the environmental, social and governance (ESG) factors that affect the companies they invest in. 

From the oil shock of the 1970s, through to the accounting scandals at Enron and Parmalat, the global banking crisis of 2007-09, the Macondo oil-well disaster, and recent vehicle emissions-testing controversies. 

ESG failures have had devastating financial consequences for companies and brands previously considered robust and sustainable. Nonetheless, investors still remain primarily concerned with business processes rather than the real impact their products are having on the planet and on society. This is problematic because by focusing on the internal processes of companies, investors measure only a fraction of the global impact.

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A little reflection makes it obvious that high scores in an ESG analysis do not necessarily imply high beneficial outcomes for the environment and society – and therefore portfolio performance. 

For example, Tesla, which is revolutionising both the automotive and battery industries, has a relatively poor ESG score because it is an immature, fast-growing firm that has yet to formalise its governance and other processes. 

By contrast, Total scores well in ESG models – it gets an 86 in our model versus just 56 for Tesla – despite the fact that its core product is a leading contributor to greenhouse gas emissions.

But we  think we have found a way to augment our ESG analysis by looking at the genuine impact criteria that is at the heart of another style of investing that evolved through the 1990s, known as impact investing. This method sought out social enterprises established explicitly to make the world better and more sustainable, while delivering good returns to portfolios.

It led investors into smaller, often private investments. This is partly because it is easier to see the beneficial impact of a private equity stake than a shareholding in a multinational engineering conglomerate, and partly because an investment of private capital represents a genuine addition of resources to a company, whereas buying public equities merely represents a financial interest changing hands.

But therein lies another problem: classic impact investing will always be a worthwhile-but-niche activity, while mainstream investing in the world’s larger companies has the potential to deliver beneficial outcomes that are much more significant – in scale, if not in depth.

The solution is to integrate some of the key performance indicators that impact investors use – the carbon intensity, water intensity and social returns of products and services – into mainstream ESG analysis.

It also helps if investors try to keep track of the direction of movement on ESG factors within a company. Signing the Carbon Disclosure Project is a positive for a company, but it should get a better score once it starts to change its fleet of salespeople’s cars to hybrid models. 

A firm achieves the best score when it can demonstrate a tangible reduction in greenhouse gas emissions as a result. This is the only way to pick up on ‘greenwashing’ that doesn’t follow-through with actions that will generate beneficial outcomes and remove real risks to the company and investor portfolios.