Environmentally Based Investing: “Feel Good” Idea, Smart Strategy, or Both?
Updated: Aug 27, 2019
If you see yourself as someone who wants to protect the environment, you probably try to act accordingly. You recycle as much as you can and buy organic produce. Maybe you even drive a hybrid or electric car. Have you ever asked yourself whether this personal priority should affect your investment choices? Should you direct your financial advisor to invest in companies that are environmentally friendly (and avoid those that are harmful)? Could this behavior by investors put enough pressure on companies to have a meaningful, positive impact? Or is the goal of investing strictly to produce the highest return for the amount of risk that is appropriate for you at this point in your life, without any type of ethical “tilt”? What if you could have both?
In this article, we briefly review the origins of what is broadly defined as purpose-based investing. We then explore why it can be trickier than you might think to determine which companies are (and are not) “environmentally-friendly”. We also describe scoring systems that aim to help investors make that determination. Lastly, we explain why it is possible to “do well by doing good.” In other words, we discuss why investing based on companies’ environmental practices can, at least in theory, generate superior returns.
The roots of environmentally conscious investing date back a few decades to what could be termed “avoidance investing”. This involved avoiding so-called “sin” stocks, such as shares of companies that sell tobacco products, run casinos, make beer, wine and spirits – essentially, any company associated with a product or service considered to be immoral. This evolved into avoiding companies whose activities were perceived to be harmful in other ways, particularly with respect to the environment, such as chemical manufacturers and energy producers. This, in turn, led to a more positive approach, with investors seeking to load up on shares in companies that consciously engage in good environmental practices.
The concept of “Socially Responsible Investing”, or simply SRI, has evolved substantially since its early days and has skyrocketed in popularity. 120 funds worldwide now focus on this type of investing and the amount of money managed by these funds has grown by roughly 200% over the past decade.
Although definitions can vary from one source to another, SRI is primarily concerned with screening out investments based on one's views (ethical, religious, etc.). Gold Medal Waters does not take this “screening out” approach. In contrast, Environmental, Social and Governance, together known as ESG, incorporates sustainability as a tool for identifying investments with a potential for strong returns. The “Environmental” category is fairly straightforward – the goal is to identify and invest in companies that are engaged in activities with a positive environmental impact and to shun those that are the worst offenders. “Social” refers to companies whose policies are responsive to societal issues. Does it show concern for its workers’ health and safety? Does it avoid doing business with suppliers who treat their own workers poorly? Does the company donate a percentage of its profits to charity? “Governance” refers to whether or not the company has been involved in any financial scandals or cover-ups, such as VW’s smog testing debacle, or managed in a way that promotes ethical behavior (yes, that’s rather vague). It can also include issues such as gender and racial equality in hiring and pay practices and whether there are any women or minorities on the Board of Directors, etc. Some funds focus on just one of these three areas, while others target all three using different approaches.
With respect to ESG, Gold Medal Waters focuses primarily on environmentally-conscious investing, which many now refer to as Sustainable Investing (SI). While identifying companies that are either especially good or particularly bad environmental citizens may sound easy, it is not as clear-cut as you might think. There are some obvious choices for the list of “good guys”, such as Patagonia, whose fleece jackets are made from recycled plastic bottles, and Seventh Generation, the company that makes cleaning products free of harmful chemicals. However, would you also choose IKEA, Unilever, and Allergan? All have been named as top environmentally friendly companies for the sustainable practices that permeate their businesses although it may not be obvious given the products they make. As for “bad guys,” you might name coal mining companies, utilities that primarily use coal to generate electricity, and probably oil companies. Having said that, do they all deserve to be on that list? Royal Dutch Shell has set aggressive carbon reduction targets and is entering the electric-vehicle market, and Exxon Mobil’s forecast for growth in its energy sources through 2040 is dominated by renewables (wind, solar and others) and natural gas.
While Exxon is clearly not as environmentally friendly as Patagonia, let’s remember that the primary goal of investing is to generate the highest returns with an appropriate amount of risk. If you shun all companies in a particular industry you introduce risk into your portfolio and are likely to generate returns below the overall market, at least some of the time. For example, let’s imagine you exclude energy companies but continue to own airline stocks. If the price of oil increases your airline stocks are likely to suffer as the price of jet fuel rises. Remember that you don’t own energy stocks that will benefit from higher oil prices, so your portfolio won’t do as well as the entire market which includes both airlines and energy companies.
To help investors sort through this, a number of firms now publish ESG scores that rate companies across various dimensions – the E, the S and the G based on various inputs and criteria. This is helpful in many ways as fund managers may use one or more of these scores along with their own “secret sauce” to construct their strategies. This is a good start, however, it is important to note that scores from different providers can reach very different conclusions about a given company; using these rankings or scores is not a “slam dunk” for a fund manager.
So, can an investor generate returns while making the environment a priority when investing? While skeptics may scoff at this notion, more and more evidence suggests it is quite possible. Businesses that adopt superior sustainability practices may very well generate higher profits than their competitors. Why? More consumers may seek out their products in a show of support for the company’s policies. Companies can reduce energy costs using solar panels, rooftop gardens and other methods, and lower other costs by recycling, reducing waste, etc. – those savings boost profits. Companies know that high ESG scores attract investors and this can create a virtuous circle. Both academic research and real-world results show that investing in companies with good environmental practices can produce superior results.
Businesses are embracing environmentally sustainable practices more now than ever before. Whether their primary motivation is to help the planet, to foster customer loyalty, to generate higher profits or to attract investors doesn’t really matter – we all benefit from these practices. And, as an investor, choosing environmentally focused funds doesn’t have to mean giving up returns or taking on more risk. That’s a two-for-one deal definitely worth considering.
Make Investment Decisions with the Help of an Expert
Investing in a way that reflects your values can be rewarding, both personally and financially. With so many funds available in the Sustainable Investing (aka ESG) arena, you’ll want some help to understand the differences within this category. Talk to your financial advisor at Gold Medal Waters about identifying funds whose strategies most closely match both your personal priorities and your investment objectives.