Six things you need to know about ESG

When it comes to environmental, social and governance (ESG), distinguishing fact from fiction can be challenging.

Take the case of Active Super, found guilty by the Federal Court in June of 'greenwashing', which is the false advertising of green credentials.

The fund, which has 80,000 members, claimed in a report there was "no way" it would invest in gambling, coal mining, oil tar sands or Russian companies since the Ukraine invasion.

But a closer reading of the fund's investment policy revealed it would invest in these areas - but does its best to avoid them.

The disparity between language and action is an ongoing concern when it comes to ESG.

Increasingly it matters, however. About 88% of Australians expect their super and other investments to be invested responsibly and ethically, according to the Responsible Investment Association Australasia (RIAA).

There is a lot at stake: global ESG assets flew past $US30 trillion ($45 trillion) in 2022 and are on track to hit $US40 trillion ($59 trillion) by 2030, according to Bloomberg.

It turns out that Active Super is only the latest to be held to account, with UniSuper, Vanguard, and Northern Trust in hot water.

It also extends to other industries: earlier this year a NAB shareholder took the bank to court to find out whether her holdings are invested in coal before she passes her shares on to her descendants.

This rising demand has led super funds to make 'ESG aware' statements without fully understanding the complexities of ESG policies, says Aman Ramrakha, executive director of research at Rainmaker Information, the publisher of Money magazine.

"Some of the difficulty lies in getting transparency from companies on how they conduct their activities," Ramrakha says.

"It can be difficult to work out if a large multinational corporation operating in many industries and jurisdictions is aligned to your ESG policies."

1. Is ESG the same as ethical investing?

People often put ESG in the same basket as other related but separate strategies such as responsible, ethical and sustainable investing, which can use ESG criteria.

It helps to think of ESG as a way to filter investments based on non-financial risks that may impact financial performance or reputation.

A greenwashing case, for example, exposes the company or fund to significant legal and reputational risk, which may impact financial performance.

Outside environmental issues, there are social factors (human rights, modern slavery and funding armed conflict) and governance concerns (corruption, crime, diversity, equity and inclusion).

"ESG is a neat way of encapsulating how a company should behave," says Ramrakhar. "It can allow super fund members to align their money with their beliefs."

2. Do ESG investments underperform?

Some people have concerns that ESG investments may underperform.

As with many investments, returns can be cyclical with periods of underperformance. However, over the long term it may have a positive impact on portfolio performance.

This is most stark when considering the 'environmental' in ESG.

Climate change, much like social inequality, is a long-term systemic risk. Extreme weather events seem to be on the increase, touching every sector.

The scientific consensus is that greenhouse gas emissions must peak before 2025 and decline 43% by 2030.

The Paris Agreement, a legally binding international treaty on climate change, aims to hold temperature rise "to well below 2°C".

3. What about investment returns?

Various studies show there is no trade-off in returns when sustainable and traditional funds are compared.

In fact, ESG funds show lower downside risk regardless of asset class and are generally considered more stable during periods of high market volatility.

"ESG helps from a performance point of view," says Ramrakhar.

Companies with good ESG practices "are more likely to succeed over the long term by attracting more customers, investment and access to funding".

4. What is ESG weighting?

All industries can be viewed through an ESG lens, but it's not always a black and white issue.

What matters is the weighting of ESG factors. For instance:
• Mining may be energy intensive and cause habitat destruction, but it also supplies minerals critical to the clean energy transition. 
• Healthcare produces unavoidable waste but is also an essential service. 
• In IT, privacy and data security are top of mind; carbon emissions produced by data centres may be less of a focus. 
• The big supermarkets have strong sustainability ambitions, but they sell salmon from Tasmanian fish farms that threaten the endangered Maugean skate. 
• Energy companies such as Origin play a large part in fossil fuel production, but are increasing clean energy capacity.

5. How can you assess your fund or investment?

There is still inconsistent regulation, policy, communication and transparency with ESG, although the situation is improving.

For example, super fund members can now scrutinise where their savings are invested. Since 2022 funds have been required to disclose their holdings.

And from January 2025, Australian entities will be required to file compliant sustainability reports, including climate statements, starting with larger corporations.

Companies with $500 million or more in revenue and 500 or more employees and asset managers with more than $5 billion under management will be the first.

"Information and transparency are improving," says Ramrakhar. "Super funds are building up their resources to ensure that they comply with their stated ESG policies."

6. What can you do to avoid greenwashing?

Investors should look for companies and funds that safeguard assets from long-term systemic risks such as climate change and social inequality.

Here are six key areas:

Policies

These are usually accessible online. Annual reports provide insight into ESG activities and compliance.

Look for sustainability reports, modern slavery statements and reconciliation action plans. From 2025, mandatory climate reporting will make it easier to tell if an entity is aligned with the Paris Agreement.

Portfolio holdings

There are many ESG options on the market, and you can't always rely on the label. Check the fine print. Super funds must disclose holdings.

Transparency

Many greenwashing cases result from mislabelling or miscommunication.

Check if your fund uses external fund managers and what guidelines and/or underlying indices they follow.

Ratings agencies

Refer to reputable agencies such as ISS ESG, Morningstar Sustainalytics and MSCI ESG.

Commitments and affiliations

Verify if the fund supports the UN-backed Principles for Responsible Investment (PRI), UN Sustainable Development Goals (SDGs), the Responsible Investment Association of Australasia (RIAA) and other initiatives.

Good governance

Look at proxy voting, stewardship initiatives and active ownership.

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