ESG investing has seen some headwinds in 2022. The ESG indexes suffered in 2022 in part due to their low representation in areas of the market that have benefitted from higher energy costs, such as the oil and gas sectors, and high representation in growth sectors that have been challenged by rising rates. However, the energy crisis has intensified the pressure to deliver on the energy transition while higher bills are fuelling the cost of living crisis and drawing attention to social issues. Hence, we expect that ESG investing will continue to gain traction over the medium and long term, but we also believe the main lesson from 2022 is that the traditional exclusion or positive screening only approaches are not sufficient anymore in a world where geopolitical risks, regulation, inflation and economic uncertainty are generating a higher dispersion in returns. This market environment requires a greater focus on stock selection.
Therefore, investors should embrace an integrated ESG approach that seeks to select opportunities where improving ESG trends are not yet fully priced into companies’ valuations. We believe doing so will add value both in terms of being able to deliver better risk-adjusted return, but also in terms of helping to put focus on -- and ultimately improve -- important ESG parameters for companies and society.
A good way to embrace an integrated ESG approach, in our view, is using a forward-looking approach to select two types of companies, ESG winners and ESG improvers. We define ESG winners as quality businesses that already have strong ESG ratings, while ESG improvers are those companies with a positive ESG path with regards to the most material sector and business drivers. Such an approach offers investors the opportunity to invest today in the ESG winners of tomorrow. In selecting these companies, ESG analysis should go handing-hand with the qualitative fundamental research process in assessing the sustainability and profitability of each company.
Turning to ESG themes, we have highlighted some which have strong tailwinds. For instance, decarbonisation has become more urgent than ever. Among the energy and utility businesses, we focus on those regulatory environments that allow for the recovery of costs associated with energy transition. At the same time, companies’ footprints are being increasingly scrutinised on “Social” (“S”) concerns, particularly those surrounding social inequalities. This has led us to focus on opportunities such as house builders in the affordable housing sector, as we believe these companies are well-positioned relative to their peers. Finally, another material issue is product safety, with companies being increasingly held accountable for their products within their supply chains while labour issues are becoming more and more under the spotlight. In particular, food and clothing companies face very complex labour risks in their global supply chains (e.g. labour issues) and thus we prefer those businesses that are actively collaborating with relevant stakeholders.