Environmental, Social, and Governance (ESG) Investing (also known as Responsible Investing or Sustainable Investing) integrates non-financial factors—environmental impacts (E), social concerns (S), governance issues (G)—alongside financial analysis in evaluating a company’s investment risks and opportunities.
Failure to fully consider factors such as climate change, human rights and business ethics when making investment decisions is imprudent. Portfolios with strong ESG scores often outperform lesser-ranked portfolios, confirming that it is possible to do good while doing well.
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The term ESG Investing refers to an investment approach that integrates non-financial factors – environmental impacts (E), social concerns (S) and governance issues (G) – with financial analysis when evaluating a company, for the purpose of identifying material risks and opportunities. The terms Responsible Investing and Sustainable Investing are often used interchangeably with ESG Investing.
There are several other investment approaches that consider ESG factors, but are not ESG Investing as described above, including:
Before investing in a company, an investor, ourselves included, will typically evaluate the company’s financial statements, calculating any number of financial metrics while looking to identify material risks and opportunities. While many risks (i.e. excessive leverage) and opportunities (i.e. the introduction of a new business or product line) can be found in the financial statements, not all are found there. As example, a company’s carbon emissions or its employee safety record may not be found in its financial reports and, when they are disclosed, they are often not in a manner that allows for comparison to other companies.
Efforts are being made to address this lack of standardized reporting. The Sustainability Accounting Standards Board (SASB), an independent, standard-setting organization, published industry-specific standards to help companies identify material sustainability issues and set out how to report on these issues in a meaningful, standardized manner. As example, firms which have greenhouse gas (GHG) emissions as a material risk are encouraged to report their emissions as “metric tons of carbon dioxide equivalent (CO2-e)”. It’s still early days, but we hope to see more and more companies begin reporting using the SASB standards. When this happens, comparison across firms will become more meaningful and will inform better investment decisions.
Identifying risks has always been an integral part of the role of an investor. As example, an investor may calculate a company’s leverage (measured as Net Debt/EBITDA) and, all else being equal, will likely demand a risk premium for a company with higher leverage. When the risks facing a company are non-financial, such as repeated safety violations or water usage in a water scarce region, an investor cannot ignore them. These risks could ultimately manifest themselves as material financial consequences for the firm.
Here are two examples where known non-financial factors, not captured by financial analysis, led to meaningful losses for investors:
While these events were not inevitable, a consideration of the non-financial risks related to each could have led an investor to a different investment decision than would have been arrived at through financial analysis alone.
While we won’t delve into these items further here, the list of reasons why ESG is important includes:
There are differing approaches to implementing ESG Investing. A common approach is negative screening, where an investor eliminates all companies involved in industries that it has identified as inappropriate. Industries commonly excluded include controversial weapons (cluster munitions), tobacco, gambling, pornography and nuclear energy.
Another approach is engagement, where an investor does not screen out companies based solely on their industry. With this approach, the investor believes that change can be better effected through engagement with the company.
We support a hybrid of these two. There are several industries, which by their very nature present abnormal risks or benefit certain stakeholders at the expense of others, which we will not invest in, such as tobacco, gambling and thermal coal. We are strong believers in engaging with the companies in which we invest. Our engagement is not limited to financial matters; ESG is often a topic we discuss with these companies. Through our engagement, we have had success in contributing to change related to employee safety, board-level governance, particularly in the area of executive compensation, and reporting of ESG metrics, including carbon emissions.
One can see the growth in ESG awareness and support by looking at the United Nations’ Principles for Responsible Investment (PRI). The PRI has as its foundation six Principles for Responsible Investment, the first of which is “We will incorporate ESG issues into investment analysis and decision-making processes”. Since its launch in 2006, over 2,500 investment managers, asset owners and service providers have signed on as a signatory to the PRI. We support the PRI’s mission and are a signatory to the PRI.
With a focus on climate change, the Financial Stability Board (FSB) Task Force on Climate-related Financial Disclosures (TCFD) was established in 2015 to develop climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers and other stakeholders.
And as we mentioned earlier, SASB published guidelines for the reporting of standardized, meaningful environmental and social-related information.
ESG has gone mainstream as topics such as climate change and the social impacts of a company’s operations have become top-of-mind for an ever-increasing number of asset owners and managers. Supporting this growth in ESG awareness and adoption is a belief by investors that it is possible to do good while doing well. Research has shown that an investment in a portfolio of stocks with strong ESG scores has often outperformed both the market and a portfolio of stocks with poor ESG scores. Perhaps not surprisingly, investments in stocks with high ESG scores may also be less risky.
An investor evaluates and measures many aspects of a business before taking a decision to invest, including items such as a company’s strategy, operations, industry, customers and suppliers, in addition to financial analysis. ESG refers to additional items to be evaluated and measured.
We are fully committed to ESG Investing – the integration of ESG factors with financial analysis and the many other aspects of the business that we consider when evaluating companies. This is not something new for us; we’ve been doing this for years. For us, ESG Investing includes ongoing engagement with companies concerning financial matters, as well as ESG risks and opportunities. When dialogue fails, we often reflect our concerns through our proxy voting.
While ESG Investing, by definition, concerns the integration of ESG factors in evaluating companies, investing in companies with good ESG performance can have long-term positive impacts on the environment and society. We are delighted and encouraged that our approach to ESG Investing, including engagement with companies, may be contributing to these positive outcomes.
This document has been prepared by Letko, Brosseau & Associates Inc. for informational purposes only and is not intended to provide, and should not be relied upon for, accounting, legal or tax advice or investment recommendations.
Where the information contained in this document has been obtained or derived from third-party sources, the information is from sources believed to be reliable, but the firm has not independently verified such information. No representation or warranty is provided in relation to the accuracy, correctness, completeness or reliability of such information. Any opinions or estimates contained herein constitute our judgment as of this date and are subject to change without notice. Past performance is not a guarantee of future returns.
This document may contain certain forward-looking statements which reflect our current expectations or forecasts of future events concerning the economy, market changes and trends. Forward-looking statements are inherently subject to, among other things, risks, uncertainties and assumptions regarding currencies, economic growth, current and expected conditions, and other factors that are believed to be appropriate in the circumstances which could cause actual events, results, performance or prospects to differ materially from those expressed in, or implied by, these forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements.