ESG Investing  

Embrace the complexities of ESG

Embrace the complexities of ESG
Pexels/Min An

At the same time as Greta Thunberg called powerful leaders to account at the World Economic Forum in Davos with uncompromising demands, including to immediately divest from fossil fuels, South Africans faced daily power cuts.

For the country’s 59m people, no electricity meant no lights, no warm water, no internet and, in cases of emergency, no help.

South Africa is almost entirely powered by coal. But if the country abandoned fossil fuels overnight, millions would suffer. This raises an uncomfortable question: how can we save the planet without adversely impacting people’s lives?

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Drawing on the concept of connected thinking, three interrelated forms of tension can be identified.

Philosophical tension: Art versus science of sustainability

Should we incorporate environmental, social and governance considerations because it is the right thing to do or because of hard evidence? The ambiguity in human behaviour highlights the importance of data in evidencing the benefits of ESG.

In 2018, the United Nations’ Exponential Climate Action Roadmap said the question was: “How do we provide governments, businesses and citizens with shared roadmaps that show the way?”

Key points

  • Planning sustainability is a difficult challenge
  • Companies incorporating sustainability have long-term prospects
  • Exclusions filters are one way to be a sustainable fund

The report argued the data needed to create these roadmaps were already accessible, from government policies to emission statistics and research.

Yet significant issues remain in collecting data. As it is not mandatory, disclosure of ESG metrics is far from comprehensive, allowing exposed companies to not report their risks. Without clear deadlines it tends to be published with long delays. 

Issues in data quality need to be balanced against our own ambiguity when interpreting and acting on information. This tension means our approach will hang in the balance between art and science; investors should embrace both.

Performance tension: Absolute versus relative sustainability

The cost-benefit analysis of incorporating ESG is another line of tension branching off in several directions, one of which is the question of investing in companies with a good ESG score versus those whose score is improving.

A 2018 Bank of America Merrill Lynch report showed the benefits of selecting above-average ESG-rated companies to avoid defaults. The caveat is that differentiating between correlation and causality can be difficult. 

Yet even if it simply correlates to a lower cost of capital, a high ESG score can be a useful starting point when looking for consistent performers. 

A high ESG score can also indicate a company’s durability; such companies typically focus on the resilience and sustainability of their business models. This will have left them better prepared for the disruption unleashed by Covid-19.

However, external ratings only show part of the picture. Family-run companies tend to have structures that do not fit with best practice; however, getting to know these businesses can separate those where cronyism is rife from those where management cares about doing the right thing.

Accounting for ESG’s dynamic nature is crucial. A timely judgment on a company’s ESG momentum can identify material risks that may be mispriced. These tend to evolve slowly but materialise abruptly. While this shows the urgency of integrating ESG into investment decisions, taking a long-term view is key.