From Morgan Stanley:

In our view, ESG is not about doing good, nor is it an investment strategy in itself. ESG is simply a framework that can and, we believe, should be applied to all investment diligence processes. ESG diligence aims to identify and mitigate economic, social and governance risks that could weaken or de-rail an investment.

For example, a company with inadequate environmental controls may suffer damage to its revenues, profitability, reputation and valuation should an incident occur. Investors who do not follow a process that would enable them to identify this company’s environmental shortcomings before they decide to commit their capital are likely to suffer alongside it.

One does not have to be a “do-gooder” to see how weak ESG can materially affect investment returns.When thinking about ESG, most people focus more on the “E” component, likely because the dangers are more tangible and potentially catastrophic. BP’s Deepwater Horizon oil spill is a prominent example. However, in our view, social and governance risks are equally important.

Social risks occur when communities are harmed in a way that is not environment related. Wonga, a pay-day lender in the UK, saw its path to a $20bn valuation wiped out when it was accused of predatory lending practices. On the governance side, the financial press is rife with stories of managerial misconduct, from fraudulent accounting to inadequate board oversight.

Theranos, for example, went from a much hyped start-up to a scandalous mess, largely in part to insufficient governance procedures.The good news is that most investment teams consider these risks when evaluating opportunities. However, they may not bucket them into discrete ESG categories or have a formal ESG investment policy or process in place.

We believe that having a strong ESG umbrella to corral these risks under in a cohesive way is valuable. A robust ESG focus embedded in all stages of the investment process, from underwriting to execution and monitoring, is fast becoming the basic requirement for any serious investment organisation. In our view, simply using an “ESG overlay” or “ESG lens”, or “giving consideration to ESG factors”, will not cut it in a sophisticated world where the asset owners and stakeholders are deeply conscious of the risks they want to avoid.

You Are Not Doing ESG Investing