What’s your investment portfolio’s ESG score?

Portfolio managers around the world are asking themselves the same question.

ESG – environmental, social, governance. The fathers of capitalism definitely did not include these three words in the first business textbook. It seems counter-intuitive that returns can be maximized if you run a business that is not only profitable, but also minimally impacts the environment, respects all people related to the business and has strong oversight for the benefit of shareholders rather than the executives running the company. But, in today’s reality, maybe that’s just good business.

Just like the Standard & Poor’s or Moody’s debt-rating agencies, Sustainalytics by Morningstar issues an ESG score for every publicly traded company. A score of 0 would mean no negative impacts on the environment or people and a strong diversified board of directors that ties executive compensation to ESG metrics. A score of 30 or higher would mean the company is having adverse impacts. Where previously we might like a company that has an AA rating from Moody’s due to its strong ability repay debt, what if it also has an ESG score of 30? It sounds like there might be other risks lurking.

ESG is growing in importance

A recent survey by RBC Global Asset management found that 89% of investors in Canada are adopting ESG considerations – not to mention 65% in the US, 94% in Europe and 72% in Asia. And while the same study found that only 25% of wealthy/professional investors felt that strong ESG companies would outperform others, the data may say otherwise. Morningstar polled 745 Europe-based funds with a stated mandate for ESG investing. More than half had outperformed funds with no ESG mandate.

Blackrock investments, the market leader in Canada for passive investing in index funds and ETFs, has recently launched a new suite of ESG offerings and has doubled-down by setting a goal to eventually make all of its investment offerings “ESG friendly”.

Strong ESG scores may indicate lower risk

Who are these ESG darlings? And what companies seem to be making a buck with some collateral cost? It’s obvious that heavy polluters such as oil companies or weapons manufacturers will have high ESG scores due to the social costs they create. But Walmart, for example, has a medium-high rating of 27.5. One of the world’s most valuable companies, Walmart suffers on the ESG scale because of human-rights issues in its supply chain, and many labour-relations incidents globally.

Among the ESG heroes, we assume we’ll find bio-fuel and electric car manufacturers. But companies such as Apple and RBC Royal Bank score well, both with a score of 16. And though you might assume e-car maker Tesla would be an ESG darling, concerns over its supply-chain practices, run-ins with securities regulators and corporate governance concerns pump its score up to 30! That’s on par with Oil producer Suncor, albeit for different reasons. This is the challenge with the nascent world of ESG investing: What is most important to you?

The fact is, no company has a score of zero. Companies such as Tesla may eventually cut our carbon emissions by enough to stop climate change. But what if they get there with questionable supply chain practices and little regard to shareholder protection?

As wealth managers, we believe that ESG can no longer be ignored. Companies with good practices in all of these areas may not deliver outsized returns, but they will definitely deliver less business risk. Companies with less risk are eventually afforded higher valuations.

While Adam’s Smith’s “invisible hand” of capitalism may have originally guided us to the most profit at the least effort, perhaps it might finally get us to the most profit with the least ESG impact.

How ESG is scored

• The environmental score is based on a number of criteria, and includes a company’s policies, plans and disclosures on climate change, and its policies regarding greenhouse gas emissions, water use and pollution, recycling, use of renewable energy and use of green technologies.
• The social score reflects the people part of the business – elements such as employee compensation, diversity and inclusion policies, whether the company uses an ethical supply chain, and its customer service practices.
• The governance score reflects how a company is run. It examines the diversity of the Board of Directors, the openness of shareholder meetings, the separation of Chair and CEO, the company’s history with securities regulators and much more.