Understanding different motives for sustainable finance is probably the biggest reason behind the confusion around ESG.
Sustainable and responsible investing continues to grow, and with that, it gets questioned, challenged, glorified, vilified and even ridiculed, and increasingly so in the public domain. There is nothing wrong with critique; we, the sustainable finance professionals, should be able to take and respond to the inevitable hype that young industries are prone to.
However, it is crucial to understand that sustainable finance is not a one-size-fits-all concept. There are various motivations and drivers, each offering unique techniques, benefits and perspectives. Trying to conduct your approach with the wrong tool or framework for another motivation is a recipe for disaster. Instead, delving into the various drivers of sustainable finance and shedding light on the diverse factors influencing sustainable and responsible investment decisions will alleviate some of the confusion in the market. It will also help you understand why I am keen on asking simple questions.
Why are you doing this? What are you trying to achieve?
1. Inherent need to do the right thing
"Where did my return come from?" Sustainable and responsible investment is rooted in a rich history of ethical investing. From a moral/ethical point of view, it is natural to avoid seeking investment returns from activities that one would shun in other parts of life. For instance, in the 17th and 18th centuries, Quakers abstained from investing in the slave trade. Similar practices continue to this day. You probably avoid investing in tobacco if you manage an endowment for a lung cancer foundation or avoid meat processing companies in your portfolio if your whole lifestyle is plant-based. Reflecting your worldviews in your investments is relatively simple. Just remove companies deemed unethical and invest in the remaining companies, minimising the deviation from the starting universe.
Due to its technical simplicity and often profoundly held personal beliefs that are difficult to associate with as an outsider, it is frequently frowned upon among investment professionals. However, it is still a valid and solid reason to pursue sustainable finance. Perhaps more importantly, it is also still what people outside sustainable and responsible finance think most professionals in sustainable finance do. Show me a political candidate moaning about ESG being woke, and I'll show you a person who thinks ethical reasons are the only motivation behind sustainable finance.
2. Duty to respect your constituents and manage your reputation
"What would my constituents think?" Public investors, such as pension funds, foundations, and university endowments, often consider reputational risk when approaching sustainable finance. As their investments are subject to public scrutiny, it is natural to avoid investing in companies that may be deemed questionable by your fiduciaries. This motive differs from ethical investing, as the motivation lies in meeting the demands and expectations of often large and diverse groups of stakeholders instead of the deeply held and much more explicit beliefs of a unique investor. The tools are roughly the same as in ethical investing, but this is much more challenging to navigate due to inconsistent expectations from various stakeholders.
Similarly to ethical investing, it often raises the question of limiting the investment universe and constraining the risk/return optimisation. But, the practical effects are usually minuscule. Not investing in a handful of companies in a well-diversified portfolio often does not have a measurable impact on your portfolio risk/return in practice.
3. Risk-return Improvement by integrating ESG
"Are these ESG risks and opportunities priced in accurately?" Thinking about the materiality of ESG issues and using ESG data to improve the risk-return of your investments is a significant step towards more sophisticated sustainable finance. It posits that if ESG risks are financially material for companies, they are equally material for investors regardless of their ethical stance or reputational risks. They are simply an extension of every institutional investor's fiduciary duty. However, the differing, often qualitative understanding of the materiality risks and their change over time make this approach complex. It also requires an interplay between the ESG issues, companies' risk profile, and investors' return expectations, which require ESG analysis to fluctuate with company valuation. The academic evidence around "Is there ESG alpha?" used to be the holy grail of sustainable finance research. It is not easy to isolate because most ESG research mixes and matches all of the motivations mentioned in this article, creating a magnificent disarray of noise in ESG data. Yes, there is ESG alpha. However, it is not easy to capture, and it is not evident in every investment decision at every point in time.
4. Impact Consideration and the societal importance of every investment decision
"What is the societal role of my investment decision(s)?" We believe that every investment decision has an impact on society. Capital allocation decisions influence how the world works and contribute to sustainable development. This approach requires diligent impact measurement, similar to risk and return assessment. If this sounds conceptually far-fetched, look no further than the EU Green Finance agenda:
"Sustainable finance has a key role to play in delivering on the policy objectives under the European green deal, as well as the EU's international commitments on climate and sustainability objectives. It does this by channelling private investment into the transition to a climate-neutral, climate-resilient, resource-efficient and fair economy, as a complement to public money.
While this "double materiality" thinking combining financial materiality and the so-called impact materiality is commonly used by regulators, academics, and consultants, most investment practitioners, even sustainable finance professionals, have not grasped the enormity of this sentiment. In the future, managing the societal importance of every investment decision will not be only between the asset owner and the asset manager, as with all the previous approaches. As investment decisions have the power to influence the world, they will be measured and scrutinised by regulators and, ultimately, by your fellow citizens, too. It does not have to be scary, though. Everything you know about ESG data, for example, will still apply. Everything in sustainable finance will be more significant regardless of what any individual might think, be it an investor or an investment manager.
Many things in finance can be technically complex or tedious. While plenty of innovation in ESG and sustainable finance looks complex or wearisome, the beginnings of the ESG journey do not have to be either. The more one can be about your motivation, the easier it will be. In the future, the societal role of investment decisions will be more transparent and accountable to the broader society. The societal importance requires a new way of thinking about impact measurement and ESG data. Tools such as SmartESG intelligently integrate risk, return, and ESG impact data, building a bespoke portfolio that achieves an optimal balance across all three dimensions; effectively navigating the complexities on your behalf, whatever your motivation.
Most importantly, the next time you make an investment decision, remember that you are affecting not only your portfolio but also the world around you. Your investment decisions have more influence and attention than you might realise from your potential and current clients, fiduciaries, employees, and the broader community. Make it count!