A primer on responsible investing

Despite the backlash against environmental, social and governance (ESG) integration, Bloomberg forecasts that global ESG assets will account for 25% of assets under management by 2030.

However, there is still no consensus on the global standardisation and regulation of ESG, leading to its politicisation in key markets. Ignoring ESG can also come with a potentially high cost.

To address these challenges and help investors, trustees, and fund managers gain a better understanding of responsible investing, Investec Wealth & Investment International has published the ESG and Responsible Investing Guidebook.  

This definitive guidebook aims to provide valuable insights and information to navigate the complexities of ESG investing.

By incorporating ESG factors into investment decisions, investors can align their values with their financial goals and contribute to a more sustainable future. This is the opinion of Nicky Newton-King, chairperson of the Social and Ethics Committee at Investec, and former CEO of the Johannesburg Stock Exchange, and Barry Shamley, fund manager at Investec Investment Management.

The pair were in conversation at the launch of the new guidebook, where they reflected on the evolution of ESG and responsible investing, investment strategies, challenges and much more.

Navigating responsible investing

At the core of responsible investing is the consideration of material ESG risks when valuing an investment. For investors and trustees beginning to integrate ESG into their processes, identifying what matters most to their mission and developing principles around those priorities is essential.

The responsible investing process emphasises the importance of considering ESG risks to maximise long-term returns, adding a layer of analysis to investment portfolios with the need to tailor strategies to specific industries, as material risks differ across sectors.  Shamley explains:

“If you look at responsible investment as a spectrum, your traditional investment is purely financial and there's no integration at all. You'd move then across to exclusionary, which has been around for many years and that would be just excluding particular stocks because they don't necessarily align with your beliefs or the philosophy of your fund.

“Then where we get to today, I'd say the majority of funds globally that are being managed, particularly in Europe, have ESG integration and that is where you do consider and integrate material ESG risks and opportunities.”

But, says Shamley, the investment spectrum stretches further than just ESG integration, “You move a little bit to the right and that's where our Investec Global Sustainable Equity Fund sits and that's in the sustainable space; it's more thematic.

“So, there we're looking at companies that contribute on a net positive basis to the 17 United Nation’s Sustainable Development Goals. Then you move a little bit more to the right and you get into the impact space [which is] normally in your less liquid alternatives.”

“And then you get a little bit further to the right where there's what you call maybe concessional finance where you're willing to give up part of the return because you're getting your return in another way, and that is a very interesting area of development. I think what's necessary now are just vehicles that are able to provide accessibility to investors looking into that space,” says Shamley.

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The cost of ignoring ESG risks

Ignoring material ESG risks can prove costly and potentially detrimental to investment portfolios – this can also impact valuation. From carbon tax, like the European Union’s Carbon Border Adjustment Mechanism, the material risks could impact future earnings and affect value.

“The simplest one is a carbon tax and trying to understand the escalation of the carbon taxes in the future and how that's going to impact future cash flows for anyone that's a substantial carbon emitter,” says Shamley.

Regulations and frameworks to consider

The ESG landscape continues to evolve, and staying informed about global trends and regulatory frameworks is crucial for responsible investing success.

This investing approach has become a global investment norm, with an increasing number of fund managers signing up to the United Nations Principles for Responsible Investment (PRI). 

Developed in 2006, the PRI is a responsible investing roadmap for the investment community, including fund managers and trustees, to incorporate ESG factors into their portfolios therefore promoting responsible investing globally.

This growing trend signifies the integration of ESG factors into investment decision-making processes, and increased regulatory focus on the concept in key markets like Europe and the UK suggests a potential future shift in South Africa as well, says Newton-King.

“Right at the very beginning we were looking at companies and what they were doing. And today we all have these neat buckets, E, S, and G but at the time there were none of these buckets.

“There were concepts in King (King Code IV) about governance, there were concepts in the mining legislation around environmental responsibilities of mining companies and so on.

“When we started this process, we discovered that many corporates, without this heading of responsible investment, were already doing things that today we would green tick.”

ESG vs returns

Although the integration of ESG factors into investment strategies has become increasingly popular, there has been a long-standing concern that investing in ESG-focused companies may result in lower returns. But some experts, such as Shamley, challenge this perception with a focus on the potential for market-leading returns, emphasising that companies integrating ESG factors are often associated with the "quality bucket" of investments.

These companies prioritise long-term profitability over short-term gains, recognising that sustainable growth is more valuable in the long run. By focusing on quality companies, ESG integration can enhance returns rather than hinder them.

“There are companies that are doing the right thing, there are companies that are incentivised to grow profitability in the long term, and they realise that they can generate significant profitability in the short term, but it will be at the expense of long-term returns,” says Shamley.

ESG integration is about managing risk and achieving higher risk-adjusted returns and companies that invest in ESG-related initiatives, such as water-saving solutions, position themselves to mitigate future risks.

For example, a company investing in water-saving solutions today will likely avoid costly capital expenditures in the future if water shortages become prevalent.

These proactive measures enable companies to maintain profitability and reduce earnings volatility, leading to higher ratings and potentially higher returns.

However, notes Newton-King, there are challenges in aligning incentives between asset managers and investors. While investors often have a longer-term horizon, asset managers are often rewarded based on short-term performance.

This misalignment of incentives can hinder the adoption of ESG strategies, as asset managers may prioritise immediate returns over long-term sustainability. Newton-King says it’s about setting the agenda: “It's confused a little bit because often asset managers are awarded in the short term. So, there are different incentives at play here. The investors have a longer-term horizon, but the incentive matrix incentivises their agents essentially to worry about today and tomorrow, and not next week.

“We do need to, and it's one of the reasons why we've got to set the right agenda, as the asset owners for our asset managers and our advisors, to say this matters to us. So don't start talking about returns for now, talk about a reward system that is differently calibrated.”

How does SA rank when it comes to ESG and responsible investing?

While South Africa has long been considered a leader in ESG and sustainability, some argue that international developments in regions like the EU, the UK, and the US suggest that South Africa may be falling behind.

Newton-King acknowledges that South Africa was leading in ESG integration for many years. The country's initiatives, such as the Socially Responsible Index and the King Codes, demonstrated an early commitment to responsible investing. Thus even during events like Occupy Wall Street, where the need for responsible capital was highlighted, South African exchanges seemed more receptive to the concept compared to their global counterparts.

“South Africa was at the forefront for many years and to such an extent that I used to have conversations with my peers running other exchanges globally and ask ‘what are you doing?’ They really didn't get it,” says Newton-King.

“I think what you're seeing now is that the world has got it and it's actually good that we get to common standards that make it easier for corporates to disclose in a manner that makes it easier for asset owners, asset managers advisors etc.”

Measuring impact

While frameworks and data exist for ESG factors, measuring impact requires a different approach. According to Shamley, the concept of additionality and intentionality should be a starting point for investors. By identifying the change, they want to achieve and assessing whether their investments can contribute to that change, investors can begin to measure impact.

“You're giving your money in terms of what the situation is at the moment, maybe it's employment. Where do you want to get to? And making sure that progress didn't happen naturally, and it was because of that investment that you made, and I think that will be on a case-by-case basis,” he says.

Newton-King says, for foundations and organisations with a specific intention to address social or environmental issues, stewardship and engagement become a powerful tool in the listed equity space.  “Some of the impact, is for instance, using your voice on diversity at a board level. If the board has no women, you start to ask those questions.  And a year later you've got one woman out of five or ten, and so you start to track what's happening with your bench strength, where are your managers, etc. These are embarrassing questions. These are the right questions to ask, that's impact,” says Newton-King.

Ultimately, responsible investing offers a unique opportunity for investors to align their financial goals with their values. By actively engaging and using their voices, investors can drive change and contribute to a more sustainable and inclusive future.

 For more on the guidebook, download a copy here.