05 Nov The 7 Fundamentals of Environmental, Social and Governance (“ESG”) Investing
At Perennial Sustainable Future we often use the ESG acronym in a way that assumes that everybody knows what it means and all that goes with it. It soon becomes clear that it is just another confusing investing acronym – so we thought that we would seek to demystify the basics of “ESG” in more detail. We will also look at how we use ESG principles when managing the Perennial Smaller Companies Sustainable Future Trust and the eInvest Future Impact Small Caps Fund (ASX Code: IMPQ).
ESG Fundamental #1 – What is ESG short for?
ESG is short for Environmental, Social and Governance. When used in the context of investing it refers to how a company is performing, or how seriously it takes, the environmental, social and governance aspects of the company’s operations.
ESG Fundamental #2 Why focus on ESG when investing?
There has been increased focus on the ESG aspects of businesses in recent times. This is in part because the impacts of climate change are becoming more real – particularly in a business sense. There is also a greater focus on community expectations of business following events such as the Hayne Royal Commission and the devastating Samarco Dam failure in Brazil.
While it feels good to “do good”, there is a growing body of evidence that using ESG in investing generates superior risk adjusted returns. So you can not only “do good” but also “do well”.
ESG Fundamental #3 – Environmental impacts
The issues to consider when assessing the Environmental performance of a company are more obvious.
Key issues when considering the Environmental aspects of a company’s performance include:
- Greenhouse Gas emissions – including emissions created by the company from operating activities (Scope 1) or from the indirect consumption of energy such as electricity (Scope 2). An important consideration is the question “What steps is the company taking to reduce emissions? And does it have reduction targets in place?”
- Waste and Water Usage – what steps is the company taking to reduce waste and water usage?
ESG Fundamental #4 Does a company have a “social licence” to operate?
When considering Social the focus moves to considering the extent to which the company is considering and looking after the interests of stakeholders including employees, customers and the broader community. This is important to ensure the acceptance of the business model and operations by the community and protects the company from reputational risk.
Key issues when considering the Social aspects of a company’s performance include:
- Safety – Are the company’s operations providing a safe environment to protect the employees and the company from incidents, fines and reputational damage.
- Employee Remuneration, Diversity and Retention – the appropriateness of the company’s remuneration, diversity and other policies and the ability of the company to retain staff.
- Fair Trade or Modern Slavery – the company’s approach to “fair trade” and whether the company is ensuring that its suppliers and supply chain are complying with employment laws.
- Social Licence to Operate – The company’s relationship with and acceptance by community stakeholders.
ESG Fundamental #5 What are the key aspects of Governance?
We will start by discussing the “Governance” aspect of ESG. This is the aspect of ESG that investors have been actively considering for the longest period of time. In short, when we are considering the governance performance of a company we are considering how seriously the company is managing risks and looking after the interests of small or “mum and dad” shareholders.
When considering Governance it is important to remember that the split of functions between the board of directors and management. The board of directors is typically 4-12 people who are appointed by shareholders and usually meet once a month – that do not work for the company on a day-to-day basis. The most important tasks for the board are to appoint and monitor the CEO and management who work full-time for the company and set the strategic direction for the company.
Key issues when considering the Governance aspects of a company’s performance include:
- Independence – Whether the board of directors is sufficiently “independent” and focussed on advancing the interests of small shareholders. A director is “independent” if they are not members of management and are free from relationships that could interfere with the independent exercise of their judgement.
- Board Diversity – Whether the board has a sufficient diversity – including diversity of gender, background experience and skills. This encourages diversity of thought and provides and studies suggest leads to better risk outcomes.
- Remuneration – Whether the remuneration arrangements that the board has put in place for management are aligned with the interests of shareholders and the strategic direction of the company.
- Risk Management – ensuring management is taking appropriate levels of risk in business operations.
ESG Fundamental #6 Avoiding Reputational Risk
One of the key positive outcomes of ESG Investing is to avoid reputational risk. When a company’s reputation is damaged it can often have a significant effect on the social licence to operate and investor returns. For example, the damage to AMP’s reputation following the Hayne Royal Commission resulted in significant share price declines. When investing in companies we are always alert to whether the nature of the company’s business or the way it conducts business is likely to lead to reputational issues or controversies in the future.
ESG Fundamental #7 Why is ESG important when investing?
It follows from the above that companies that are performing well in relation to ESG:
- are looking to improve or are appropriately managing the company’s Environmental
- are developing a strong Social licence by nurturing positive relationships with employees, customers and the broader community; and
- have in place Governance procedures to ensure that the interests of shareholders are aligned with management.
In more basic terms these companies are “doing the right thing”. For many people (us included!) it feels good to be investing in companies that are “doing good”. But some people wonder if there is a share price performance trade-off in investing in these companies.
In some ways it seems obvious that companies that are performing well in these areas are likely to be good investments and this conclusion is confirmed in a number of studies of the impact of ESG on a company’s share price performance.
More importantly, we feel confident this is the case given the experience to date of investors in the Perennial Smaller Companies Sustainable Future Trust. The Sustainable Future Trust has delivered performance of 12.7% per annum since it started on 1 February 2018 to 31 October 2019. This has outperformed the benchmark S&P ASX Small Ordinaries Accumulation Index by 7.1% per annum over that time. While it has been in existence for a shorter period – since 23 May 2019 – investors in the eInvest Future Impact Small Caps Fund (ASX Code: IMPQ) have experienced a return of 7.9%, outperforming the S&P ASX Small Ordinaries Accumulation Index by 5.7%.
Disclaimer: Please note that these are the views of the writer and not necessarily the views of Perennial. This article does not take into account your investment objectives, particular needs or financial situation. Past performance is not a reliable indicator of future performance. Gross performance does not include any applicable management fees or expenses. Net performance is based on redemption price for the period and assumes that all distributions are reinvested. Fees indicated reflect the maximum applicable. Contractual arrangements, including any applicable management fee, may be negotiated with certain large investors. Investments in the Trusts must be accompanied by an application form. The current relevant product disclosure statements, additional information booklets and application forms can be found on the Trust’s page.