Although responsible investment and environmental, social and governance (ESG) approaches have become more prevalent over recent years, this has not meant the environment has become any less complex. It can be very confusing for charity trustees at the moment partly because of all the jargon. On top of that, it’s an ever evolving, dynamic environment. Government policy is constantly changing, with the dates on electric vehicles being rolled back and new licences being awarded for drilling for example.
From a charity point of view, it looks like the goalposts are constantly being moved, which can be confusing when trying to align investment with each charity’s values, while at the same time securing a stable return. Moreover, the layers of subjectivity around ratings and ESG scores can present challenges.
Indeed, many charities view ESG investment as a combination of risk management and values-based investing because a lot of charities conflate ESG investing with ethical investing. But the two are not the same thing. Ratings companies, which provide quantitative scores on companies’ ESG risks, and which clients often like to see, are not looking at it as values-based investing at all; they are looking at risk management. It is beholden on us as investment managers to make sure that the client understands that there is this inherent contradiction.
The mechanics of ESG integration
We have been told by clients that a lot of investment managers say that they integrate ESG risk factors into their decision-making but then struggle to explain how they do it. Therefore, it is essential to ensure that integration of ESG is mechanistically built into evaluations of companies, engaging both internal and external resources.
A company’s share price is based on its long-term cash flows, discounted back to present value. Depending on the level of ESG risk we have identified, by combining ratings agency scores with our own analysis, we can then translate that into a higher discount rate, in effect reducing the price we are willing to pay for that company to compensate for the additional risk. This naturally excludes a lot of companies with high ESG risk scores early on.
This differs from a high-level exclusionary policy because it does not start from the investment manager imposing its moral views on clients. But having said that, you do tend to find a high correlation between a traditional exclusionary approach and stocks within our portfolios because our valuation adjustment process means that companies with high ESG risk scores do not tend to get through our quality threshold. So, you get a similar result, but by taking a different approach. If a client wants to apply specific exclusions, as a segregated manager we can do that, but we often find that we do not have many, if any, of those stocks in the portfolio anyway.
Financial return is imperative
This non-exclusionary approach can help trustees and charity finance professionals to remain flexible and navigate the ever-shifting sands of ESG investment without risking return. Indeed, we have seen a bit of a change in mindset among trustees and a kickback in some cases against the severity of exclusionary policies. That is to say, some charities signed up to more stringent ethical policies because they believed that equated with their values, but others signed up because it was outperforming. Very few charities are prepared to sacrifice financial return when applying exclusions as the financial return is imperative to enable them to fulfil their charitable objectives, so a pragmatic approach is favoured by most and we are happy to provide advice on the consequences of different levels of severity of exclusion.
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