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Is ESG Really ESG?

Published 01-08-2023, 03:19 am
Updated 09-07-2023, 04:02 pm

The frequent appearance of ESG in everyday conversations is a welcome development. However, it is crucial to clarify what ESG is (and what it is not) and to use this commonly used term in its proper context. ESG, an abbreviation for Environmental, Social, and Governance factors, is on the rise. Although the concept has been around for some time, mentions of "ESG investments, ESG funds, ESG strategies" seem to have increased in the media and data providers in recent months.

The term "ESG investment" is often used in the context of sustainability or impact investment for the planet. Comments like "Investing in renewable energy is a fundamental part of our ESG strategy" are frequently heard. In short, it is believed that investing in ESG requires seeking positive impact or good actions – for the planet or those in need. However, this is not the case. ESG is not about doing good, nor is it an investment strategy itself. ESG is merely a framework that can, and we believe should, be applied to all investment due diligence processes.

Due diligence in ESG aims to identify and mitigate the economic, social, and governance risks that can weaken or harm investments. For example, in the event of an accident, a company with inadequate environmental controls may cause damage to its revenue, profitability, reputation, and valuation. Investors who do not follow a process that allows them to identify the company's environmental deficiencies before deciding to invest their money may suffer.

One does not need to be a benefactor to see how ESG weakness can affect investment returns. When thinking about ESG, most people focus more on the environmental aspect, probably because the dangers are more obvious and potentially catastrophic. An example of this is an oil spill. However, social and governance risks are equally important. Social risks arise when communities are compromised in ways unrelated to the environment. For instance, the case of construction companies like Odebrecht and their unfinished works and overbilling highlighted by Operation Car Wash.

When it comes to governance, the financial media is full of stories of managerial misconduct, from fraudulent accounting to poor board oversight. JBS (BVMF:JBSS3), for example, faced a similar problem in 2017 largely due to poor governance practices.

However, we should always consider these risks when assessing opportunities. Nevertheless, they cannot be grouped into distinct categories of ESG or have a formal ESG investment policy or process in place. I believe that having a strong ESG framework in place to contain these risks cohesively is valuable. A robust ESG focus incorporated at every step of the investment process, from underwriting to execution and monitoring, is rapidly becoming the basic requirement for any serious investment organization.

However, considering only ESG factors will not be sufficient in a sophisticated world where asset owners and stakeholders are deeply aware of the risks they want to avoid. But how does this translate into action? An ESG policy is not reliable if it remains only on paper. For it to have an impact, the entire investment team needs to be trained, and this training must be periodically updated.

Thus, solid ESG processes are defined at the top of organizations, and as such, a senior member of the investment team should be the leader of the ESG process. The trained investment team should then proactively discuss ESG risks during the investment process and not address them as an afterthought. The ultimate test is whether an otherwise attractive investment is rejected because ESG risk cannot be mitigated.

It is also important to recognize that ESG is not a rigid and blunt instrument. There are issues with varying levels of ESG intensity. An investment in chemical manufacturing will require greater consideration of environmental risks than an investment in the software sector. The sales practices of a business focused on the public sector may require a different level than that of a direct-to-consumer business, for example.

With this understanding, there is no such thing as an ESG investment, but there is something like employing an ESG framework to assess the merits and risks of an investment. I believe that over time, as more and more individuals, companies, managers, and analysts put this framework into practice, it will simply be known as "investment," nothing more than that.

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