ESG integration essentially focused on excluding an investment on ethical grounds. The scope of ESG integration has since broadened and in subsequent decades, issues such as climate change and social objectives like equal opportunity and diversity grew in awareness. Over time, greater advocacy from the investment community, governments and non-government organisations has led to a broader acceptance of the impact on a company’s longer term financial performance – positive or negative – attributable to ESG factors.
Modern society is becoming increasingly aware of the environmental and social factors which are presenting real challenges to lives and livelihoods. What many may not realise is the implications of Environmental, Social and Governance (ESG) factors on an investment portfolio. Analysis and integration of ESG factors by professional investors is not a recent phenomenon – these approaches date back to the 1960s and have grown considerably in importance over time.
The initial practices of ESG integration essentially focused on excluding an investment on ethical grounds. In this way, the investor excluded a company from its investment universe based on its business activities and the prospective harm it caused to people or the planet. Examples of such business activities included tobacco production, deforestation, or manufacturing practices that violated human rights.
The scope of ESG integration has since broadened and in subsequent decades, issues such as climate change and social objectives like equal opportunity and diversity grew in awareness. Some investors began to assess positive behaviours of companies, particularly in areas such as waste and recycling, conservation of natural resources, protection of employee rights and corporate governance practices that promoted greater transparency and accountability of management. The wide range of ESG factors now prompt investors to look at ways of assessing the financial materiality of this growing list.
Over time, greater advocacy from the investment community, governments and non-government organisations has led to a broader acceptance of the impact on a company’s longer term financial performance – positive or negative – attributable to ESG factors.
Today, many companies are essentially compelled to act, measure and respond to these non-financial risks through legislation, competitive pressures or societal expectations. But how much of these actions represent a genuine focus on improving sustainability? This is among the key challenges for investors to understand today.
“We believe that a high standard of business conduct and a responsible approach to ESG makes good business sense and has the ability to enhance financial performance over time.” - Sebastian Evans, Managing Director and Chief Investment Officer, NAOS Asset Management
With the collection of issues growing each year, it is vital for investors to gain a clear understanding of the areas that really make a difference to a company’s long-term sustainability.
What resources does a company use and how do they use them? How do they appropriately treat waste and manage risks to the environment? Areas of focus include:
• Greenhouse gas emissions
• Use of renewable energy
• Water usage
• Waste disposal methods
• Recycling programs
• Board and senior management oversight
• Adherence to environmental regulations
How does a company’s actions affect its employees, communities and customers? Areas to consider:
• Diversity of the workforce – gender, age, cultural heritage, disability, income status
• Remuneration practices and appropriate incentives
• Employee satisfaction
• Community engagement
• Health and safety practices
• Observance of human rights
• Customer satisfaction and business integrity
• Prudent management of supply chains
How is the company run and do its leaders and employees act fairly, honestly and ethically to benefit all stakeholders? We recommend gaining insights into:
• The company’s Code of Conduct
• Independence and diversity of the Board
• Remuneration and nomination principles
• Audit programs
• Management of capital and operational risks
Sadly, there are plenty of examples of financial consequences from failures to observe ESG risks. Losses to companies have come in the form of hefty regulatory penalties, reputational damage, loss of assets or negligent behaviours, which can reach into the billions. There is also a growing body of evidence both in Australia and overseas, which supports the argument that integrating ESG factors into investment decision-making processes, delivers performance that is equal–if not better than–returns from the broader investment market. One such study on US stocks from the PRI found that a portfolio of stocks with high ESG incident rates underperforms the broader market by 3.5% per year. [1]Similar findings of ESG outperformance in the Australian and UK share markets have been noted in a prior NAOS article: “A key to long-term success”.
Understanding and quantifying the risks and opportunities from ESG factors represents an intricate, yet vitally important component of investment decision-making. As investors, we at NAOS seek to ensure the companies we invest in conduct their business in a responsible manner. Our investment process systematically screens each company on a wide range of factors, which is supplemented with regular engagement to ensure that any company we invest in is aligned with our responsible investment goals. We apply a negative screen to exclude companies which largely generate income from industries such as tobacco, gambling, uranium, controversial weapons, fossil fuels and animal exploitation. We then incorporate ESG considerations through the use of our internally developed ESG Questionnaire. This provides us with a framework for capturing consistent data in a transparent manner. Through this approach we seek to answer questions like “Is the company having a positive impact on its employees, its clients and the community?” and “What investments are being made to drive business sustainability?”
Our investment team assesses each company within our investment universe to understand the actions being taken that will promote better social, environmental or stewardship outcomes. We believe such actions will ultimately drive better returns for shareholders and benefit all stakeholders.
Investing through an ESG lens needs to be seen as a constant evolution. It’s not a set-and-forget strategy; it requires forward thinking on how to tackle emerging ESG risks and capture opportunities as they evolve. Some companies are inherently complex and have far-reaching ESG risks and opportunities compared to others, hence the need for company-specific analysis.
At NAOS we firmly believe that a high standard of business conduct and a responsible approach to managing ESG risks are associated with developing a sustainable business model over the longer term that benefits not only shareholders, but also the broader economy. NAOS is a signatory to the United Nations-supported Principles for Responsible Investment (PRI) which have guided our integration of ESG factors within the broader investment process. NAOS is committed to progressively evolving our analysis of non-financial factors which can have a meaningful impact on investment returns and a positive impact on society.
[1] Source: Principles for Responsible Investment, “ESG Incidents and Shareholder Value”, Simon Glossner, University of Virginia Darden School of Business, June 2021
Important Information
This material has been prepared by NAOS Asset Management Limited (ABN 23 107 624 126, AFSL 273529) (NAOS) and is provided for general information purposes only and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or needs of any particular investor. This material may include data, research and other information from third party sources. NAOS makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material. Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of NAOS. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon.
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