Whether you’re an impact investor, or you invest for sustainability or ethics—it all starts with ESG investing.
Amid the alphabet soup of sustainable investing options: responsible, ethical, impact etc. ESG investing is the common thread, all of these approaches involve some form of ESG analysis. That is, they consider Environmental, Social and Governance (ESG) factors in their investment decision making.
This is Part 3 of the Future of Investing series, stay tuned.
ESG is a baseline for the new world of finance, and while some ESG strategies may not be as ‘green’ as advocates may hope, it’s a vital starting point that’s changing the face of finance.
1. This is a movement
Investors are a pragmatic bunch. They want strong returns with as little risk as possible, and this is a big part of the reason the ESG movement is booming.
It’s been a long road, and an early turning point was the launch of the UN Global Compact (UNGC) in 2000. It brought together some of the world’s largest corporations, to formalise their Corporate Social Responsibility promises; it began a new age of transparency.
And in 2005 a report from the UNGC brought this three-letter acronym, ESG, into the investment lexicon. The report was called “Who Cares Wins”, and it was a joint effort by leading CEO’s and investors (brought together by Secretary General Kofi Annan and the UNGC), and while its design may be looking rather dated today, its mission is still relevant;
“The institutions endorsing this report are convinced that in a more globalised, interconnected and competitive world the way that Environmental, Social and Corporate Governance issues are managed is part of companies’ overall management quality needed to compete successfully.”
It was a remarkable achievement, which flew in the face of the Milton-Friedman-era ideology of profit-above-all-else. Since then, there’s been no turning back.
It was closely followed by the introduction of the UN supported Principles for Responsible Investment (PRI) in 2006. The initial cohort was 63 investment companies with $6.5 trillion in AUM.
Fast-forward to 2018 and there’s now 1,715 signatories, managing a massive $81.7 trillion.
And in 2020, research from the Global Sustainable Investing Alliance showed there is a massive US$31 trillion of capital invested under ‘responsible investment’ standards across the world.
In Australia, RIAA suggests that 48% of funds are invested with some sort of responsible overlay. To reach a total of US$641 BILLION.
This is no longer a niche field, it’s the new-normal.
The Larry Fink effect
Larry Fink is the CEO of Blackrock, the world’s largest asset manager, and his annual letter has been making waves since 2018. In that year his letter was titled A Sense of Purpose, and it told companies they MUST operate with a purpose that benefits people and society, not just shareholders.
In 2019 the rhetoric didn’t retreat, it went deeper, to show that a sense of purpose drives profitability and growth.
And in 2020, the world of finance took notice. Larry Fink put ESG issues on par with financial issues in his letter, titled A Fundamental Reshaping of Finance; “Every government, company, and shareholder must confront climate change.”
Now of course this is just talk, and there’s plenty of criticism that Blackrock isn’t taking action proportional to Fink’s words. Analysis from Altiorem suggests Blackrock’s engagement team is only 45 people strong, responsible for voting on 17,000 annual meetings; it’s a huge task, and we must question how much influence they can have. But of course the asset manager has another 15,000 employees, all with the potential power to integrate an ESG lens across the entire business.
Either way, progress is being made, and it’s motivated by the pragmatism of a universal owner. Blackrock is the steward of $6 trillion of capital, they care about the long-term health of the environment, people, businesses and governments because they hold stakes in all of it.
Business Roundtable never makes changes, until they do
The momentum of this snowball further picked up pace in 2019 when the Business Roundtable (BRT) made a statement on behalf of 180 of the USA’s largest companies. The letter essentially updated their definition of a corporation, it declared that the purpose of a corporation is not just to serve shareholders, but “to create value for all our stakeholders”.
It may seem like a subtle, semantic shift, but the statement refutes the neo-liberal orthodoxy, that the free-market rules, and shareholder returns are all that matter. The statement formalised the view that ALL stakeholders matter.
If we dig a little deeper we find analysis by directors of the Harvard Law School Program on Corporate Governance, which surveyed signatories, found that “of the 48 companies that responded, only one said the decision was approved by the board of directors.”
Similarly, research from Aneesh Raghunandan and Shivaram Rajgopal suggests that the signatories of the BRT statement actually have poor ESG performance when compared to their peers.
As investors, we need to hold these business leaders accountable, and ensure talk turns into action.
Incumbents are taking notice
The market-cap of Tesla is now bigger than that of Toyota! (Noting of course that Tesla currently produces less that 1% of the number of cars). One explanation for this is that the market recognizes Tesla’s business model and technology will overtake its rivals in the long-run.
Sure, the share price could be vastly over-valued, but what’s certain is that Tesla has shaken-off the daggy image of cars like the Prius and other early EVs. Tesla has made the energy-transition sexy. And it’s making petrol-powered cars look very last-century.
And I’ll finish this section by noting that the gravity of these changes can be most clearly recognised in the forces that Australian industry groups, and the Trump Administration, are marshalling against the movement.
In May 2020, leaked documents showed what many of us had expected, that the Government’s National COVID Coordination Commission, Chaired by the director of a gas company, was advocating for a “gas-led manufacturing recovery”. It’s not surprising, but it is a poor approach to stimulating economic growth when renewables offer more jobs and cleaner energy than fossil fuels such as gas.
And in June 2020 the US Department of Labor drafted a new rule that would require pension fund managers to prove that they weren’t sacrificing financial returns for an ESG focus. As explained above, it’s a painfully short-sighted approach. It ignores the profit drivers that have led ESG funds to outperform amid the covid-crisis. Those being resilience, a focus on long-term risk, diverse boards and a sustainability mindset.
This inelegant attempt to unwind the progress of past decades should be ample evidence that the ESG movement is having an impact.
2. Analyse the whole company, not just the financials
ESG investors analyse the financials of a company as much as any other investor, but, they go a lot deeper. They also explore ‘non-financial-factors’, and while these can be generalised as being Environmental, Social and Governance factors, the term ‘non-financial’ is beginning to look decidedly clumsy.
In the end issues like; climate change, online privacy and board diversity will clearly have financial impacts. It’s just a question of your time horizon.
The days of assessing a company by only looking at yearly or interim-financial-results are long gone. By assessing a company on ESG factors, as well as standard financial metrics, an investor has a more complete picture of a company’s strengths and weaknesses.
A recent survey by EY suggests that 72% of investors conduct a “structured, methodical evaluation of non-financial disclosures”. Which is a big jump from 2018 when only 32% said they used a structured approach.
A company is guided by customers on one side, and investors on the other, and in 2020 neither group will accept environmental destruction or social exploitation.
The system isn’t perfect. Despite a growing suite of ESG measurement frameworks (GRI, TCFD, IR and SASB) companies either fail to disclose enough details, or they use their own systems of measurement and data capture, which makes it difficult for investors to compare companies on a like-for-like basis.
But, as the use of globally recognised standards becomes the norm, it will put pressure on companies to be more transparent, as investors will put a risk premium on those businesses not offering data in the prescribed format.
3. ESG is about risk, not ethics
ESG is a risk metric. In technical terms it has nothing to do with your politics, your religion or your ethical standpoint. But of course, not all ESG strategies are created equal.
It’s important to differentiate between the many tools that an ESG investor can deploy to build a more resilient portfolio, and support companies building a better future.
ESG is not necessarily a positive or negative filter
‘ESG Integration’ is the most widely used approach (according to RIAA) with 45% of responsible investors adopting it.
ESG integration involves the systematic and explicit inclusion of material ESG factors into the investment decision-making process.
This is what most investors are referring to when they talk about ESG as a strategy. It simply means they consider issues beyond those found in quarterly or annual financial reports.
In some ways it’s hard to believe that there are investors that DON’T factor issues like climate-change impacts, board diversity or wage policy into their investment decisions. This goes to the heart of why ESG is a baseline for the new world of investing.
But at the same time, we must not fall into the trap of thinking ESG is panacea for the many problems with modern capital allocation. ESG is not accelerating action on climate change at anywhere near the pace that’s required.
This helps us understand that a fund using ESG integration is not the same as a ‘Sustainable’ or ‘Ethical’ investment approach, as discussed here.
ESG doesn’t mean an investor has positive filters to identify high impact companies, nor do they have negative filters to avoid ‘sin stocks’.
Funds define their approaches differently, and there’s no universal standards for an ESG Policy. The buyer must beware, there is no assurance that an ESG fund is having a positive environmental or social impact.
Engagement and activism
With ESG integration as a baseline, the process of ‘engagement’ is the next step in an investor’s journey towards reducing risk, and building more resilient economies.
While a standalone ESG approach tends to be passive, an engagement approach pushes an investor to try and directly influence a company’s operations.
Engagement could entail filing shareholder proposals, proxy voting, or organising one-on-one meetings with company executives to discuss key concerns.
It can also be referred to as ‘Active Ownership’ or ‘Stewardship’, because it puts the onus back on the shareholder to recognise that ownership of company stock entails a certain level of responsibility for a company’s actions.
Climate Action 100+ is an organisation that brings together the interests of some of Australia’s largest super funds. They’re backed by large stock holdings and they use this power to amplify their voice on climate change issues with major polluters.
Other groups have moved beyond engagement to activism. There have been unlikely allies in the alignment of campaigns by ACCR, Market Forces and the Church of England. They’re engaging directly with companies, while also speaking loudly and proudly, about the concerns and risks they see in the operations of companies they’re invested in.
As investors, and consumers, we all have power to influence company behaviour.
Best of sector
Another approach is the ‘best-of-sector’ approach. This means a company will not necessarily be excluded simply due to its industry, it will be assessed on its merits.
This is why people often find, to their surprise, that their ‘ESG fund’ includes companies in industries like mining. While most miners score poorly on environmental factors, some will naturally perform better than others, and the company chosen was likely the best performers among its peers, in terms of E, S and G factors. The key here is that mining as a sector was not screened-out or excluded.
Ethics vs risk management and the fiduciary duty debate
Investment managers have a duty to invest their client’s money in the best interests of the client. And if you’ve made it this far through the article then you’ll have a good sense for the benefits that an ESG approach can have on a person’s investment portfolio.
Unfortunately, there remains an outdated view that an investment manager’s only duty is to maximise financial returns, and so to ignore environmental and social issues.
Of course, these two positions aren’t mutually exclusive. It’s most likely going to be in a client’s best interest for their investment manager to consider climate risk, reputation and governance issues when making an allocation. These issues have proven themselves to be financial risks, with their severity only increasing as time-lines grow longer.
Fortunately, the rules have been amended, with many legal opinions and guidelines now recognising that including ESG factors in decision making is indeed consistent with a fiduciary duty, and in some cases they’ve stipulated that it’s a breach of fiduciary duty if a manager does not consider ESG factors.
4. ESG outperforms – in the long and short term
ESG investments have seen strong returns and a considerable evolution over the past decade. But, in the years leading up to 2020 there were suggestions that it was a fair-weather trend. And that people’s tendencies towards green-issues and community harmony were a luxury; that they would be forgotten in a downturn.
They were wrong.
In the first four months of 2020 the S&P500 ESG Index did better than the mainstream S&P index by 0.6%.
According to Morningstar, 39% of ESG funds in the US were in the top quartile for their broader category, in terms of performance.
Bloomberg has found that 88% of a global selection of ‘sustainable investment indices’ outperformed their mainstream peers.
We shouldn’t get carried away. As pragmatic investors, we must always approach these kinds of statistics with caution. Short-term results don’t tell us a great deal, and reversion to the mean often unwinds gains. So, it’s important to look into longer term results.
A study across 3, 5 and 10 year returns of European funds shows that ESG strategies outperformed their mainstream peers. Many ESG funds don’t have a track-record stretching back ten years, so it’s useful to look to the experience in Europe where ESG is more mature.
The myth of trade-offs
The myth is dead. There is no longer a trade-off between decent returns, and avoiding the exploitation of people and the environment.
It’s been a painfully persistent myth. In some ways it’s understandable, for a long time the sustainable approach has come at a cost. Polluting industries had a free ride, while the pioneers working to decarbonise their operations were forced to shoulder the financial burden.
There was a view (now outdated) that investments and environmental considerations should be kept separate. That any negative impacts could be dealt with through philanthropy and donations to good causes.
The landscape has changed, as many recognise it’s better to avoid the damage in the first place.
The cost of renewable energy is now below that of coal-fired power, regulations around carbon emissions are growing stronger, and digital disruption is exposing companies that are poor performers. Their customers are now voting with their wallets.
And while philanthropy will always have a vital role in helping those most in need, investors are now empowered to shun the companies doing damage in the first place. It’s a question of risk; it’s better to bet on the innovative companies; those that recognise that efficiency and resilience are the most important traits going forward.
5. ESG investing is just the beginning
On the mission to reboot finance, ESG is just a starting point. It’s certainly not sufficient to slow climate change, or drive social equality.
Change is never easy, and norms take a long time to bed-in. A consideration of issues beyond just the financial is only the first step.
Once ESG factors are understood, identified and integrated, then the real work can start. The work to engage with companies and influence them, to specifically target companies driving towards sustainability, and maybe even investing in ‘impact companies’ that are working to solve the world’s most wicked problems.
ESG is driving a mindset shift, and in turn, that’s moving markets.
Technology, data and a demand for transparency will shake the foundations of finance. The status-quo will not be tolerated, and as companies are forced to offer more information about their operations. So too investors will be expected to integrate it into their valuation models.
The millennial generation is set to inherit many billions of dollars in coming decades, and their allocations will be decidedly different to that of their parents.
This is an evolution, we’re at the vanguard of change, and we’ll need to become comfortable adapting to new terminology, new actors and new conceptions of the role of business.
An ESG overlay is only the first step in retrofitting our financial system for the coming century.
This is Part 03 of the ‘Future of Investing’ series.
Part 01 is here: What is Impact Investing?