What ESG investment themes should investors consider?

Climate change, diversity, shareholder rights, executive pay – the list goes on.

The first of these, climate change, can certainly seem like the most pressing environmental issue as extreme weather conditions continue to affect the UK and US in particular.

The heatwave experienced by the UK this summer was a reminder of just how harsh climate conditions may get and how much our lifestyles will have to adapt if those sorts of temperatures are to become the norm.

“The most enduring theme over the past 15 years has been climate change,” suggests Christopher Greenwald, head of sustainable investment research and stewardship at UBS Asset Management.  

“Investors understand its material importance for companies, and the direct experience with the effects of climate change in Europe and the US over the past several years has made the issue more prominent.”

There is a significant degree of consensus that the greatest risk to medium and longer term investors is climate change.Julia Dreblow

What are the most important ESG themes for investors to consider?

When advisers have this conversation with clients, it is important to establish exactly what issues they want to tackle through their investments – is it a thematic one? Are there simply certain companies the client wants to avoid investing in?

“For a financial adviser, the simple answer to the question ‘which are the most important areas to consider’ is, ‘it depends which issues matter most to your clients’,” says Julia Dreblow, founder of sriServices and Fund EcoMarket. 

“This, of course, points to the need for having in place processes that enable advisers to understand their clients’ opinions on social, ethical and environmental issues.”

Social risks

Ms Dreblow agrees: “There is a significant degree of consensus that the greatest risk to medium and longer term investors is climate change.”

Research conducted by HSBC Global Asset Management and published on 19 September, reports of the 204 UK IFAs surveyed, interest in social concerns, such as diversity, human rights, consumer protection, and animal welfare, is the main reason for client demand for investments explicitly incorporating ESG issues.

Figure 1: Drivers of investor interest in ESG products

Source: HSBC Global Asset Management

“Climate change is also, too often, considered to be entirely an ‘environmental’ risk – when in reality it is a ‘social’ issue also,” Ms Dreblow asserts. 

“Indeed, it is increasingly clear that changing weather patterns and the resultant droughts, floods and other extreme weather events will impact poorer people and nations more than wealthier nations, as they are less well equipped to cope with the damage caused.”

Bryn Jones, co-manager of the Rathbone Ethical Bond fund, suggests social themes are important issues for investors but that so too is governance – the ‘G’ in ESG.

“Governance is another important part of sustainable investment. Businesses that have poor governance can put cashflow at risk, and as debt investors, these risks can be significant,” he explains.

David Harrison, manager of the Rathbone Global Sustainability fund, points out the United Nations Sustainable  Development Goals are a “useful roadmap for addressing a number of ESG challenges”, including resource efficiency, health and wellbeing, and social inequality.

Under pressure

Is there evidence asset managers are applying enough pressure to companies to address a host of ESG and corporate social responsibility issues?

“Asset managers are stepping up their engagement efforts,” asserts Hortense Bioy, director, passive strategies and sustainability research, manager research at Morningstar.

The price to pay could be high for those companies which fail to act.

Over the longer term, we would like to think that businesses that have strong governance will not be subject to the same degree of litigation and regulatory costs.Noelle Cazalis

“They’re also increasingly willing to name and shame the ESG laggards, especially in Europe. A good example is LGIM,” she says. 

“In its Climate Impact Pledge report published in June, LGIM praised the companies that have improved their environmental strategies and shamed those that have shown persistent inaction to address climate risk. LGIM has also divested these companies from its Future World range.”

Joshua Kendall, ESG analyst at Insight Investment, part of BNY Mellon Investment Management, notes: “Today, a significant short-term risk is information security. 

“There have been several recent incidents of major cybersecurity breaches and it can be difficult to identify which companies might be most at risk. 

“It makes sense for asset managers to encourage companies to provide more information on their cybersecurity practices, engage with them on their preparedness and policies, and to ensure these risks are managed effectively.”

Less volatile?

Given that investing in companies which take their ESG policies seriously should mean they are less likely to be scandal-hit and therefore suffer a sudden drop in share price, does an ESG portfolio dampen drawdowns in a volatile market – more so than a conventional portfolio?

Noelle Cazalis, co-manager of the Rathbone Ethical Bond fund, explains: “Over the longer term, we would like to think that businesses that have strong governance will not be subject to the same degree of litigation and regulatory costs, as well as any losses associated with this. 

“Businesses that protect the environment also are likely to benefit in the future for the same reason.

“However, in periods of extreme volatility, we tend to find government bonds can outperform credit risk, given the former are still perceived as safe havens. As a result, a portfolio like ours that can’t invest in government debt, owing to their exposure to armaments and war, might underperform.”

Ms Dreblow adds understanding the potential upside is important too.

“Understanding the risks that are relevant to individual companies – and making investment decisions based on information gained - can clearly reduce investment risk, however equally important is understanding the upside,” she acknowledges.

“In general, (all other factors being equal) companies that manage ESG risks better than their competitors are likely to be better and less volatile investments.”

eleanor.duncan@ft.com