Why do we need to demystify ESG?

“Give a man a fish and he will feed himself for a day” the advert began.

“But give him the means to catch fish and he will feed himself and his family for a lifetime”.

This was insane.

I was twelve years old and this made sense. This wasn’t just “feed the hungry and then forget”. This was a real solution.

Even to this day, it’s shocking how effective this advert was.

They weren’t just helping the poor. They were going to invest in eradicating poverty all together. What Oxfam had done was introduce the concept of sustainable investing to the world.

It was such a simple message. One that even a twelve-year-old could understand. And, twenty five years later, the number of people living in extreme poverty has halved.

So why on earth do I still need to demystify sustainable investing?

I’m not complaining. I’m an investment writer. This is good money for me. It usually involves explaining what the experts think about ESG, which for those not in the know is a nonsensical acronym that is widely used in asset management industry.

This is what it is…

And these are environment, social and governance.

The acronym was defined in August 2005 at a conference held in Zurich – the city where I live.

At the time 20 financial institutions with a combined USD 6 trillion in assets under management got together. You can probably guess where this is going.

None of these financial heavyweights had any skills in marketing. One of them was probably a former member of the British SAS, or at least he thought he was.

And, the rest were finance guys, so they came up with a TLA – a three letter acronym. As a result, ESG was born and they wrote a white paper about it call “Who Cares Wins”.

Ever since then, there has been tongue-twisted confusion on sustainable investing, which has been a good source of revenue for me.

Jokes aside and despite the terrible name, ESG is really is quite important.

There’s a shift underway as old theories of portfolio management have been debunked. Traditional measures of risk, dart throwing monkeys and six sigma events that frequently defy the probabilities of normal distribution have re-framed the way investors think.

Investing is no longer a matter of strategic asset allocation, but more about dynamically allocating yourself to risks that might reward you and removing those risks that never will.

ESG has now entered the mix with three new sexy risk factors that portfolio managers need to manage.

It’s a big deal. Believe me!

A 16-year old Swedish girl has already floated across the Atlantic Ocean to give our world leaders a dressing down on the environment. This is serious stuff.

The point is that we are entering a world where ESG risk factors could grow significantly in magnitude and have a big impact on corporate profitability.

This will therefore affect investment returns. In fact, some are even saying that ESG will become one of the most powerful sources of long-term returns in the 21st Century.

In the US alone, more than USD 12 trillion has already flooded into sustainable investments.

This is not a fad. Sustainable investing is nothing new. It’s just growing in importance.

Long before the incomprehensible ESG acronym was born, Jim Collins published two brilliant books: ‘Built to last’ (1994) and ‘Good to great’ (2001).

Both books touched strongly on sustainable investing through a rigorous study of empirical evidence.

There have also been some incredibly good research papers published by the academic community too.

For instance, George Serafeim and his colleagues at Harvard Business School looked at companies that measured, managed and communicated their performance on ESG back in the 1990s. What they found was that over the course of 18 years, these companies outperformed a well-matched peer group of comparable companies.

A paper from Nordea – one of the largest financial groups in Northern Europe – found that from between 2012 to 2015, companies with the highest ESG ratings outperformed the lower-rated firms by as much as 40%.

Then there is Bank of America Merrill Lynch. They found that companies with better ESG track records than their peers produced higher three-year returns. They were also more likely to be considered high-quality stocks and were less likely to suffer from price declines or enter bankruptcy.

So, despite the terrible marketing, ESG really does matter. The question is how should we manage it?

This is where it gets tricky.

Every asset manager claims to have a unique or better approach. I’m not going to go into each one because I could write a book on it. Over the past year I’ve written about nine unique approaches from individual asset managers. I’m not kidding!

A popular method, however, is to use an index or sustainability score to assess a company on how sustainable its business model is. The problem with this approach is that you prevent portfolio managers and analysts following their own convictions when assessing ESG risks.

For instance, an oil and gas company could offer a convertible bond to finance a solar power plant or a wind farm to supply energy for its operations. Such projects are not that uncommon, especially when they operate off grid or when wholesale energy prices are too high.

You could argue that we shouldn’t penalise this green bond just because its being issued by a filtered-out stock. Instead, we should perhaps encourage its decision to diversify into renewable energy.

These things aren’t simple and the problem that investors face is that there is a lack of clarity on such issues.

Perhaps an industry wide codified system could work. The problem again is that this removes the freedom portfolio managers have for eliminating ESG risks.

There also are many portfolio managers that have been managing ESG risks and investing sustainably, long before the acronym was born. A lot of these managers don’t even market themselves as ESG or sustainable investors. You only realise their credentials when you study their prospectuses.

We don’t really need to demystify anything.

We just need to deliver the solution. Like Oxfam did.