The E in ESG explained

Most investors by now have some awareness of environmental, social and governance (ESG) investing. It’s easier than ever before to do some good, or at least seek to limit harm, as you invest or trade for your own financial future. In this first article of a short series for those interested in this way of investing, we’ll get under the skin of the ‘E’ in ESG.

Environmental investing takes into account how a company uses natural resources, how it interacts with its local and global environment and whether it is a good environmental steward. Some investments may strive to actively do good while others seek to not do any harm.

Environmental concerns increasingly have real world effects for companies and, by extension, for investors. Companies that do not manage their environmental risks effectively – from carbon emissions to water scarcity to extreme temperatures – or are seen to contribute to climate change, face an existential risk. While those with solutions to environmental destruction have a strong pathway of growth.

The recent COP 27 summit in Egypt brought together the heads of state from every major country around the world to agree targets and strategies to mitigate climate change. Increasingly those targets are backed with real capital as policymakers enact legislation to encourage change.

The war in Ukraine has accelerated this process. The environmental argument for shifting to renewable energy has collided with a national security argument, galvanising policymakers into action. The result has been a flurry of legislation. This includes the RePower EU strategy, which brought forward a package of measures and financial incentives to move Europe away from Russian fossil fuels and promote renewables. and the Inflation Reduction Act in the US, which saw capital directed to green energy projects and development. Similar legislation is being created across the globe, with 80% of the world’s GDP currently under a net zero target.

For companies, this is an opportunity and a risk, depending on which side of the fence they sit. Companies seen as contributing to the environmental crisis risk losing their social license to operate. There is already a gap in the cost of capital for environmentally-friendly companies versus their unfriendly peers. There are now meaningful financial consequences for companies seen to be doing environmental damage.

For companies with solutions to the climate crisis – renewable energy providers, infrastructure groups, electric car makers, components manufacturers – there is a significant pathway to growth. They are well-supported by governments and are likely to see increasing demand for their products as the world decarbonises.

Issues around the environment have drawn the attention of investors for longer and is perhaps the best advanced element of ESG. In Europe, for example, the EU’s environmental taxonomy has given companies a framework for measuring and reporting environmental impact and increasingly, it is possible to see the progress companies are making year on year. Most large companies now have detailed environmental impact reports and are charting their progress towards net zero.

That said, measurement is becoming more sophisticated. Increasingly, companies are under pressure to disclose their impact on areas such as biodiversity, or water consumption. This is a new frontier for environmental measurement and management.

They can take a ‘do no harm’ approach by investing in a generalist environmental, social and governance fund. These funds will have a higher weight towards those companies with a lower environmental footprint. They will often also aim to engage with companies to improve their environmental impact. There may still be polluting companies within the portfolio, but they will either be getting better, or at a lower weight. 

However, there will be those investors who are uncomfortable holding fossil fuel companies in their portfolio at all, even where those fossil fuel companies are helping with the energy transition (BP, for example, owns Chargemaster, the network of electric charging points). A more purist approach is to invest in those companies making an active contribution to the reversal of climate change. These might be areas such as carbon capture technologies, wind, solar, or hydrogen development.

These areas will often have very different investment profiles. Hydrogen technology is relatively early stage but has seen a significant commitment from both the US and EU governments. As such, it represents a higher growth, higher risk option. In contrast, there are a number of renewable infrastructure investment trusts focused on wind and solar, such as JLEN Environmental Assets or Impax Environmental Markets. These are well-established, mature businesses with predictable cash flows. They offer an inflation-adjusted income stream and, potentially, steady capital growth.

There are also a range of ETF options. The iShares Clean Energy ETF has been volatile but remains a cheap option to get access to a range of renewable energy companies, including Vestas Wind Systems and Enphase Energy. L&G Clean Energy ETF is another option. L&G also has ETFs focused on Clean Water, the Hydrogen Economy and the Battery Value Chain.

The market took a close interest in the sector in 2020 and prices rose sharply. Having moved too far, there was a sell-off in the latter half of 2020 and into 2021. However, more recently, investors have started to reappraise these companies in light of the Ukraine crisis and renewed commitments from governments to renewable energy. Since mid-October, there has been a significant recovery. As with any major trend, such as technology, clean energy will almost certainly be subject to periodic bouts of exuberance, followed by moments of pessimism. 

Investors have an important role in the preservation of the planet, whether it is by avoiding those companies that are damaging the climate or focusing on those companies that provide climate solutions. The path is unlikely to be smooth, but citizens, policymakers and institutional investors are aligned, which suggests this will be a growth story for decades to come.

Fineco takes a long-term view to secure positive outcomes for all our stakeholders. Fineco Bank currently features in the FTSE4Good index and the S&P Global 1200 ESG index.