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Investors are being encouraged to think more about sustainability, but can it actually make money?

Investors are being encouraged to think more about sustainability, but can it actually make money? Critics claim it is a sure way to underperform - more about doing good and feeling virtuous. With the European Union planning to legislate on measures for responsible business, and the UK likely to set similar standards, stewardship in investing cannot be ignored.

What was once labelled Socially Responsible Investing, has now been rebranded ESG; Environmental, Social and Governance. More than the name has changed, with the focus no longer on excluding areas considered by some as “bad” investments, but instead on responsible stewardship of assets. The aim is to create sustainable investment returns from companies that will last. This now involves all companies across every sector. It is not just environmental impact, but what companies are doing to align themselves with stakeholders and society. And there is evidence that this can enhance investment returns and reduce portfolio risk.

ESG has been reduced by some to mere box-ticking, but this misses the real opportunity. What appears to help investment returns is not an absolute compliance with some ideal notion of a sustainable company, a fixed set of attributes. Instead the key is whether company boards and management are fully committed to progress towards being a good corporate citizen. Investors seem to recognise a journey of improvement. This can range from monitoring and reducing adverse environmental impact, such as greenhouse gas emissions, to making improvements in board and management diversity.

In some parts of the world environmental factors are prized, but in the UK the emphasis seems to be on governance. This can deliver better alignment of management pay with genuine value creation. And it can help to ensure that corporate environmental and social policies are joined up with measurable change and management incentives. Today, one of the biggest assets of most companies is reputation – something that can be destroyed quickly by social media or press coverage when something goes wrong. Getting companies to focus on high standards of customer service and public accountability can cut risks. It should help shareholders to sleep easier.

Individual investors can still exclude industries such as tobacco from their portfolios. But ethical boundaries are not always clear. Some sectors are more contentious and the materiality of a particular activity can be debatable. Should supermarkets that sell cigarettes be excluded, even if it is just a few percent of profits? Investing by exclusion has a mixed record. The status of not being a shareholder in a company does not give much leverage for driving change. Excluding those shares from portfolios may not achieve much.

More usefully, ESG can be used as a lens to view risk in a business. Any company that is out of line with society’s norms is more likely to fail, like Wonga has shown. There is value in aligning a company’s ESG policies with public expectations. In some companies, the elements of sustainability are deeply entangled. Tesla, for example, might score well for developing electric vehicles, yet has seen regulatory intervention on its governance and will need to reduce the environmental impact of battery components such as cobalt.

The area most likely to pay-off short term is governance. Investing institutions are now starting to use their voice, and more consistently exercising their votes. All investors can include in their analysis the commitment that a company makes to ESG improvement. Company annual reports can be scrutinised for evidence that laudable aims are carried through into specific measurement and incentives. Investors should take another look at sustainability. This is not just a matter of social conscience, but something that can improve performance and cut risks.

Disclaimer: At the time of writing SVM Asset Management does not hold positions in any of the companies mentioned in this article.

A version of this article was published in The Herald on 22/10/18