Does Ethical Investment Pay?

There’s a widespread assumption that, in the world of investing, all that matters is where your next fast buck is coming from.

Take the popular view of stock market and currency trading, hedge funds, venture capital and all the rests, and what is described sounds little different to a horse race – punters piling the big money on what they assume will be a sure thing, before moving swiftly on to the runners and riders in the next race.

This isn’t exactly true. Or at least, it’s only half true at best. Yes, investment is all about making money, growing assets – call it what you will. There would be little point otherwise.

But short term gain is definitely not the be all and end all. In fact, for most investors and investment managers, it’s the opposite of what they aim for. It introduces too much risk. With investment, you have to ride with the inevitable ups and downs. Only by looking long term can you hope to smooth out the bumps and come out with a positive.

All of this feeds into debate around ethical investments. For some people, considering the ethical, environmental or sustainable credentials of a business or entity as part of the due diligence process ahead of making an investment decision goes against tried and tested principles. You are introducing non-financial variables into a financial equation. All that matters is how likely you are to get a positive return, what the risks are etc.

But on the other side or the argument, a growing number of people would argue that ethics and sustainability are financial considerations. Moreover, choosing who to invest in based on what we might call ‘cultural’ aspects like the environment and ethical stances is no great departure from traditional investor behaviour. Investors are well versed in taking the long view and making considered judgements about how much value they will get based on a wide range of factors.

Ethical propositions generate value

The concept of ethical investing has become so popular that it now has entire indices dedicated to it. These are based on what are known as ESG ratings, which stands for environmental, sustainability and governance. ESG evaluates and ranks businesses on everything from diversity and workforce welfare policies to how they source products and materials to carbon off-setting or reduction.

Critics argue that while these indices and ratings might be fine if your primary concern is ‘doing the right thing’ with your money, they have little bearing on whether an investment will be successful or not.

But a growing number of analysts argue just the opposite. And they have a growing body of evidence to back them up. McKinsey, for example, points to a review of more than 2000 studies into the impact of ESG propositions on equity returns. In 63% of those studies, ethical stances were associated with positive equity returns. In just 8% were they associated with negative returns. 

In other words, businesses that adopt ethical stances are found to perform better. That alone is a sound argument for investment.

McKinsey goes on to offer five reasons why ESG propositions have a positive impact on business performance. They include things like the fact that reducing energy consumption or switching to renewables also reduces costs, and that looking after your workforce better is likely to lead to an uplift in productivity. Another point is that consumers and corporate clients alike are increasingly looking for ethical and environmentally responsible options. Considerations around ESG influence purchase decisions. Businesses who make the right propositions are creating market opportunities.

Better governance equals longer term stability

The final point the McKinsey paper makes is that ESG creates value by boosting investment returns in the long term. The point is actually focused on business’s own capital investments, for example on the basis that more sustainable, efficient equipment will last longer and have lower running costs etc. But it can be expanded to inward investment into companies, too.

Going back to the point about customer preferences, we can compare the situation now where oil and gas companies are reporting record revenues because of soaring prices. Some investors are sticking rigidly with fossil fuel-based portfolios and no doubt making some significant gains as a result. 

But given current consumer sentiment, given the increasing vulnerability of supply, how long will that last? Looking decades ahead, renewables markets look far less volatile and far more likely to deliver sustained long term growth. And what is the reputational damage to those who continue to back fossil fuels worth?

As another example, consider the business that prioritises good governance across the board, from how it looks after and nurtures staff to its relationships with external stakeholders to how it sources stock or materials. Compare that to the business that pays the minimum possible in wages, cuts back staff at every sign of margins being eroded and buys the cheapest products wherever they can get them. Which is more likely to have the strong, stable foundation to ride out tough market conditions?

What we’re waking up to in both the world of business and business investment is the fact that an organisation’s ethical and environmental credentials are of no little consequence to broader considerations of how a company is run. ESG tells you a lot about a company’s culture, its leadership, how it understands its place in broader markets and ecosystems, and whether it is dominated by short term or long term thinking. They are all good reasons why ESG ratings are very much worth considering when making rounded, informed investment decisions.

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