ESG Investing : Everything you need to know

There is clear progress in the environmental, social and governance (ESG) space. ESG is everywhere. It features in daily discussions with fund managers on their investment process; in conversations with the globe’s smallest and largest corporates; and in Invesco’s suite of European funds that promote ESG characteristics — all in the context of the real commitments and show of financial muscle on the sidelines of Cop26. Ahead of Cop27, more momentum is expected to build on the environmental side of ESG. Key climate-related themes are increasingly appearing in company transcripts, including biodiversity, biofuel, carbon capture, carbon offset, decarbonisation, net zero, electric vehicles, the green deal and the EU taxonomy.

The Covid-19 pandemic has highlighted the need for more work to be done in the social and governance space too. The same analysis of company transcripts show the increasing interest in themes such as employee welfare and digital tax. This comes amid a backdrop of increasing global ESG assets under management and more sustainable fund launches across the world.

To fulfil the goals of the Paris Agreement, countries, corporates and consumers will have to take steps to reduce their carbon footprints. The switch from a carbon-intensive economy will require huge public and private sector investment in innovative technology and green infrastructure. Meanwhile, any delay in the transition to net zero could exacerbate the climate crisis and pose risks to portfolios and assets. Investment portfolios and asset allocation will increasingly reflect the realities of the transition to net zero. Shareholders are also increasingly focused on good governance and sound social policies.

Socially responsible investing (SRI) is one component of conscious investing, and includes any investment strategy that aims to consider financial return and social and/or environmental good to bring about social change.

While there’s evidence to suggest ESG-focused funds do outperform, there are several factors to consider. These include the strategy applied to portfolio, its allocation and how stocks in the portfolio are selected (i.e., using their ESG score). In Responsible investing: common myths debunked; we explore ESG outperformance in more detail.

There’s no one-size-fits-all approach for measuring ESG, which makes standardisation difficult. Investors can’t easily compare ESG funds – and while there are now different agencies, covering varying numbers of businesses, each uses a different ESG ratings scale.

In ‘More than numbers: Meaningful measuring and reporting in an ESG landscape’, we explore the complexities – and potential solutions in more detail. Standardisation is imperative but it’s also important to define the different elements of measurement. There’s a distinction between measuring ESG implementation and ESG impact; as well as between fund-level and entity-level ESG scoring.

Fund categorisation based on the specific area of ESG each fund targets is one way to help, allowing investors to align their decisions with their non-financial objectives – or their desire to ‘do good’. There are three main components:

• Objective – what are the fund’s ESG goals?
• Investment process – how does it go about achieving them?
• Outcome (which is focused on measurement and reporting) – how well did it do, what was the drawdown and how risky was it?

As ESG continues to grow globally, different regions have made efforts to introduce regulatory standards. Regulation will be a key factor in ensuring that efforts to integrate ESG have a tangible impact. It’ll also help to drive the standardisation of measuring and reporting.

The EU has introduced green taxonomy, Sustainable Finance Disclosure Regulation (SFDR) and most recently, the Sustainable Finance Strategy to provide rules and structure to the way businesses report on their ESG activities. You can read more about this in our A-Z guide.

Greenwashing is when companies portray a public image of sustainability but aren’t taking sufficient or tangible action behind the scenes or undertake other questionable business activities. It could be a global drinks company committing to using 100% recycled plastic but setting no actual target, or a fast fashion brand using sustainable materials but with questionable manufacturing processes.

In the investment industry, it could be excluding obvious companies like tobacco manufacturers from a portfolio but not applying ESG analysis to the rest of it. Greater regulation and efforts to standardise measuring and reporting should help reduce the effects of greenwashing, as well as wider education. Our ESG@Invesco series features a wealth of content and discussions on the importance of meaningful ESG implementation. A key part of this will be net zero implementation, which will include decarbonisation; company-level assessments of alignment to green targets; and further engagement on reducing carbon footprints.

Growing concerns over climate change mean it’s often considered the leading ESG issue. Climate data is already playing an important role in investment strategies and in investors’ decision-making, putting business practices and disclosures under increasing scrutiny. Global initiatives like the Paris Agreement, the Task Force on Climate-Related Financial Disclosures and COP26 aim to address climate change at a sovereign and institutional level – with the goal of limiting global warming to 1.5°C degrees Celsius, compared with pre-industrial levels.

In the investment industry, the Principles for Responsible Investment (PRI) supports its signatories by setting out six guiding principles to help understand and integrate ESG into their investment decisions. They view education as key and there are several resources available. The objectives include using analysis as a tool to create climate-friendly investment strategies. This could be investing in areas that specifically target climate change, like renewables, to investing in businesses operating sustainable practices, like better energy efficiency.