At the start of this new decade all UK financial advisers are going to be expected to ask our clients about their desired approach to ethical investing. But what exactly is an ethical stock and how do we define its ethicalness?
Funds qualifying as ethical, otherwise known as environmental, social and governance (ESG), now account for over $20 trillion or around a quarter of professionally managed assets1. And this figure is set to continue to grow as ESG becomes an increasingly important component in investment selection decisions and even which companies’ capital markets decide to lend to.
This growth has led to the creation of ESG ratings, which are based on a diverse range of non-financial indicators. These indicators are compiled by various companies who employ teams of analysts, using algorithms, which create a single score that can be used to compare one stock to another.
These ESG ratings therefore try to give some element of measurability to a firm’s societal impact, with factors such as a firm’s carbon emissions and the number of female board members having been quantified. But can we be sure that these ratings accurate, or even usable?
Whatever your view is on ESG ratings, without a coherent industry-wide standard to follow the providers of such ratings will find it hard to justify the accuracy of their products. So, talk of an industry standard ethical rating for every fund being brought into place soon will be a welcome development for investors. However, this unfortunately still looks some way off.
But with the likes of Blackrock joining Climate Action 100+, the world’s largest group of investors pressuring companies to act on climate change, and a new ESG reporting mandate from the Chinese state it is clear that the trend is largely moving away from increasing shareholder value being the main measure of a firm’s success.
Just imagine what would happen to the share price of a polluting company if central banks started charging a carbon price for each tonne of carbon dioxide they emit. Or what would happen to the dividends of a large pharmaceutical company if increasing plant-based consumer diets were to cause a reduction in the quantity of drugs people consume.
Theoretically, then, investment managers who actively engage with companies that they are considering investing in will be better placed to manage this new risk landscape. And by trying to influence their decision-making process, perhaps by voting against the management, may well achieve greater returns for your investments.
It is not, therefore, hard to imagine a future where ESG factors will form an increasingly important role in investment performance. And careful consideration of how any investment manager incorporates such factors into their current research and selection process should be a key consideration for any advisor or self-investor in the fund selection process.
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