An Introduction to Environmental, Social, and Governance (ESG) Considerations in Investing
Introduction
Environmental, Social, and Governance (ESG) investing has grown dramatically in popularity and the investment industry expects this trend to continue. According to a 2018 US SIF report, sustainable investments now account for approximately one quarter of all assets under professional management in the U.S.
What was once a niche market has now become a mainstream industry, largely driven by the demand of younger generations, who now make up the largest share of the workforce. This is not just a shift in occupational demographics, but also a cultural one, as surveys have consistently shown that millennials are more ethnically diverse, socially aware, and loyal to companies that care about their effect on society.[i] According to a 2016 Natixis Global Asset Management survey of employees participating in defined contribution plans, 74% of respondents indicated that they were interested in more socially responsible investments in their retirement plan.[ii] And as interest increases, so too has efforts at regulation. The Department of Labor (DOL) recently published a new proposed rule that would materially impact the ability to select investments based on ESG factors, asserting that “ESG investing raises heightened concerns under ERISA.”[iii]
With the increased interest and recent regulatory developments around ESG, it is crucial that Plan Sponsors are equipped with information and guidance in this fast-evolving field. This article aims to provide an overview of ESG factors, their history, and why it is important to be aware of these factors when managing your plan.
What is ESG?
ESG stands for Environmental, Social, and Governance and is also known as “sustainable investing.” ESG sets forth criteria that measure the sustainability and social impact of an investment in a company or business. ESG factors are used by investors to evaluate investable firms in the broad markets around the world.
The main categories of factors organized under each of the key ESG headings are shown in the images below.
ESG evolved from what is known as Socially Responsible Investing (SRI). The SRI-movement started among activist investors and was aimed at addressing capitalism’s responsibilities beyond maximizing shareholder value. The belief among its proponents was that money invested in countries or companies doing material harm fostered negative impacts for everyone, not just those immediately affected by those organizations’ damaging actions.[iv] Workers’ rights, environmental responsibility, transparency, and advancing the interests of all socio-economic groups were important considerations to add to the factors investment managers were supposed to consider. Few could argue with the goals of the movement, but many disagreed on how to define and measure them.
SRI grew further in prominence during the late 1990s. During this period of excessive speculation, shares of Technology, Media, and Telecommunications firms (e.g., Microsoft, Cisco, and Intel) reached stratospheric valuations and came to represent a significant portion of the overall market capitalization in US-based equity markets. Shortly after the beginning of the millennium, the Tech Bubble burst and sent stock prices crashing. This event led to a considerable questioning of SRI investing, as it had been highly concentrated in these technology-based equities.
With that backdrop, the ESG movement has become a quiet but steadily growing force in markets over the past 20 years.[v] ESG is distinguished from SRI by an approach which draws on established analytical tools in finance which allow investors to assess the sustainability of company business models. Over the past several decades, thousands of studies have been published examining the link between ESG and corporate financial performance, concluding that there is a positive correlation between ESG strategies and strong financial results.[vi] It turns out that ESG is good for company performance, wholly separate from any moral or ethical considerations.[vii] For many businesses it makes sense to waste less, act responsibly toward employees, vendors and customers, and to utilize sound and transparent corporate governance approaches. More and more the research is indicating that companies doing “good” in terms of ESG factors are prospering, while those that score less well are languishing.[viii]
An Evolving Perspective
ESG investment managers analyze firms across all industry groups, applying relevant metrics of ESG scoring to each company. In other words, ESG permits investors to compare firms using a set of recognized barometers that can be developed and varied by industry. This analysis was something SRI investing was never adequately able to do, as it tended to screen out whole groups considered “bad” for the environment, public health, or for involvement with despotic regimes around the world.
An example of the older SRI thinking was the investment boycotts of South Africa during the latter stages of the apartheid era[ix]. The idea was that if a firm wanted to be considered “just” or “good,” it had to divest its holdings in South Africa or avoid making investments there in the first place. While apartheid was abhorrent, the efficacy of investing in companies that did business in or with South Africa was open to debate. Some argued that engagement was a better way to encourage good societal behavior as opposed to isolation. Since opinions and attitudes about such important considerations can differ, it was often difficult for plan fiduciaries to assess the best way to proceed. Similar threads focusing on whether countries are well governed continue to impact investment decisions for institutions and practitioners to this day.
Unlike much of SRI methods, ESG scoring is quantifiable. Governance at the corporate level involves transparent practices and avoidance of corrupt conduct. For example, the payment of bribes for access or the strangling of competition through market manipulation earn a lower score from the ESG reviewers. While market participants may differ in their opinion of societal governance practices around the world, the means to analyze company practices for sustainability is considerably more quantitative and open to evaluation through statistical analysis. Politics and morals, while important, can be left on the side lines, as the effectiveness of corporate governance is evaluated and ranked in financial terms. Many argue that this gets to the same destination, namely a better world, but in a way that is far more open to practical and unbiased testing and analysis.
The Spectrum of Ethical Investing Approaches
The following chart summarizes the context for ethical investing methods. It walks through the evolutionary stages from traditional investing in a risk-adjusted methodology through progressive steps to impact based investing. The key current development is that the measurement instruments have changed from something nebulous and prone to personal perspective and bias, to more objective and data centric methodologies.
In the chart, we can see how mission-type investing started as sorting through companies that were “good” and “bad” and attempted to screen out the latter. The trouble, of course, is one person’s “good” may be another person’s “bad” or at least “not so good.” As with all moral judgements, it is hard to put a number on them. This is where ranking comes in.
By taking firms in every industry group and ranking them numerically according to how they measure up on the axes of sustainability (environmental, social/societal, governance), an investment analyst can begin to make sense of investment opportunities across all industries. By applying broad definitions of these sustainability factors drawn from across the investable universe throughout the world, a truly global spectrum of ESG ranked firms can be identified and tracked.
This is not to say that judgement does not enter the picture. Practitioners need to be wary of too narrow a screening process or the results will end up a mish mash of useless tools and substandard outcomes. Standards of scoring need to be developed, vetted, and ultimately certified so that companies, as well as benchmarks, can be objectively understood and used with confidence.
This is where the investment consulting community can play an important role. Identifying and testing benchmark construction methods will aid in the development of industry standards. Just as computing and internet service provider industry groups needed to arrive at common standards and definitions (MS-DOS, iOS, BlueTooth, HTML), financial practitioners will need to agree on appropriate benchmark tools to assist in the measurement of sustainable businesses and their practices. Much of the early work in ESG financial measuring tools is already done. A number of benchmark indices have been deployed, each with its own pedigree and adherents. The table that follows offers a summary of the most prevalent.
The Current Environment and the Path Forward
While ESG has been gradually growing in reach and influence since its inception, the curve has markedly steepened as of late. Beginning in March 2020, the trajectory has gone nearly vertical.[x] ESG is yet another societal trend that COVID-19 has acted as a catalyst to accelerate, with assets in ESG ETF funds alone doubling to $80 billion over the past year and the “broadly defined” ESG market expected to grow to $45 trillion by the end of 2020.[xi] This movement has garnered the attention of both the financial industry and financial regulators.
An old industry adage goes “some financial firms sell what they make, while others make what sells.” In the context of ESG investing, the term “green washing” refers to the practice of applying an ESG label to an investment product regardless of its accuracy or appropriateness.[xii] While truth in advertising rules apply to the financial world, many marketing-oriented strategies shade the edges of rule-based protocols. Investors will need to be methodical and duly cautious in evaluating and selecting ESG-oriented products.
The regulators are characterized by either having nothing of material impact to say about ESG (e.g., the IRS) or having a more skeptical stance. An example of the latter is the rule recently proposed by the Department of Labor (DOL)[xiii]. In an effort to give plan fiduciaries guidance, the DOL proposed a rule that specifically excludes the selection of investments for ERISA-covered plans using criteria other than investment efficacy (i.e., does it make sense in purely ‘profit vs loss’ or ‘risk vs reward’ terms?). According to this position, mission investing is to be avoided and any investment selected using criteria other than appropriateness with respect to traditional risk and reward metrics will not be defensible. In the eyes of DOL examiners, if or when a plan committee is challenged on its manager or investment product selection methods, mission investing will not be an among the acceptable criteria on which to base a reasoned defense. While a nod is given to the potential inclusion of ESG factors that contribute to the pecuniary[xiv] characteristics of an investment, the message is clear. Plan fiduciaries need to proceed with caution when applying mission-investing criteria to the plan stewardship process. In the view of more than a few market participants, this is an example of the DOL fighting the last war against methods used under SRI conventions rather than the more relevant practices used in the ESG-focused sustainability.[xv]
How We Can Help
We at NWCM are actively engaged in identifying and evaluating investment management firms that focus on sustainable business practices when constructing their investment portfolio products. We are not alone in this mission, as a number of investment management firms have been investing with sustainable business practices in mind, some for decades. The products offered by these firms are being vetted using new scoring and ranking methods. In this way, we are preparing to respond to a growing interest in ESG amongst plan client employees and our private/individual clients. We are proceeding with due care concerning this research, not least due to the pitfall of green washing mentioned earlier.
We are committed to providing investment options and opportunities to all of our clients that are consistent with their investment interests, financial objectives, and risk tolerance. This applies to ESG as much as any other investment criteria. Feel free to reach out to our community of financial advisors to find out what we are learning each day as we walk the ESG investment path together.
[i] Seelan, J. (2019). Sustainable Investing: The Millennial Investor. Investments & Wealth Monitor. Retrieved from https://investmentsandwealth.org/getattachment/bbdef004-2fe8-4e71-a445-918a270b5ff7/IWM19MarAprTheMillennialInvestor.pdf
[ii] Natixis Investment Managers (2016, August). Survey of US Defined Contribution Plan Participants. Conducted by CoreData Research.
[iii] Groom Law Group (2020, June 25). DOL Proposes Rule to Crack Down on ESG. Groom Benefits Brief. Retrieved from https://www.groom.com/resources/dol-proposes-rule-to-crack-down-on-esg/
[iv] Townsend, B. (2017). From SRI to ESG: The Origins of Socially Responsible and Sustainable Investing. Retrieved from https://www.bailard.com/wp-content/ uploads/2017/06/Socially-Responsible-Investing-History-Bailard-White-Paper-FNL.pdf
[v] US SIF Foundation (2018, October 31). Report on US Sustainable and Impact Investing Trends.
[vi] Deutsche Asset & Wealth Management (2015). ESG & Corporate Financial Performance: Mapping the global landscape. Retrieved from https://qtxasset.com/cfoinnovation/field/field_p_files/white_paper/Deutsche-AWM-ESG_and_corporate_financial_performance_mapping_global_landscape.pdf
[vii] Oberoi, R., &; Cano, G. (2020, April 6). Quantifying ESG fund performance. Retrieved from https://www.msci.com/www/blog-posts/quantifying-esg-fund/01760099215
[viii] Nagy, Z., Kassam, A., &; Lee, L. (2015). Can ESG Add Alpha? An Analysis of ESG Tilt and Momentum Strategies. MSCI ESG Research Inc.
[ix] Apartheid, as defined by the Merriam-Webster dictionary, was a policy of segregation and political and economic discrimination against non-European groups in the Republic of South Africa. Apartheid. (n.d.). In Merriam-Webster’s online dictionary. Retrieved from http://www.m-w.com/dictionary/apartheid
[x] Hale, J. (2020, July 30). Sustainable Funds Continue to Rake in Assets During the Second Quarter. Retrieved from https://www.morningstar.com/articles/994219/sustainable-funds-continue-to-rake-in-assets-during-the-second-quarter
[xi] Hecker, J., & Dubourg, H. (2020, July 1). Why COVID-19 Could be a Major Turning Point for ESG Investing. Retrieved from https://www.jpmorgan.com/insights/research/covid-19-esg-investing
[xii] Bourlioufas, N. (2018, September 18). Beware greenwashing as ESG momentum builds. Retrieved from https://www.morningstar.com.au/funds/article/beware-greenwashing-as-esg-momentum-builds/170434
[xiii] Cho, E., Cole, J., Eller, J. et al., (2020, June 25). DOL Proposes Rule to Crack Down on ESG. Retrieved from https://www.groom.com/resources/dol-proposes-rule-to-crack-down-on-esg/
[xiv] Pecuniary, as defined by the Merriam-Webster dictionary, is something relating to or consisting of money. Pecuniary. (n.d.). In Merriam-Webster’s online dictionary. Retrieved from https://www.merriam-webster.com/dictionary/pecuniary
[xv] Smith Fay, A. (2020, September 24). The Latest on “ESG” Investing: Trends, Risks, & Best Practices [Webinar]. Northwest Capital Management. https://nwcm.com/retirement-plan-video-library/
