Climate Walks, Joe Biden’s stance against his predecessor: sustainability is no longer a fad, but a new global paradigm. Finance is not excluded from this movement, and many of you share your concerns with us on the subject. While Europe has just positioned itself, it seemed appropriate to clarify the very notion of sustainable investment, which is subject to multiple interpretations.
ESG, you may be familiar with these three letters. They refer to a series of business evaluation criteria organized around three dimensions: Environment, Social and Governance. Together, these three axes define "sustainability". ESG criteria are therefore extra-financial, that is to say, they allow an economic player to be assessed outside the usual criteria of profitability, share price, growth prospects, and so on. But what exactly are they measuring?
The environmental parameter assesses the management of the company's environmental risks and impacts, particularly climatic ones. The criteria analyzed will be, for example, CO2 emissions, energy consumption and waste production in relation to turnover, the recycling rate, etc.
The social parameter takes into account the management by the company of its human resources and external stakeholders. Here the criteria can be the level of safety for the workers, the number of hours of staff training, the absence of child labor in the production chain, etc.
Finally, the governance parameter looks at how the business is managed and run. In this context, we will measure the diversity of the management team, executive compensation, respect for the rights of minority shareholders, the quality of financial communication, etc.
Companies themselves provide more and more ESG data through their annual reports. In addition, several external agencies specialize in the analysis of this data: Bloomberg, Morningstar, Refinitiv or even the famous rating agencies Moody’s, Fitch and S&P to name a few. The added value of these agencies is the establishment of a rating system that gives an overall idea of the "ESG performance" of a company. Morningstar has therefore developed an "ESG Risk Rating" system in 5 stages, ranging from "negligible" to "severe". Refinitiv offers an "ESG score" ranging from 0 to 10, S&P another ranging from 0 to 100.
These two acronyms are often confused, wrongly. While "ESG" refers to a series of non-financial evaluation criteria that can be used as filters, Socially Responsible Investment (SRI) is a management strategy that uses ESG criteria to build a universe of "responsible" investment.
To invest in a socially responsible manner, there are two strategies available to the investor or the fund manager. At the level of an investment, these strategies are mutually exclusive; at the level of a fund, they can coexist. Either way, each has its advantages and disadvantages.
The simplest option, and probably the best known to the general public, consists in excluding from its investments companies whose activities or practices are in contradiction with certain ESG criteria: companies active in arms, tobacco, highly polluting, known for their failure to respect human rights, etc.
Another option is to adopt activist behavior within the companies in which you invest. Engage in dialogue with these companies on ESG issues, or even use your right to vote as a shareholder to influence decisions: this make things happen internally to move towards a more socially responsible investment.
What about the ESG "label" attached to certain ETFs? In the majority of cases, it's simple: it means that these funds are practicing the exclusion strategy. Almost every other ETF managed by the majors BlackRock, State Street and Vanguard is activist, at least according to their annual reports. As a small investor, then, one can do activism by proxy ... but to make sure of that, it will be necessary to follow the votes of these managers on the proposals related to sustainability in general assemblies.
Even in the light of ESG criteria, tensions remain among investors. Already because the definition of sustainability depends on each person's value system. Age, socio-economic background and cultural values are all factors that influence the idea of "socially responsible". Moreover, tensions are inherent in the two major SRI strategies defined above or in the choice of one over the other. The list is not exhaustive, but here are some examples of trade-offs you may face in your quest for "sustainable" investing.
Take the example of the chocolate industry, which unfortunately we know uses child labor. It is a practice that many leading companies in the industry deplore and promise to eradicate over time. The investor who evaluates the possibility of buying shares of one of these chocolatiers can do so through a fund present on the board of the company, with the conviction that this voice will promote the transformation of the value chain. But he can also decide to exclude this chocolatier from his portfolio, deeming these practices contrary to his values. The dilemma arises without being able to say a priori which of the two options will have the most positive impact in the long term.
The exclusion strategy has the merit of being simple, but it is therefore not very nuanced. By adopting it, there is a particular risk of excluding a company that has a low score on one dimension, but perhaps also a particularly high score on another. Or, conversely, to keep in portfolio an exemplary company on one axis, but with poor performance on another. So, how to consider nuclear, a good technology for the climate in the short term because of its low CO2 emissions, but whose long-term consequences, in terms of waste management, could impact the health of all living beings?
Another very telling example to illustrate this second tension: that of Tesla, a company with a green positioning par excellence, revered by millions of investors, yet posting in 2020 an ESG score of 22/100 according to S&P. Morningstar also assigns it a "high risk", level 4 out of 5. Several factors explain this poor performance: the high environmental impact of the manufacture of cars, especially batteries which require the extraction of rare metals, bad relations of Tesla with unions and Elon Musk's dominant role in governance.
Closer to home, how to perceive the French energy company Engie? The group presents an average ESG risk according to Morningstar. Its production capacity is split between 67% carbon-based fossil fuels, 28% renewable and 5% nuclear. Its objectives are, however, ambitious in terms of ESG: stable divestment in carbon-based energies and growing investment in renewables, which should reach 58% of the mix in 2030. In this case, the key question will therefore be rather: do we believe in the ability of management to achieve its long-term objectives?
The investor-consumer may also be torn between the desire to pursue a responsible investment strategy and the more prosaic one of satisfying his personal desires in the short term. It is one thing to exclude Ryanair from its portfolio, to stop buying cheap Ryanair tickets is quite another… with an even more immediate effect on the company's ability to grow.
The lack of a regulatory framework and harmonization of calculation methods means that there are almost as many varieties of ESG scores as there are actors involved, each claiming to have the largest database and sharpest methodology. Strictly speaking, there is therefore no "ESG label" but indicators, which are more or less reliable depending on the sources. An MIT study looked at the discrepancies between the scores of six different agencies. Another, from the OECD, highlighted the relative inadequacy of "E" scores for the investor seeking to align their portfolio with a low carbon economy - this due to the multitude of criteria used within this dimension.
As we can see, even aware of the stakes, investors today are not easily able to base their decisions on clear and uniform information. This is why Europe is legislating: not only does it make it compulsory for financial services to publish information related to sustainability, but it also wants to harmonize this information. It is about leveling the playing field to make investors' decisions as objective as possible. While compliance of affected companies is likely to be difficult, the scope of the regulation is likely to be a game-changer for the industry globally. At easyvest, we are preparing for this deadline and will get back to you when the time comes, in complete transparency, to explain our sustainability policy.
Note: This article was written when Easyvest was authorized and regulated by the FSMA as an agent in banking and investment services.