How to invest ethically on the AIM market

22nd October 2021 14:40

by Andrew Hore from interactive investor

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Investors are increasingly looking for ethical opportunities in small-cap stocks, and AIM has plenty of them. Our award-winning AIM writer looks at the issues and an ESG scorecard for smaller companies.

The topic of environmental, social and governance (ESG) information and reporting has gained significant momentum in the past few years, and this year investors are even more engaged, demanding greater disclosure and basing their investment decisions on the information provided.

The main driver of ESG was previously government and industry regulation, but investor enthusiasm means it is being taken increasingly seriously, particularly by fund managers.

Fund manager Impax Asset Management (LSE:IPX) has shown that fund managers can prosper by offering sustainable investment funds to investors.

And it’s clear that demand for ESG-focused investment is growing. The London Stock Exchange says more than 50% of all exchange-traded fund (ETF) listings so far this year have been ESG funds. There have been 68 ESG ETF’s, up from 37 at the same time last year. That takes the total number of ESG ETFs on the London Stock Exchange to 231, providing plenty of choice for investors.

Global inflows to ESG-focused funds doubled to $36.7 billion in 2020 and that momentum has continued. The marketing of funds to investors is making the ESG criteria a key selling point.

In the UK, over a two-year period, assets under management in UK shares has risen by 13%, while assets under management in responsible investments increased by 225%, with accelerated growth from the end of 2020 onwards.

According to a survey by private equity firm Foresight, more than 80% of independent financial advisers (IFAs) believe that ESG considerations are important. More than 50% of their clients express a preference for ESG investments, up from 9% in 2020. However, 49% of the IFAs say that the biggest challenge when advising their clients is that the lack of an industry-wide definition of ESG investing makes it difficult to advise clients. They believe additional education would help.

ESG elements

ESG has also been known as impact investing and sustainable investing. It measures the sustainability of an investment over the three categories of environmental, social and governance. Individual investors can place higher relevance on specific aspects of ESG or take an overall view.

The environmental part of ESG is the most obvious and topical, covering use of global resources and emission levels. Other elements are the management of waste, biodiversity, such as overexploitation and the destruction of habitats, and conservation of water resources. This makes fossil fuel investments much less attractive because of their effect on CO2 emissions, while greener technologies like development of hydrogen fuel cells can score more highly.

The social element covers things such as diversity of employees and directors, human rights, animal welfare and consumer rights. The social aspect has gained greater attention since Covid-19 became a concern because it brought a focus on how employees are treated.

The governance part relates to the corporate governance of the company. This includes management of the business, directors pay and employee relations.

Lack of understanding

Companies are still learning how to react to ESG requirements and what is expected from them by investors. At the end of last year, a Quoted Companies Alliance (QCA) and Downing sponsored publication called ‘ESG in small and mid-sized quoted companies: perceptions, myths and realities’ was compiled by Henley Business School. The report was based on 30 in-depth interviews plus survey responses from 50 investors and 100 companies.

There appeared to be a lack of in-depth understanding of what ESG entails, and smaller companies tend to be less knowledgeable about the reporting. In smaller companies it was more likely to be the finance director that is accountable for ESG, whereas the chief executive of larger companies is likely to be more involved.

This study is a year old, but at that time investors’ views were that companies were taking too much of a short-term approach to the impact of ESG.

A more recent survey of UK smaller company funds by broker finnCap in its publication “A finger on the ESG pulse” suggests that all funds are assessing ESG factors in their investment process, compared with two-thirds in 2020. Governance is still the greatest focus, though, followed by the other two factors. The environmental component was the least important the previous year, but it is now on a par with social.

Risk management is the predominant reason for the increased focus on ESG, but investor pressure, which was not a factor the year before, has become important as they seek more sustainable investments. Last year, helping to drive returns was the major factor, but this year it is on a par with investor pressure.

Equiniti’s EQ Shareholder Voice survey found that 82% of UK and US shareholders believe that it is the responsibility of companies to provide relevant information about ESG, but 43% believe that they are not doing this well enough. One-third of the investors say that they suffer “intense frustration” when a company does something they believe is unethical.

Some companies say that they are doing ethical things, but even if it looks that way, they could effectively be having no positive impact, or even having a detrimental effect.

An ESG scorecard for smaller companies

finnCap has three key recommendations to smaller companies so that they can cope with the greater scrutiny of ESG by investors. The first is to obtain the important environmental information on energy use, CO2 emissions, waste and water usage and use this to help to develop a strategy to move to net zero.

The second is to prepare and apply the most important policies, while the third is to continue to try to achieve greater diversity in the company, as well as the boardroom.

finncap has developed its own ESG scorecard for smaller companies which has five data-points for each of the three areas of ESG. These are generally things that can be quantified, such as energy consumption and CO2 production for environmental, employee turnover and percentage of profit paid in corporation tax for social, and representation of women on the board and chief executive pay as a multiple of UK median pay for governance.

The broker has collected the data for around 100 companies. However, it does admit that it found it difficult to collect some of the data, and it is impossible for individual investors to come up with a score for a company themselves.

The financial sector had the best ranking in terms of the environmental factors, with technology and industrials the worst. Financials have low consumption of energy, but then their likely use of the internet could lead to significant energy consumption at data centres. That shows how difficult it can be to assess these things.

Industrials come out well on the social data-points with life sciences the poorest rated sector. That is partly because of tax. Life sciences companies are generally loss-making and pouring money into development, so they receive R&D tax credits. This lack of tax payments marks them down. It also means that alternative energy companies developing new technologies would also perform poorly on this form of assessment.

On the governance side, life sciences comes top. This is the one area that all fund managers focus on, and all the sectors do relatively well, although the energy sector comes out worst.

There are four sectors with scores across the three aspects of ESG because the others do not have the data available to assess them properly. Of these, industrials is top, which is the same as last year. Despite its strong environmental rating, the financials sector has the worst overall rating, due to its poor governance. Technology had the worst rating the previous year.

The finnCap survey shows an increasing focus on the environmental and social factors, in particular. Fund managers focusing on environmental factors have increased from 14% to 60%. Next time, as COP26 gets nearer, I will focus on the environmental aspect, including the establishment of the Taskforce for Climate Disclosure (TCFD), and companies that have strong environmental credentials.

Andrew Hore is a freelance contributor and not a direct employee of interactive investor.

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