ESG is here to stay, here’s what investors need to know.

It’s not an exaggeration to say that virtually every investment manager in the world is beefing up their investment process to take environmental, social and governance (ESG) considerations into account.

Managers have always considered ESG factors, but they are now expected to clearly communicate how they do it, what weight they place on them and, in some cases, why they own companies that are poorly ranked in such terms.

I developed an appreciation for the complexity of the topic as our firm worked toward formalizing and communicating our approach. Clients know exactly what ESG means to them (most often it’s the “E”), but, for us, it’s full of surprises and contradictions. It also fuels some heated debates.

Here’s a sampling of what I’m talking about.

The slippery slope

One type of sustainable investing is called socially responsible investing (SRI). Investment mandates vary across practitioners, but SRI funds generally either exclude certain types of companies (including tobacco, weapons and coal) or invest only in the most ethical companies in each industry, which means the cleanest dirty shirt in some cases.

SRI sounds simple enough and is a good solution for many investors, but the road to exclusions is a slippery one. You’re faced with a constant question of where you draw the line. Do you exclude energy companies that operate in the oilsands? If so, how much of their production must be from there to be excluded? And what about the service companies that work with the producers, and the banks and insurance companies that finance them?

How far you go down the value chain depends on how wide a lens you want to use. In the case of oil, 85 per cent of greenhouse-gas emissions come from the burning of it, so should airlines, shipping companies, mall operators and plastics manufacturers also be excluded?

Other industries have equally difficult issues. For example, how do you balance the damage done by weapons makers and defence contractors against the democratic freedoms they help protect?

Voting with your feet or shares

Institutional investors, such as foundations and endowments, that exclude fossil fuels from their portfolios send a strong message to energy companies and policy-makers. The question is: could they have more impact if they remained as shareholders, advocated for change with management and voted their shares each year? Once the shares are sold, these large players lose their ability to influence.

This dilemma was in plain view at Exxonmobil Corp.’s annual general meeting in May. Shareholders rejected management’s board slate and elected three independent directors who were nominated by Engine No. 1, an activist firm. Investors supporting the Engine No. 1 initiatives, including indexing giants Vanguard Group Inc. and Blackrock Inc., weren’t satisfied with Exxon’s climate plan and financial performance.

A theme or a factor

It’s not yet clear whether a singular focus on ESG will lead to higher returns. Is it like other market factors that investors count on, such as quality, value and momentum, or is it simply a strong, but transient market theme?

Riding the ESG train has been a winning strategy in recent years, but Research Associates Inc., a highly regarded firm in the United States, said in a July 2020 report that there isn’t sufficient historical data yet to declare it a persistent market factor that will generate market-beating returns.

In the absence of proof, it could be argued that totally focusing on ESG will lead to lower returns. There are far fewer companies to choose from, and investment theory would suggest that if higher ESG scores translate into lower risk, as one would hope, investors will be willing to accept a lower return.

I’ve only touched on a few ESG questions. There are many others, including: Do you rate companies relative to their industry peers (i.e., Suncor Energy Inc. vs. Tourmaline Oil Corp.) or against all companies (Suncor vs. Facebook Inc.)? Should you focus on companies that rate highly now, or ones that are improving? And, how do you reconcile the different scores for some companies by different ESG ratings firms?

Investing is all about trade-offs and ESG is no different. It might be here to stay, but there’s still more questions than answers, and a whole lot more to talk about.