What is ESG?

-- | 16/11/2020

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Holly Black: Welcome to the Morningstar Investment Board. I'm Holly Black. Today, we are talking ESG. ESG is getting an awful lot of attention in the investing world at the moment, increasingly popular way for people to invest, but really confusing. Why is it confusing? Because it's got so many names and so many different ways that we refer to it and it's all very personal how we think about these things. So, it can be called ethical investing, sustainable investing, SRI, green, impact. It is no wonder that most people end up looking a bit like this chap when they are trying to work out if ESG is for them. Their legs shrink, their head gets massive. It's all quite terrifying.

But ESG is actually really simple. So, all you need to think of it is environmental – how do companies treat the planet; social – how do companies treat people; governance – how a company is being run. A lot of people think ESG investing isn't for me. I just want to make the most money possible. Maybe ESG investing isn't for you. But if you are at all interested in climate change, equal pay for men and women or bribery and corruption at companies or modern slavery, then ESG investing is for you because this is all of those things. And you can still make profits from it. We're now seeing increasing amounts of evidence that investing in this way doesn't mean compromising your returns.

So, how does it work? We need to think about – let's think about some different companies that are listed on the FTSE as an example. So, we've got Ocado, Aviva, Just Eat, British American Tobacco, HSBC, GlaxoSmithKline, trying to remember which I wanted on my list, Rio Tinto, Barratt, that's a house developer, Diageo. Is that about 10? Always works better with even numbers. So, if we have that list of companies, ESG investing just means picking and choosing which ones align with our personal values. So, a few ways you could go about this.

You could screen negatively. Now, that means leaving out things you don't want to invest in. Maybe you really don't – you're worried about climate change, you don't want to invest in any companies that have anything to do with fossil fuels. So, you'd go, well, I'm not going to invest in Rio, I'm not going to invest in BP, which I forgot to write down here, and you'd look for a fund that invests in that way and rule those companies out. Maybe you don't agree with tobacco and alcohol. You can find a fund that rules out any company that makes a significant portion of its revenues from those activities. So, that would probably be things like Ocado. That would be Diageo because that brews drinks and it would definitely be British American Tobacco because the clue is in the name.

But you don't have to just screen things out. More commonly, what funds now do is to look for companies making a positive impact, and that's positive screening. I mean, it's really not difficult stuff. So, you could look for companies that are members of the 30 per cent club. So, that means at least 30 per cent of their board members are women, in which case, you would invest in Aviva, you would invest in HSBC, you would invest in Barratt. You might look for companies that have been shown by research to be working in line with the UN sustainability goals. If you wanted that, you'd probably pick out Glaxo and Diageo. So, that is an example of how personal ESG investing is, because the same person could rule out Diageo because they don't like alcohol and rule it in because it's working towards the UN goals.

So, there are a few ways that we can invest with ESG criteria in mind. You can pick out individual stocks in this way and that is just researching companies that align with your goals that you think are working in a way that you want them to. Morningstar has something called a Globe Rating, which is an indicator of how sustainable we think a fund or a company is in comparison to its peer group. But if you don't want to do research yourself, you can find a fund manager to do the hard work for you. That's getting easier. Around 25 per cent of funds now invest with some kind of ESG goals in mind.

There are a few different ways they go about it. They get more stringent as you go. So, you could have an ESG consideration fund which is – where it's not the main aim of the fund, but they do like to bear these things in mind and probably avoid the worst of the worst companies that are doing very dirty things. You could have an ESG-focused fund, which as the name suggests, is more focused, has some specific goals, wants companies to be making a positive impact, wants to see evidence of good stewardship, so will be voting at those annual general meetings if they don't agree with executive pay.

Impact – this is getting more specific now. This will be a fund manager that's looking for companies that are having a positive impact on the world, perhaps in energy efficiency or carbon reduction, or even just fair pay. And finally, you can get a sector or a thematic fund. And that will really focus on, again, clue in the name, specific sectors. So, that could be a renewable energy or a water fund, really targeting companies that are trying to make an impact in a specific industry. So, ESG, maybe it's not for you, but it's not as confusing as you think.

This report appeared on www.morningstar.com.au 2021 Morningstar Australasia Pty Limited

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