ESG Investments Join the Mainstream

Summary

More and more people are aligning their values with their investments. With Environmental, Social, and Governance investing, you can choose companies that also choose to focus on impacting positive change toward environment and social issues.

 

Your investments can have an impact for positive change

To many of us, it can feel like a lot is going wrong in the world. But there are ways you can be an active participant in spreading good – even when it comes to investing. One of the fastest growing segments in the investment world is Environmental, Social, and Governance (ESG) investing. At the end of 2019, nearly 500 investment funds had launched using ESG strategies.1

Investor demand, growing concern about climate change, and a positive track record for risk and return in the category have all contributed to this growth; the expectation is this trend will continue. Morningstar reported that for the first half of 2020, 56% of ESG funds outperformed their traditional investing counterparts and nearly $21 billion in new dollars was invested in funds with ESG criteria, roughly the same amount that was invested during all of 2019.1

 

When did ESG investing start?

To understand how ESG investing has grown in popularity, it’s helpful to understand where it started. In 1983, Professor Michael C. Jensen of Harvard University co-authored “Reflections on the Corporation as a Social Invention2 which advocated that a corporation’s only responsibility was to maximize shareholder value through short-term stock price increases. Corporations ferociously embraced this mindset and shareholder capitalism ruled the day.

However, decisions made to maximize short-term stock prices often came with negative and unintended consequences, and beginning in the early 2000s, advocates for stakeholder capitalism emerged. Rather than focusing strictly on maximizing short-term shareholder value, stakeholder capitalism focuses on maximizing long-term value for shareholders, management, employees, customers, supply chain partners, and the communities where a corporation operates. The rise of stakeholder capitalism was punctuated in August 2019 when 181 CEO members of the Business Roundtable issued a statement redefining the purpose of a corporation to benefit all stakeholders. Short-term profits still matter but there is now further emphasis on maximizing the long-term value for all these groups who have a stake in a company’s success.

 

How to measure ESG investment performance

So what is ESG investing? ESG investing—along with Socially Responsible Investing and impact investing — comprise a range of customizable investing strategies that seek to achieve a financial return while bringing about positive social or environmental change.

In short, ESG investing focuses on firms with high sustainability ratings relative to its peers. There’s value in knowing how a company is performing with respect to environmental, social, and governance issues, along with traditional financial measures. To that effect, ESG scorecards can help measure a company’s current and future performance, and any risks or exposures a company may have to changes in the business environment. While reporting is mandatory for companies in the European Union (EU) and other parts of the world, it is optional in North America. And yet by 2018, over 86% of the S&P 500 companies had begun providing annual impact statements reporting their ESG scores, in large part, due to investor demand.3 Let’s take a look at how each of these factors are measured.

Environmental factors. How does a corporation perform as a steward of the natural or physical environment? This includes both the direct effect of its operations as well as the indirect effects across its supply chains. ESG scorecards consider four broad environmental factors:

  • Greenhouse gas emissions
  • Water use
  • Waste and pollution, and
  • Land use and biodiversity

The ratings are based on how efficiently a company uses resources, how effectively the company minimizes its impact on them, and perhaps most importantly, how exposed the company is to changes in the availability or cost of natural resources. For example, if a company is 100% reliant on fossil fuels, it will score poorly in this category because of the great risk of reduced access to fossil fuels in the future. A company can improve its score by participating in activities that offset its carbon emissions, even if it heavily relies on fossil fuels. Purchasing carbon offsets, preserving forests, and using renewable energy are examples of activities that can be implemented to improve a company’s environmental score.

Social factors are those that arise between a company and the people or institutions outside of it. In this category, three broad factors are assessed:

  • Workforce requirements and composition (labor)
  • Safety and health risks, and
  • Impact of future demographic or consumer changes

Some typical questions used to assess a company’s social score include: Does a company take care of its employees? Does it pay a living wage and provide health care? Is the work environment safe? How diverse is the workforce? Does the company provide opportunities for career advancement? Social factors typically include not just the company’s operations, but those of its supply chain. A company that scores poorly in this category is at risk; numerous studies have shown strong linkage between profitability and a stable workforce.

Lastly, governance factors are those that pertain to decision-making – from policymaking to the distribution of rights and responsibilities among different participants, including the Board of Directors, managers, shareholders, and stakeholders. Four broad factors are used to evaluate a corporation’s governance policies:

  • Structure and oversight
  • Its code and values
  • Transparency, and
  • Cyber risk and systems

Poor governance can be costly, as Volkswagen Group learned in 2015 when it was discovered the company had programmed 11 million cars to cheat emissions tests. Gender diversity and gender equity are issues that impact a company’s governance score as well.

 

Using the ESG scorecard to further your investing values

One of the most powerful aspects of the ESG framework is how ESG scorecards can be used to compare companies within an industry as well as how a company could potentially improve over time. Walmart is an example of a company that has greatly improved its environmental scores in recent years. In 2017, for example, it launched Project Gigaton, a global effort in partnership with companies in its supply chain to cut one billion metric tons of carbon emissions out of their operations by 2030. More than 2,300 suppliers have committed to the effort, with suppliers reporting 136 million metric tons of avoided emissions.4 Its social and governance scores still lag those of its peers, yet it is improving each year.

You can find many investment opportunities that include ESG strategies. Typically, these portfolios will take an index (such as the Russell 1000) as a base and sort companies by sector. Within each sector, such as pharmaceuticals, energy, or technology, companies are ranked not only by their traditional quantitative techniques but by their ESG scores to determine expected financial risk and return. Companies with poor ESG scores, relative to their peers, are eliminated or screened out from the portfolio so only the best remain for each industry.

A 2019 study of mutual funds by the Morgan Stanley Institute for Sustainable Investing showed “no financial trade-off in the returns of sustainable funds, and they demonstrate lower downside risk.”5 Using ESG criteria alongside traditional financial analysis offers investors greater insight into a company’s true financial exposure to risk. All Mercer Advisors clients have access to ESG investing strategies. We build personalized and diversified portfolios for our clients using a series of 17 different negative screens. We also have a climate change portfolio and a series of other impact portfolios, including climate change, gender equity and diversity, and a few others. We encourage you to speak with an advisor about how you can use your dollars to support companies that are motivated to be competitive in their ESG scores.

 

For more information about ESG and Socially Responsive Investing, join our special SRI webinar on September 23rd. Register here.

 

Footnotes

1 Hale, Jon., “The Number of Funds Considering ESG Explodes in 2019,” Morningstar. https://www.morningstar.com/articles/973432/the-number-of-funds-considering-esg-explodes-in-2019

2 Jensen, Michael C., and William H. Meckling, “Reflections on the Corporation as a Social Invention.” In Controlling the Giant Corporation: A Symposium, edited by Robert Hessen. Rochester, NY: University of Rochester, Graduate School of Management, Center for Research in Government Policy and Business, 1982. (Reprinted in the Midland Corporate Finance Journal, Vol. 1, No. 3 (autumn 1983); reprinted in International Institute for Economic Research Reprint Paper 18 (November 1983).

3 “86% of S&P 500 Index Companies Publish Sustainability / Responsibility Reports in 2018,” sustainability-reports.com https://www.sustainability-reports.com/86-of-sp-500-index-companies-publish-sustainability-responsibility-reports-in-2018/#:~:text=In%202016%2C%2082%25%20signaled%20a,cap%20companies%20of%20sustainability%20reporting%3B&text=In%202017%2C%20the%20total%20rose,companies%20reporting%20on%20ESG%20performance%3B&text=And%20for%20year%202018%2C%20the,of%20S%26P%20500%20companies%20reporting

4 Walmart’s 2020 ESG Efforts: Making Important Progress Toward Positive Societal, Environmental Change, 8/26/20. https://corporate.walmart.com/newsroom/2020/08/26/walmarts-2020-esg-efforts-making-important-progress-toward-positive-societal-environmental-change

5 “Sustainable Reality – Analyzing Risk and Returns of Sustainable Funds,” Morgan Stanley Institute for Sustainable Investing, 2019. https://www.morganstanley.com/pub/content/dam/msdotcom/ideas/sustainable-investing-offers-financial-performance-lowered-risk/Sustainable_Reality_Analyzing_Risk_and_Returns_of_Sustainable_Funds.pdf

 

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