rethink sustainability
Going beyond ESG – sustainable investing explained
Not long ago, ESG (Environmental, Social and Governance) investing took up just a small percentage of the trillions that make up funds around the world. But that trend has shifted enormously and now hundreds of billions are being poured into a variety of ESG funds and sustainably invested funds. In the first 11 months of last year alone, one source estimates USD 649bn was invested, eclipsing the USD 542bn invested for the entirety of 20201. But is an ESG-based strategy enough?
At Lombard Odier, we are convinced that most traditional ESG approaches don't go far enough as they have tended to focus on historical and static data. In order to select companies that are truly transitioning to a sustainable economic model, asset managers must take into account forward-looking metrics that can assess the pace of a company's transition.
Discover more on why investors need to look beyond ESG and more on our unique investment approach:
What is the difference between traditional ESG investing and Lombard Odier's approach?
At the heart of ESG is the understanding that companies have a significant impact on the environment. This can be through their business practices, the products and services they produce and/or their supply chains.
When companies have an adverse impact, this may not fit with investors' values. And that exposure can materially affect the companies' financial performance. A company failing to mitigate its adverse impact may fall foul of regulation, changes in consumer preference, technological shifts, and the increased cost of capital. But companies that do recognise their exposure to sustainability concerns and are able to manage those concerns well may be better-positioned for new opportunities.
The challenge arises in how we should assess companies' management of these issues. Today, all too often investors focus only on the scale of a company's impact today, rather than on what it is doing to address this. If we only look at the current emissions, water, energy or land use of a company or sector, many sectors – including most industrial, material and food industries – might seem unsustainable. Here, we must recognise that while these sectors have a significant environmental footprint as of today, they are likely to remain essential in the future. What matters, therefore, is identifying which companies in these industries are transitioning to more sustainable, lower-footprint business models, and are doing so quickly enough.
Isn't sustainable investing a narrower field? Does that mean investors will miss out on returns?
For us, sustainability is an investment conviction. We believe our current economic model, and many of the companies within it, are fundamentally unsustainable, and will no longer be fit for purpose for the future. Our economy is wasteful, idle, lopsided and dirty, and it has a tremendous adverse impact on our environment. The costs of all of these problems are borne by society and also impact on company performance. But change is on-going and the transition to a Circular, Lean, Inclusive and Clean aka CLIC™ economy is in motion. Therefore, companies with more sustainable business models will be the winners of the future. Understanding sustainability is part of our fiduciary duty to our clients and is material to the risk and return of their portfolios. Sustainable investors will be better prepared for the transition to a net-zero and nature-positive economy.
But this approach does not impact returns negatively - the exact opposite in fact. Companies failing to transition will be adversely exposed to changes in regulation, markets and consumer behaviour, with the leaders of the transition taking their place. We measure and report on our results on a yearly basis, with a clear objective to improve our impact year after year.
Not everyone is on the same page when it comes to sustainable investing. Is change around the corner?
ESG investing has been around for decades. In 1971, just 1% of shareholders from General Motors backed a resolution to withdraw from South Africa due to racist policies. Now, the amount of money going into sustainable funds is growing by hundreds of billions every year following a decade of strong growth. So times are changing. Investing from a more holistic point of view, as we do at Lombard Odier, is yet to go mainstream.
Investing depends on the investor's objectives. One investor may choose to exclude certain types of investments based on their values. Another may integrate sustainability factors as a means of derisking their portfolios. A third may pursue specific investments aimed at delivering positive societal impact. Or they may see sustainability as a potential driver of outperformance in high-conviction strategies. These different objectives require different types of frameworks and analysis, which we work to try and help our clients to put in place.
Regulators, too, are seeking to enter the mix. European legislation, for instance, is aiming to specify a taxonomy to define what activities count as “green,” albeit this exercise is not a straightforward one. The financial sector is also developing methods to compare the positioning of each company against its peers, which will allow savers to invest in companies best positioned in relation to their competitors.
Read also: Showing leadership in sustainable finance through climate transparency
How can we be sure that this is not just a fad?
This is far from a passing trend. Proof of this is clear in the moves taken by governments around climate transition. Over 90% of the world's economies are now subject to government targets to pursue net-zero emissions over the coming decades. This is a transition with the scale of the industrial revolution but unfolding at the pace of the digital one. To achieve net zero, every sector of our economy will have to decarbonise at a rapid pace. At the same time, green technologies are becoming cheaper, so that even in the absence of government regulation, understanding exposure to legacy assets and the shifts taking place within markets will be vital for investors to understand. The Sustainability Revolution is not a fad, nor something that will disappear in a few years. It is the new order of things and it is imperative that all sections of society engage fully with it.
How does Lombard Odier select companies for their portfolios?
We aim to assess companies based on how they operate, what they do and where they operate. We have developed a number of proprietary capabilities to help us in this assessment. While traditional ESG data, focused on the types of business practices companies have put in place, is part of this, we do a lot more. We have developed systems which are better suited to looking at the future capabilities of a business. These seek to understand not only where a company is today, but where it will be in the future, and how its trajectory may impact its financial performance.
A good example is in the analysis of alignment to the climate transition. Traditional ESG approaches may look at the carbon footprint of a company, but this merely tells one whether a company is high-emitting or low-emitting, not how it is managing those emissions, or how it is aligned to the goals that need to be achieved in its sector. More forward-looking metrics are needed to assess this. Implied Temperature Rise (ITR), for instance, considers the rate of decarbonisation that a given sector can and needs to achieve, and compares this to the projected emissions of a company, to assess the company's alignment to the Paris Agreement and a net zero economy. It is these assessments that can help us distinguish decarbonisation leaders from the laggards, and help us allocate capital more effectively.
Read also: How to select companies for net zero portfolios?
How do you exclude companies?
There are a number of areas we will not invest in, such as companies with significant exposure to coal power or thermal coal mining. We also avoid tobacco and food derivatives, due to our concerns over the stability of food prices. Clients may have their own concerns that we work with them to address. In many other sectors – such as steel, cement and chemicals – we do not believe excluding these types of companies from our portfolios is the right answer. These companies might have high environmental footprints today but they will remain economically essential and it is in these sectors where financing is most urgently needed to accelerate transitions. It is also in these sectors where companies leading the way, for instance in terms of credible decarbonisation, can develop the most significant commercial advantages.
So finally, what's the advantage to investors in going beyond ESG?
Many traditional ESG scores are backwards-looking, assessing only a company's present or past exposure, giving limited insight as to a company's direction of travel. Such backwards-looking analysis does little to prepare us for the future, particularly when that future is uncertain and likely to be very different from the economy we face today. As the world changes and transitions to an economy that is greener and cleaner, so too must we reconsider where we allocate our capital – and the approaches needed to help us in those decisions.
1 https://www.reuters.com/markets/us/how-2021-became-year-esg-investing-2021-12-23/
Important information
This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.
Read more.
share.