Sustainable investment not just a case of virtue being its own reward

Sustainable investment has grown in popularity in recent years, not just as the virtuous thing to do for the planet but also as a wise choice in a world where it is becoming increasingly unacceptable for companies to engage in practices perceived as being environmentally or socially harmful.

But the challenge for many people is how to define a sustainable investment and be sure that it really does do what it says on the wrapper.

“There is no one universal definition of a sustainable investment,” says Deirdre Timmons, sustainable finance lead, ESG reporting and assurance, with PwC Ireland. “However, under the EU Sustainable Finance Disclosure Regulation (SFDR) there are certain investment standards that must be met and disclosed before a fund can be classified as having a sustainable investment objective.”

An example of one such standard which can be used is the disclosure of the fund’s percentage portfolio alignment with the EU Taxonomy, which is a scientifically based classification system of environmental economic activities.

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“This is intended to remove any subjectivity from the determination of what can be classified as green activities, making it comparable and transparent,” adds Timmons. “However, at present it is limited in so far as it is still in development and does not cover all sectors or all activities as yet, therefore, most funds’ alignment is also limited currently.”

The taxonomy also includes the concept introduced by the EU of “do no significant harm”, whereby it must be demonstrated that an investee company producing goods or services cannot be considered sustainable if it does so while exploiting workers’ rights, for example, or sourcing raw materials from suppliers who use child labour.

“So, good business and governance practices also need to be demonstrated before investment selection,” Timmons points out. “This principle also includes no harm to the environment, such as pollution and waste, water usage, causing marine damage or biodiversity loss as examples.”

Catherine Duggan, head of sustainability advisory at Grant Thornton, also points to EU regulations as being helpful with regard to defining sustainable investments and preventing greenwashing.

“A key output of the suite of connected regulations and directives coming from the EU as part of the Green Deal is clarity around terminology and what is considered a sustainable economic activity,” she notes.

“This is limited to activities focused on six environmental objectives covered under the current EU Taxonomy but there is a desire to develop a social taxonomy as well. Projects that can demonstrate they meet the detailed technical screening criteria of the EU Taxonomy can then attract investment from those seeking to develop Article 8 or Article 9-aligned funds.”

Conal Cremin of RBC Brewin Dolphin explains that, under SFDR, an Article 8 financial product – also known as a light green product – is a financial product that promotes ESG characteristics but does not have any set objectives or targets to achieve.

“An Article 9 financial product, known as a dark green product, is a financial product that has sustainability investment as its objective, which is measured on key performance indicators (KPIs). Therefore, Article 8 sustainable products will have more of a focus on investment returns than Article 9 products,” says Cremin.

Duggan also points to the Insurance Distribution Directive which places an onus on insurers and insurance intermediaries to integrate customers’ sustainability preferences when they provide advice on insurance-based investment products.

“By mandating that customers are asked about their sustainability preferences, it provokes a conversation by what is meant by the term and may influence their investment choice and therefore the demand for those disclosing under Article 8 and Article 9 requirements,” she says.

One of the biggest challenges in relation to identifying and reporting on sustainable investment is access to timely, meaningful, accurate data, Duggan adds.

“The Corporate Sustainability Reporting Directive has the potential to address this,” she says. “On a phased-in basis, it will require an estimated 50,000 companies to disclose standardised granular data, including the sustainability-related impacts, risks and opportunities arising as a result of the companies’ activities.

“The disclosures will be reviewed as part of the audit process and provide data that can be used by investors to assess sustainable performance and facilitate their own reporting requirements.”

The big question for many investors will be the returns they can expect for their money. How do sustainable or green investments stack up against more traditional or brown options? Quite well, as it happens.

“There is a growing body of evidence that shows sustainable investments outperform more traditional types of investment, but it is still a live debate,” says Duggan. “At a practical level, issues around sustainability can be considered as drivers of traditional risk. Companies and funds that incorporate sustainability-related issues into their-day-to-day business have the potential to be more resilient on that basis.”

She points to a sustainable reality report from the Morgan Stanley Institute for Sustainable Investing that showed that in the first half of 2023 sustainable funds saw a median return of 6.9 per cent, beating traditional funds’ 3.8 per cent and reversing their underperformance in 2022. It also showed that investor demand remained strong as sustainable funds’ assets under management reached record levels of more than $3.1 trillion.

Making comparisons is not always straightforward, however. “There are many studies out there; some will show that sustainable investments outperform, others will show that they underperform because the issue is there is no such thing as a standard sustainability fund,” says Timmons.

“The key thing here is to really understand the investment objective of the fund because without that it is very difficult to compare.”

ESG funds that employ negative screening processes to exclude certain investments such as oil stocks can be problematic, for example, as removing many sectors or stocks from the portfolio can make it more difficult to diversify risk.

There is evidence to suggest that these funds can perform well over time as in many cases it would seem it is hard to argue with good business practices

—  Deirdre Timmons, PwC Ireland

“Often funds with negative screening can have a lot of concentration in tech stocks as they generally tend to screen well for ESG risk factors, for example,” Timmons explains.

“Any fund that has a high concentration in any one sector will then tend to perform more in line with that sector rather than in line with the market, which would mean they can be riskier funds than your average traditional fund and may well underperform as well as outperform depending on macroeconomic circumstances.”

Focusing on such concentrated ESG funds is not really a fair comparison, she contends.

“When looking to the wider universe of sustainability funds which focus not just on screening out sin stocks, but actively investing in stocks with good governance, good gender and diversity profiles, awareness of impacts of environmental footprint, and so on, there is evidence to suggest that these funds can perform well over time as in many cases it would seem it is hard to argue with good business practices.”

Cremin agrees: “We believe high quality companies that manage environmental, social and governance risks and opportunities well will make attractive long-term investments.

“We actively seek out the best investment opportunities for a given level of risk while considering both diversification and sustainability as drivers of long-term return.”