The evolving ESG context – advice client conversation guide

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Advisers will benefit from developing a framework to develop their own approach to ESG conversations with both new and existing clients.

The evolving ESG context – advice client conversation guide

The relentless growth of ESG investing over the last few years is well documented. And, notwithstanding several ‘bumps in the road’ the sector has been forced to contend with during 2022, there are many leading indicators – including consumer sentiment, fund flows, ESG hiring and new product launches – suggesting this growth is expected to continue unabated.

Indeed, a Dow Jones Survey of US Financial Leaders[1], the results of which were released in September 2022, projected ESG investments to double between now and 2025. And locally, the 2022 Benchmarking Report released by the Responsible Investment Association of Australasia (RIAA) found the value of Australian assets managed within a responsible approach had grown to AUD $1.5 trillion, representing 43% of the total investment market[2].

Unsurprisingly, financial advisers have recognised the long-term and irreversible nature of this trend and are now seeking to build their skills and develop their offerings in this specialised space. Yet uncertainty remains, especially about how to best incorporate ESG investing into client conversations, advice processes, portfolio construction techniques and compliance obligations.

The challenges of 2022, a year where most ESG funds underperformed the broader market, and in which ESG sceptics were given new voice, have created an extra level of complexity – and perhaps an additional barrier – for advisers.

In this article, we will explore the topic of client conversations on ESG investing, examining the ever-evolving ESG context and the deeper nuances within this context. Readers will then be provided with a framework in which to develop their own approach to ESG conversations – initial and ongoing – with both new and existing clients.

Speak the language

The first step in preparing for more effective conversations around ESG investing is to be clear about the language used. This is easier said than done, as the sector is characterised by a lot of jargon, some of which is used interchangeably (correctly and incorrectly).

Take the term ESG for example. And what about the terms responsible investing, sustainable investing, ethical investing and impact investing?

Well, starting with ESG, it’s important to firstly differentiate between ESG integration, which can be thought of as an extra form of risk analysis conducted before investing in a stock, and ESG as an objective, which means investing in ways that achieve desired environmental and/or social objectives.

According to the RIAA, this second form of ESG investing falls under the umbrella of responsible investing (RI), a term it uses interchangeably with ethical investing and sustainable investing. They define responsible investing as “a broad-based approach to investing which factors in people, society and the environment, along with financial performance and risks when making and managing investment”[3].

It’s also important to understand the spectrum of responsible investing. Figure 1 below shows this spectrum, bookended by traditional investing (which takes no account of ESG considerations at all) at one end, and philanthropy (where there are no financial return objectives) at the other. In between we see a range including ESG integration as well as:

  • Exclusionary or negative screening – where certain sectors, companies or geographies are screened out for being inconsistent with core values
  • Norms based screening – excluding companies on behavioural or governance grounds
  • Corporate engagement – actively using power as a shareholder to shape company behaviours in line with desired ESG outcomes
  • Positive screening – proactively seeking out companies achieving better ESG outcomes than peers
  • Sustainability themed investing – specifically targeting investment themes such as sustainable development goal (SDG) aligned; and
  • Impact investing – investing to achieve specific and measurable positive social and/or environmental impacts.

Understand consumer sentiment expectations of financial advisers

Banish any fear that initiating an ESG conversation with clients may harm your relationship or be seen as imposing your own values or politics. The massive growth in ESG investing is mostly investor led and, if anything, it is the industry that has been lagging consumer demand, not the other way around.

According to the RIAA, the deteriorating economic outlook was not found to impact any planned or existing responsible investment practices among Australians. Their ‘Values to Riches’ 2022 Report[5] found the percentage of Australians with responsible investments has grown 28% since 2020, and is now close to one in five. A further 46% are considering investing in responsible investment products within the next five years.

The same report found the number one expectation Australians have of financial advisers in 2022 is to know about responsible investment, increasing to 64% compared to 54% two years ago (and, for the first time ever, a higher priority than maximising investment returns, at 58%). Almost half the population (47%) also expect advisers to provide responsible investment recommendations, while 43% expect them to know which responsible or ethical products are independently verified or certified. These trends are characteristic of Australians of all walks of life, regardless of where they live, employment status, age, or gender.

Coredata[6] also conducted research into client/adviser interactions on ESG and found similar results in terms of expectations. They also specifically looked at client perceptions of adviser-initiated ESG conversations and found them very receptive:

  • 47% of women and 37% of men surveyed agreed that investing in companies with strong ESG credentials is part of leaving a legacy for younger generations
  • 65% of women and 69% of men expect the performance of companies with strong ESG records to be the same or better than companies with weaker ESG credentials
  • 93% of women and 87% of men said their trust in their adviser would be the same or higher if that adviser initiated a conversation on ESG (just over a quarter of men and women said their trust in that adviser would increase)
  • around 80% of women and 75% of men would be open to having an ESG conversation with their adviser.

Be across the nuances

It is vital to remember that responsible investing is not a black and white, one size fits all approach. There are many nuances to be aware of, making it crucial to truly understand your clients’ motivations and objectives before engaging in an ESG conversation.

Some of these nuances relate to the large number of issues and ‘causes’ your clients may be interested in. ESG investing is not just about mitigating climate change or caring for the environment; there are a myriad of social issues that consumers are interested in, and which provide investment opportunities.

The RIAA 2022 Values to Riches[7] report found the most important social themes for Australian investors to be:

  • healthcare, public health and medical products (48%)
  • support for employment and local business (33%)
  • green property, social and community infrastructure (28%).

While the most important environmental themes when investing were found to be:

  • renewable energy and energy efficiency (53%)
  • sustainable water management (41%)
  • healthy river and ocean ecosystems 38%.

The issues investors were most keen to avoid in their portfolios included:

  • animal cruelty (58%)
  • Hhuman rights abuses (52%)
  • pornography (50%)
  • Ccompanies seen as tax evaders (48%)
  • gambling and tobacco (each 48%)
  • violation of Indigenous rights (42%)
  • labour rights abuses (40%).

As you would expect, gender and age differences are apparent. Figure 2 shows how investment priorities vary by generation.

Some nuances are contextual and evolving

2022 has been a rough year for investment markets generally, but ESG investments have been impacted particularly hard. This is because many ESG investments are underweight in energy stocks – the only sector of the market to have generated positive returns – and overweight in technology stocks, which have been sold down as interest rates began to climb.

This relative underperformance (after years of outperformance) has emboldened many ESG sceptics, and the anti ESG noise has really dialled up during 2022, a year when Elon Musk declared ESG a scam[8], the head of responsible investments at a global fund manager resigned after claiming that climate change posed no investment risk9[9], and the US state of Texas is blacklisting fund managers who are ‘anti fossil fuel’[10].

What is undeniable is that these nuances are complex and evolving.

The conflict in Ukraine, for example, has caused many to rethink their positions on several fronts. Weapons and defence stocks have traditionally been a longstanding and easy exclusion from ESG funds, however, as Ukraine needs to defend itself from an aggressive invader, defence stocks may be seen in a new light.

Similarly, the conflict’s impact on the energy sector has seen many tweak their views on this space.

Energy stocks have actually been an area of debate amongst ESG circles for quite some time. While a common approach for environmentally conscious investors has been to simply exclude all investments in fossil fuels, many observers argue a more effective way to achieve this objective is to invest in and engage with these companies and influence them to transition towards renewables.

Complexities in supply chains and production processes are also challenging for advisers and investors alike. For example, one person with a core desire to benefit the environment may feel strongly about investing in electric vehicles (EVs), while another individual may find the lithium mining to build EV batteries abhorrent.

ESG conversation tips

At a basic level, engaging your clients in ESG conversations is a normal part of the ‘Know Your Client’ process. Certainly, understanding if there are any areas your client specifically wants to include or exclude in their portfolio, and their objectives (if any) that relate to ESG outcomes, seems crucial to truly act in their best interests. That said, there may be a degree of reluctance on the part of some advisers, especially when dealing with existing clients (‘why haven’t you mentioned this before’), and uncertainty as to how best to position the conversation. The following tips have been gleaned from advisers that are active in this space:

  1. For new clients, incorporate questions about their responsible investment priorities (if any) into the initial fact – finding questionnaires. Their priorities could include values, impact, financial return, or a combination. Determine if they have particular beliefs (ethical or religious) that preclude investments in particular areas. In conversation, a softer way to introduce this topic, is to simply ask “do you mind where your money is invested?”, or “do you ever wonder where your money is invested?” Alternatively, you could ask “are there industries or companies that you prefer we emphasize or avoid as we manage your assets?” Or: “how do you feel about investing some or all of your portfolio to reflect specific values or beliefs you hold?”.
  2. Pick up cues through their behaviours and experiences – have they just bought an EV, and if so, what was the main motivator? Was their last holiday a hike in the Tasmanian wilderness? Do they volunteer for any charities or community groups? Have they been affected by floods or bushfires? What other hobbies or interests do they have that are relevant?
  3. If your client hasn’t volunteered for any ESG interests, or if you are introducing the concept to an existing client, don’t come at it from a political or environmental angle. Come at it from an angle of risk management, positioning a portfolio to guard against risks and take advantage of the opportunities embodied in an ESG approach. Companies that aren’t positioning themselves in the face of increasing climate risk or tightening legislation are undermining their own sustainability which makes them a riskier investment.
  4. Some environmentally-friendly behaviour is driven by hip pocket concerns rather than idealism or politics. In September 2022 (the month the fuel excise relief was stopped), the third best-selling vehicle across Australia – behind the Toyota Hi Lux and Ford Ranger – was the Tesla Model Y[11]. It seems reasonable to assume many of the buyers are motivated as much by soaring petrol prices as they are by lowering emissions. (The same probably applies to people switching to solar energy in their homes). You don’t have be to an environmental activist to be into renewables and recyclables.
  5. Raising ESG with existing clients for the first time can easily be done at review time. Introduce it by saying “this is something we’ve been looking at”, “this is a situation we’ve been monitoring”, or “it’s a new initiative”. The availability of ESG options in the past has been relatively limited, hampering the ability to construct fully sustainable portfolios. A conversation could legitimately be started by saying that, only recently have you become satisfied that the breadth of options available enables you to truly help your clients in this area. As one adviser put it:
    “A year or so ago, we could finally hand on heart and say we can build a properly diversified portfolio across most asset classes with sufficient management, diversification and style to replace the more traditional options we were using up to that point”[12].
  6. Make the conversation educational and collaborative by taking clients through the many different solutions available to meet their investment and ethical objectives. This will also help narrow the focus on their true priorities.
  7. The conversation needs to be an ongoing one, meaning your reviews and newsletters and other ongoing client communication needs to reference ESG issues generally as well the impact achieved by specific investments.
  8. Finally, remember ESG is not a novelty or niche – it’s mainstream. As such, these conversations should be held in the context of normal advice conversations and not treated as some standalone topic to be discussed separately to ‘normal’ investments. ESG is the new normal.

The performance conversation

As already referenced, 2022 was when years of outperformance by ESG investments came to a grinding halt, an outcome of energy stocks doing well and technology stocks doing poorly.

Advisers worried about having tricky conversations about the performance of ESG investments should remember the following:

  • Firstly, the mentality you constantly encourage in your clients in relation to other assets (don’t panic, take the long-term view, focus on the plan) apply just as equally to ESG investments as to others.
  • Secondly, and perhaps more importantly, when a client feels more connected to an investment, as is often the case with ethical or responsible investments, short-term performance blips, and indeed other extraneous ‘noise’ about ESG, just fades into the background.

Conclusion

As interest and demand for ESG investment solutions continues to grow, it is inevitable that advisers will be having conversations about ESG with their clients. These conversations, if approached properly, represent an opportunity to engage more deeply with clients, and facilitate outcomes which can meet both ethical and financial objectives and add a new dimension to their advice offering. While some advisers are understandably uncertain as to how best position these conversations, and are fearful of broaching ‘controversial’ topics, there are a number of strategies that can be applied to ensure the focus remains on investment goals and approaches and doesn’t veer into politics or idealism.

 

 

 

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References:
[1]  https://www.dowjones.com/press-room/esg-investment-expected-to-more-than-double-in-the-next-three-years-new-research-from-dow-jones-shows/
[2]
https://responsibleinvestment.org/wp-content/uploads/2022/09/Responsible-Investment-Benchmark-Report-Australia-2022-1.pdf
[3] Ibid.
[4] Ibid.
[5]
https://responsibleinvestment.org/wp-content/uploads/2022/03/From-Values-to-Riches-2022_RIAA.pdf
[6]
https://www.hub24.com.au/courses/esg-matters-how-to-start-the-conversation-with-your-clients/
[7]
https://responsibleinvestment.org/wp-content/uploads/2022/03/From-Values-to-Riches-2022_RIAA.pdf
[8]
https://www.cnbc.com/2022/07/01/elon-musk-is-a-smart-person-but-he-doesnt-understand-esg-tech-ceo.html
[9]
https://finance.yahoo.com/news/exec-hsbc-suspended-over-climate-173304739.html
[10]
https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/texas-bans-10-banks-348-investment-funds-over-fossil-fuel-policies-71842914
[11]
https://www.afr.com/companies/transport/tesla-has-no-3-selling-vehicle-in-australia-as-new-car-sales-jump-20221004-p5bn4m
[12]
https://www.xyadviser.com/responsible-reflections/13/

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