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Corporate Engagement, Sustainability Research

Beyond ESG: Sustainable Investing

With the wind seemingly at its back, ESG investing has hit unexpected chop. The trending investment strategy, focused on “environmental, social and governance” factors, has become the focus of intensifying political attacks, as we have noted. More recently, some investors have reportedly shorted stocks seen as ESG darlings. At the same time, a range of factors have boosted companies shunned by many ESG investors, including oil companies, whose valuations jumped following Russia’s invasion of Ukraine. On the other side, high interest rates and supply chain snags have created challenges for some renewable energy companies, most evidently those in the offshore wind business.

Is this the beginning of the end for ESG investing? Emphatically not. But it is an opportunity to reassess how the mainstream ESG approach could be changed to better meet the moment.

As we have written about previously, ESG investing is neither well-defined nor well-regulated. As a result, many mainstream “ESG” offerings rely heavily on outside ratings, which can allow companies with environmentally or socially destructive business models into ESG portfolios. This helps drive a perception that ESG is essentially another form of greenwashing. In fact, approximately 61% of investors in North America believe “asset managers predominantly use ESG as a marketing tool to sell products and enhance their reputations,” according to the Capitol Group. Such perceptions leave ESG vulnerable when economic winds shift.

At the other end of the spectrum are ESG funds or managers who go all in on a particular theme. While thematic investing can be an important tool for anticipating and supporting real-world trends, concentrating investments too heavily into narrow themes (e.g. meatless protein, next-generation battery technologies, etc.) can significantly increase risk. This is especially true for thematic investments largely built around newer companies, or those without a clear track record of success to build on.

How could mainstream ESG strategies and funds be improved? We believe the answer lies in what we call sustainable investing. A sustainable investing strategy—like the one we deploy at Prentiss Smith & Company—is an integrated approach that fully incorporates environmental, social, governance and financial factors. For example, not only do we avoid fossil fuel and defense companies, whose destructive core business models are rife with climate and political risk; we might also avoid renewable energy developers with overly leveraged balance sheets, solar companies with no consistent record of profitability, and newly public companies run by untested management or without a viable product offering. Piling investment dollars into such companies would not only put our clients’ money unnecessarily at risk; it could imperil the success of the renewable energy transition, by keeping companies in the market that are unlikely to achieve the speed and scale demanded by this moment.

Instead, sustainable investing relies on the sound judgment of integrated research. We source our own research in-house, enabling us to evaluate different risks and opportunities in an investment side-by-side, rather than simply “tacking on” investment screens, ratings or outside research to create the appearance of a package. When our judgment suggests an investment has innate potential to improve the world (making it a less risky place), and is likely to deliver a suitable return, we consider it for client portfolios. Identifying such investments across a wide variety of themes, we believe, is a further hedge against risk.

Along with an integrated approach, our practice of sustainable investing also focuses on active ownership. Because our clients are part owners of the companies we invest in, we believe it is important to continually push those companies, however well-intentioned they may be, to do even better. For this reason, we think truly sustainable investing must incorporate the responsibilities of ownership as well as its potential benefits. So we carefully analyze and vote at the annual meetings of all companies whose shares we purchase on behalf of clients, pushing for more egalitarian executive compensation, better governance and board diversity, and shareholder resolutions that favor environmental and social progress. For many portfolio companies, we also engage directly on topics of heightened concern, through communications, meetings, and in some cases by filing our own shareholder resolutions to present at annual meetings.

Active ownership, we believe, brings to life the values espoused by environmentally and socially responsible investors. If choosing which companies to own is an investor’s “vote” for more sustainable ways of doing business, then casting actual shareholder votes and engaging with those companies directly is investor activism. Together with an integrated research and investment process, active ownership offers the potential to accelerate environmental and social progress while simultaneously pursuing optimal financial returns.

The rapid spread of ESG investment strategies, we believe, can have a positive impact on the world. But much like “natural” foods, the ESG label today obscures gaps that investors may not be aware of. Sustainable investing, on the other hand, demands more rigor from investment advisors and fund managers—but it has the potential to truly deliver on what clients want, when they make the decision to align their investments with their values.