Exclusion is not the only answer

Qayyum Rajan
August 8, 2020

As ESG investing continues to grow in popularity, the importance of utilizing the best ESG data, analysis and strategy is also growing. In the past, ESG investing was largely defined by negative screening, or the exclusion of certain types of companies deemed un-investible. While some ESG investors are still in this old school mindset, there are compelling opportunities to leverage more productive strategies in the ESG sector. In this article, we discuss the importance of comprehensive forward-looking ESG information, and the decreasing usefulness of a black and white, exclusion driven approach.

Case in point: The energy sector

The energy sector is generally front and centre when ESG investors are focused on risk mitigation, or when activists are presenting their views of what needs to change to address climate change. But, what if some of those views and perspectives are missing significant parts of the bigger picture by being too absolute? As Mark Twain famously said "Whenever you find yourself on the side of the majority, it is time to pause and reflect".

If we pause and reflect on what’s happening in the energy sector from an ESG investment perspective, many ESG aware investors currently have policies in place which preclude them from investing in traditional carbon-based oil producers. This makes some backward-looking sense as carbon-based energy is directly contributing to climate change, and it’s widely understood that we are approaching a climate change crisis. Climate action is needed, so it’s easy to point the finger at the carbon-based energy sector, which has become a villain in this story.

Those same ESG aware investors are also calling out for more renewable energy, since renewables are seen as one of the most direct ways to address climate change. However, the black and white exclusion approach to ESG ignores the key point that it’s often the larger energy companies who are investing in renewable energy solutions and technologies. The reason is simple: energy is their core business and some of these companies have funds at hand to invest in compelling sector opportunities, including renewables. Not all energy companies are in the same boat, but the key point is that there are some great management teams in the energy sector who are aiming to effect positive environmental change.

With this example in mind, a blanket negative view on all carbon-based energy companies may not achieve the objectives most ESG aware investors are focused on. The world is a far more nuanced and dynamic place than that view presumes, and investing is not just about mitigating risk and potentially negative impacts, it’s also about identifying positive investment opportunities which will generate strong investment returns looking forward.

ESG is not just about risk mitigation

Recent McKinsey research highlights the five key ways in which a strong ESG proposition creates value for investors as shown below.

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None of this is rocket science. Management teams who are focused on creating shareholder value are almost always aligned with ESG success, since sensible ESG strategies are consistent with generating higher shareholder returns. For example, consumers are increasingly demanding sustainable goods, and companies which can tap into this structurally growing market often generate stronger revenue growth than their unsustainable competitors.

The key point here is that while many investors mainly utilise ESG data to mitigate against risk, it also has a compelling role to play in highlighting investment opportunities. Hence, investors need ESG data and analysis which provides context and highlights nuances.

A better, more ESG aligned approach

Financial markets are forward looking, and so are ESG investors. So, rather than a blanket backward-looking exclusion approach, a comprehensive forward-looking approach to ESG analysis is far more valuable and market relevant. It may not be as simple as the black and white exclusion approach to ESG, but it allows investors to value the ESG related opportunities as well as risks with the context of up-to-date and comprehensive information. Both risk and opportunity are equally important for investment returns, so this approach is well suited to the mainstream of professional investment.

It’s also worth noting that on a deeper philosophical level, a forward-looking approach which values positive change is more likely to lead to greater positive change in the future. Management teams who know that their positive changes are being recognised and rewarded will do more of the good stuff looking forward… and vice versa.

This comprehensive approach to ESG is more aligned with the philosophy underlying ESG investing: make the world a better place while generating strong investment returns.

ESG Analytics: An AI leader in the making

ESG Analytics is one of a new breed of ESG data providers, aiming to create the value the institutional investment world wants and needs. ESG Analytics’ AI technology scans the world of unstructured media to provide a comprehensive and up-to-date picture of a corporate ESG performance, which covers issues analysts may have missed, or issues which have happened more recently than the information analysts are relying upon.

This AI-focused approach creates a top level view of the ESG world based on ESG frameworks and internal knowledge, which in turn generates the most powerful, high value-add data for investors. Importantly, this is data which incorporates not only what companies say about themselves, but also what the rest of the world says about them. It’s objective information, and therefore particularly valuable as an investment tool, particularly in combination with subjective analyst research.

Conclusion

ESG investing is growing up as an investment strategy. We’ve moved past the days when a simple black and white exclusion approach was the best way to add value in the sector. Complex financial markets need an holistic, integrated approach to ESG which is focused on both identifying opportunities and mitigating risk. ESG Analytics’ all-encompassing AI-focused approach helps uncover both material risks and opportunities to help investors invest where it matters.

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