How I might go about identifying UK ESG stocks for a sustainable investing portfolio

According to data from Morningstar, funds with an environmental, social, and governance (ESG) theme had a record €1.1trn invested in them by the end of December 2020. Hundreds of new ESG funds have been launched to satisfy the growing appetite for sustainable investing. The coronavirus pandemic crashed stock markets, shut economies, destroyed businesses, and, of course, lives. The clear and present danger of the virus has, I believe, made less tangible threats, like climate change, easier to appreciate. Sustainable investing, it would seem, has finally gone mainstream.

Sustainable returns

Data from Morningstar suggests that sustainable investors are not giving up returns, as the majority of the 745 European ESG stock funds studied outperformed non-ESG funds over multiple time frames. So, it seems ESG factors could be drivers of performance rather than nice things to have in a portfolio.

A company that is not energy-intensive, minimises waste, hires the best talent regardless of background, and is run by a competent board would have decent ESG credentials. Assuming the business model is sound and profitable (a high ESG score alone does not make a good investment), many investors might be interested, regardless of their sustainability stance. 

However, it is difficult to build a framework for scoring companies on their ESG strengths and weaknesses. Most companies divulge water and energy use, which could help define an environmental score, at least partway. Some businesses seem obviously at odds with the environment. There are accepted principles of corporate governance, and checking adherence to these could help with the ‘G’ part of ESG, but it’s a lot of work. Assessing a companies social performance is even more of a struggle. So, I asked myself: is there a simpler way to find potential ESG stocks? I think there is.

Finding ESG stocks

I used the Morningstar fundscreener to build a list of UK funds that are rated highly on performance and sustainability measures, using the following criteria:

• Morningstar sustainability rating 4 or 5
• Morningstar rating 3, 4, or 5 stars
• Bronze silver or gold Morningstar analyst rating

I ended up with 10 funds and made a note of the top five holdings in each of them. Some stocks appeared more than once in the top five holdings, and it would be logical to assume these might be ESG stocks. A table of these stocks and their sectors is presented below. 

At first glance, there is a lack of what I would think of as obvious ESG stock candidates. Furthermore, Shell and Rio Tinto are perhaps anathemas to a sustainable investor. However, like other oil majors, Shell is talking of a transition to a greener future. In addition to coal, Rio Tinto also mines copper, a key component for sustainable technologies.

One important thing this exercise has revealed is my bias for the “E” part of ESG. These stocks are not the wind turbine makers or equivalent that I had in mind when I started. But, sustainability is measured holistically across the environmental, social, and governance factors. This list does give me a manageable starting point for further analysis.