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The evolution of ESG investing

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Shades of Green 

We all like to have choice; that comforting feeling we get from having agency to decide how to move forward. But being faced with an excess of choice can lead to an overload of information and confusion, which in turn leads to procrastination. Worse still, when faced with too much choice we may opt to take a quick and ill-informed decision, which can lead to a sub-optimal or unintended outcome. We’ve all been there, pondering how to take a decision that will likely influence a future outcome. How do we narrow down the options? And what information do we need to help us take that first step...

It isn’t just an excess of choice that blunts decision making ability. Complexity and getting to grips with what it means can be a way bigger impediment. For any complex system it’s far from obvious how the elements interact or impact results. Even decisions around small changes to a complex system can have long-term and significant impacts.

So, as decision makers, we face the significant challenges of overcoming complexity and excessive choice. And systems don’t get more complex than the environment, infrastructure or the world of global finance. Now imagine the scale of the challenge in bringing these three together, which is exactly what is faced by institutional investors and corporations as they engage in making decisions aimed at reducing carbon emissions and addressing climate change. As if the investment challenge for pension funds wasn’t difficult enough already!

Times change, and sometimes quickly. As an investment consultant it’s unusual now to attend a meeting that doesn’t have responsible investing somewhere on the agenda. Five years ago that was a rarity. Across the country, trustee boards are busy debating what ESG means for their scheme, for their members, for their sponsors, and what they can and should do about it. As is often the case, the line between objectivity and subjectivity is unclear. Definitions evolve and morph over time. Consensus can be tricky to find. This is a case of complexity at work.

Meanwhile, fund managers are busy refining their approaches for incorporating ESG into their investment selection processes. The vast majority of managers are making concerted efforts to implement positive change, while a small minority are marketing what they’ve always done but in a greener shade – so-called ‘greenwashing’. The number of ESG aware investment products is growing, almost by the week it seems, and deep analysis is required to differentiate products across fund managers. Alongside the proliferation of products, attention to asset classes more suited to ESG continues to grow, for example: green bonds, infrastructure, social housing and agriculture. Sufficient choice is good but, as noted earlier, too much choice is an enemy of effective decisions.

Not so long ago, some investors had concluded it was an ‘obvious’ answer to the ESG challenge to exclude the ‘bad’ companies. After all, ‘bad’ companies should fall out of favour over time, and investors in them would be punished with poor returns. And if those companies did the unexpected and continued to perform well, then that wouldn’t be a disaster because not holding them is morally justified, right? Well, perhaps not if it means there won’t be enough money in years ahead to meet the scheme’s obligations but, this point aside, the ESG answer has moved on apace.

Last week we received some helpful clarity from the Department for Work and Pensions. It suggests that rather than selling out of less green companies, institutional investors should look to hang on in there and lobby their fund managers to use voting rights to influence corporate change. We’re told that such engagement is essential for companies to be nudged towards achieving carbon neutrality, improving governance and raising the positive societal impacts of industry. Better to help established companies clean up their act and become more sustainable, whilst benefitting from share price appreciation in the process, than to walk away and leave the problem for somebody else to fix. It won’t be the right answer for every investor or board of trustees, there seldom is one answer that fits all, but as a principle it makes total sense and arguably honours a social obligation.
What’s more, it likely relieves some of the pressures of complexity and excessive choice. Thank you, behavioural economics

Paul Francis of Quantum Advisory.