Future-proofing your investment portfolio with ESG

06 Oct Future-proofing your investment portfolio with ESG

Environmental, Social and Governance (ESG) investing has become a hotly debated term. There are ongoing discussions about how front-and-centre ESG should be in its position in different investment strategies but the general consensus suggests that ESG is a priority for most investors.

To appreciate how ESG impacts investment plans, it’s critical to understand what ESG means. All investors lie on a scale of responsible investment. Some invest to make positive changes to the world without any expectation of financial return. Then some are solely focused on financial returns and less attached to the implications of the impact of their investments. Most investors stand somewhere between both and this is where ESG metrics become vital. Whether investors are committed to climate change, most recognise the trends influencing the regulatory decision, policy and public attitudes. Sustainability has become a popular term in recent years. Sustainable businesses are capable of withstanding disruption because they can adapt to change. ESG metrics are a way to support investors measure the risk and opportunities in this field.

To adapt ESG metrics toward investment goals, it is critical to understand how they work. Each industry has its own individual ESG risk, and some might be more challenging than others to overcome. Many people assume that ESG investment excludes industries like ones dependent on fossil fuels, but this isn’t necessarily true. Investors with a sustainability focus can apply ESG metrics to explore businesses that are leaders within their industry. This is important for sectors experiencing a transition – such as oil and gas. With the continued drive for renewable and clean energy, investors can use ESG metrics to discover oil and gas companies with the best opportunity to benefit from the move toward sustainable energy.

Governments are committed to incentivising new technologies supporting the transition from fossil fuels. This creates opportunities for companies to make that move. Those likely to benefit from this are the companies dedicated to improving their ESG profile with net-zero goals and ongoing investment into renewable energy. By using ESG, investors can create a diversified portfolio without ignoring the continued transition toward sustainability.

One way to apply ESG metrics is for risk management. All investments have some level of risk, and there are many to consider. ESG risks can result in significant barriers to long-term investment plans. For example, ESG metrics in the automotive industry have enabled investors to make better decisions.

The industry has experienced significant change over the past few years as it radically transitions from conventional to electric. Johnson Matthey, a leading manufacturer of catalytic converters that eliminate harmful emissions from petrol, faced rising risk as the concern about the environmental impact of these vehicles increased. In 2021, the UK announced a ban on selling new petrol vehicles by 2030, which resulted in a decline in the share value of Johnson Matthey. Their core business became unsustainable, and many companies that didn’t pivot toward sustainable alternatives have struggled.

ESG investment is more than eliminating risky stocks – it’s also a great way to identify opportunities in a sector likely to change. The electric vehicle manufacturer Tesla spent years with analysts determining whether the group would become profitable. To begin with, the government was issuing regulatory credits for businesses making electric vehicles. As this was the sole focus of Tesla, the group acquired the credits for free and sold them at a profit to other automotive companies. The regulatory credits represented the majority share of their initial operating profit in 2020. Without regulatory or government support, these businesses often struggle to get off the ground. Ultimately, Tesla’s strategy paid off, albeit with several other risks attached. Notably, Tesla was recently left off the S&P 500’s ESG index, which was unfortunate due to its focus on clean vehicle technology. However, the concerns surrounding working conditions and rising figures relating to accidents resulted in a decline in its overall rating as other businesses continued to improve their environmental credentials. These factors show why it’s critical to monitor the social and governance side of ESG ratings.

ESG metrics vary in importance depending on where an investor is on the responsible investment scale. But the next consideration is embracing ESG beyond its drive for climate action and recognising its overall impact on investment plans. ESG represents a process of discovering what businesses are willing to adapt to our changing world.

ESG investing is one way to determine whether a business is actively making positive changes, and this often translates into more sustainable operations further down the line. This is why all investors should pay close attention to ESG issues as part of their broader strategy.