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Investing Beyond ESG

Investors must now apply a double materiality perspective to their sustainable investment process to ensure real economy impacts, according to Louis Bromfield, Lead Sustainable Investment Associate at Foresight Capital Management.

Asset managers have faced a backlash over the last 12 months, with scrutiny emerging from across the political and economic spectrum. Investors, regulators, and politicians have directed their criticism at a sector they view to be in certain cases overly virtuous, ineffective, and inherently subjective. With ESG facing such a retaliation, questions have arisen as to the merits of focusing on sustainable investing. The answer is simple: climate change presents systematic risks to global economic structures and actors across all industries and sectors. The legal, regulatory, and consumer pressures on companies to achieve carbon neutrality by the middle of the century have grown massively. These pressures are becoming tangible financial issues. In this environment the most successful future companies will be those that are positioned to both help decarbonise the global economy and thrive in a post-climate law economy.

The evolution of the ESG market

At its core ESG investing has an easily digestible approach to assessing potential material impacts that emerge from environmental factors, social issues, and corporate governance practices. ESG investing is based on the understanding that by managing risks and opportunities associated with long-term economic, social, and environmental trends, companies will have the best chance to prosper over the long run. However, the inherent broadness of ESG has catalyzed a subjectivity to the sector with opposing terms often used interchangeably. This subjectivity has meant that the threat of greenwashing – the practice of companies and funds exaggerating the environmental benefits of their actions – has risen precipitously. Understanding therefore that ESG is inherently subjective, it has become vital to accurately define how to incorporate ESG into fundamental investment analysis.

Investors must begin to analyse how companies are positioned to take advantage of trends that are emerging as the world prioritises net-zero. For example, how a company’s provision of goods and services that look to decarbonise highly emitting sectors will impact their market share, their pricing power, or indeed create new markets to enter into. Investors must then look to couple this investment analysis with a ‘double materiality’ investment process.

Incorporating double materiality

A double materiality approach focuses on a company’s operational footprint whilst also assessing the environmental and social impacts of the products and services that the company provides. Research by MSCI found that ‘Information Technology’ was the largest sector allocation for most ESG funds, with Alphabet being the most commonly held stock followed by Microsoft, Adobe, and Apple. Whilst these companies have wide-reaching operational climate and social targets, their products will not lead to the decarbonisation of the global economy. The integration of a double materiality perspective means investors can look to invest into companies that have sustainable operations embedded into their long-term strategies but who are also defined by their innovative products and services which seek to address key environmental or social issues. The importance of adopting a double materiality approach to sustainable investment is seen particularly within the infrastructure and real asset space.

Infrastructure is the essential backbone to modern economies and societies. Though vital to both climate mitigation and adaptation, companies that own and operate real assets will naturally be more carbon intensive than many companies that are popular in the largest ESG funds. MSCI’s research found that toy-marker Hasbro and sports apparel company Nike were held in seven out 20 of the largest global ESG funds. By contrast, the largest ESG funds had almost no allocations to the energy sector. The impacts of these allocation decisions are made starker by the fact that over the next three decades the energy sector’s required investment will be £3.5 trillion (US$4.25 trillion) per year. This statistic serves to highlight the contradictions between ‘greening’ portfolios (creating portfolios that have low carbon footprints) and ‘greening’ assets (holding securities in more carbon intensive sectors which are vital for the low-carbon transition). Whereas ESG fund managers may look to tilt their portfolios based on metrics such as carbon intensity, applying a double materiality lens when investing in real asset owning securities allows investors the opportunity to manage and improve the impacts of assets that are vital for the net-zero transition.

What next for sustainable investing?

The motives behind the inexorable rise of sustainable investing are well-meaning and vital. Addressing the climate crisis is the defining issue of our generation, and investors cannot afford to slow the movements of capital towards environmental and social solutions. The focus on double materiality will ensure that portfolios are created that have a deep grounding in climate science, overlay climate-analytical lenses on social issues, and fundamentally impact the real economy through the products and services of underlying holdings.

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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