A Value-Based Approach to ESG Integration?
Interest in sustainable investing has surged around the world in recent years. In boardrooms, C-suite offices and policy conferences, the stakeholder has overtaken the shareholder as the primary focus of discussion.This is an excellent comment which argues for a certain kind of value-based approach to ESG integration, one driven solely by the goal of better investing (ie. return maximization).
Across the business world, conversation about sustainable investing still tends to center on new products, from green bonds to impact private equity funds, with less attention paid to the process and return enhancements that can be achieved by incorporating sustainable insights into traditional investment processes — particularly by integrating environmental, social, and governance considerations.
Done well, improving existing investment processes though the integration of ESG can mitigate portfolio risks and unlock long-term opportunities. In other words, it is about what all investors should strive for: enhancement of return and/or mitigation of risk.
Even so, despite pronouncements from senior leaders, skepticism still abounds among those whose buy-in is critical for ESG integration to succeed: The portfolio managers and investment professionals responsible for capital allocation decisions who are on the front line of this process and need to develop tools, data and analysis to better assess these factors. It is as critical as financial ratio analysis.
What the skeptics miss is the primary reason for investors to integrate ESG into their portfolios: such integration correlates with improved long-term performance. Simply put, in the long run, values and value converge.
The prevailing, values-based view identifies three main reasons why an asset manager might focus on integrating ESG insights into their investment processes. The first is for reputation, marketing and public relations: especially since the global financial crisis, the financial services industry has sought to communicate how it can provide value to society.
A second motivation is to address growing client demand for ESG-conscious investment processes — a desire to deliver what the market wants. A third reason is to preempt growing regulation of how investors incorporate ESG considerations. While the U.S. still lags other jurisdictions on this front, the overall direction of travel is clear.
But all three of these motivations miss the most powerful argument for integration — the potential to improve their portfolios' risk-adjusted returns. By underweighting that primary goal and focusing solely on one or all of the above commercial motives, managers are more likely to integrate ESG in a way that does not improve returns and can even cause performance drag.
Many skeptics' concerns arise mainly because asset managers conflate two distinct approaches to sustainable investing: A historical one that starts from personal values and a newer approach based solely on investment value. The former, a historical values-based approach, sets out from a client's moral and ethical viewpoints, screening out objectionable investments. However, this approach theoretically narrows the investment universe and can create longer-term performance drag.
Unlike a values-based approach, an investment value-based approach starts from material ESG insights (say, that an issuer's rising carbon emissions intensity is a predictor of equity underperformance) and then integrates these ESG-informed insights into security selection (i.e., underweighting issuers with rising emissions intensity).
Unlike the other motivations for ESG integration, the value-based approach actually leads to better investment decisions and is far less likely to have unintended consequences. For instance, it would reward companies that take material steps to improve their ESG performance and therefore provides incentive for change (such as encouraging oil majors to invest in a transition to renewable energy), whereas screening just leaves poor performers to continue to be owned and controlled by investors that are disinterested in negative ESG impacts.
Whereas a values-based approach to ESG integration may seek to manage negative "externalities" that firms cause for society (such as pollution), an investment value-based approach only considers those externalities that society is likely to "internalize" to the firms (say, with a pollution tax) — and thus affect long-term financial performance. A value-based approach does not look at all ESG issues for all companies, but rather adapts based on sector (environmental issues are more material to the financial performance for energy companies, whereas social and governance issues dominate for tech firms).
The kind of value-based approach to ESG integration that we advocate is driven solely by the goal of better investing. It is thus fully compatible with even the narrowest definition of fiduciary duty (i.e., return maximization).
This value-based advantage is particularly relevant for traditional fundamental and private investments strategies. As we have seen, it is increasingly difficult to outperform benchmarks in traditional active equities by using only financial data, which is fully transparent and immediately priced into markets.
If investors start to incorporate a value-based approach to sustainable investing, they can take advantage of less obvious insights related to sustainability and ESG factors. While difficult, understanding information that is still not well documented, less standardized, hard to quantify, but increasing in investment materiality is precisely where there is an opportunity to outperform — which is exactly what clients pay active managers to do.
So, while it is encouraging to hear themes of sustainability and responsibility echoing in the halls of Davos, many are still approaching them from the wrong angle. A longer-term and investment-led approach to sustainability will see a better outcome where value and values truly converge. Simply put, a true value-based approach is more likely to achieve the values outcome that many are trying to achieve.
For ESG integration to grow across the asset management industry, we need a clearer narrative for what it is and how it can drive outperformance that is not linked to reputation, client demand, regulation, or any other commercial imperative besides simple long-term risk-and-return-based capital allocation decisions — and the opportunity to use additional data and insights to improve long-term investment returns across a portfolio.
Mark Wiseman, is former senior managing director at BlackRock Inc. and former CEO of the Canada Pension Plan Investment Board, based in New York and Toronto. Tariq Fancy, based in Toronto, is special adviser to the president at Ryerson University and former chief investment officer of sustainable investing at BlackRock. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.
Last week, I discussed the sustainable capitalism wake-up call and agreed with those who think we need to start taking ESG and sustainable capitalism more seriously in light of this pandemic.
The comment above written by two experts doesn't focus on sustainable capitalism or the coronavirus, it just states that taking the right value-based approach to ESG integration will lead to better long-term returns.
The authors state: "A longer-term and investment-led approach to sustainability will see a better outcome where value and values truly converge. Simply put, a true value-based approach is more likely to achieve the values outcome that many are trying to achieve."
In other words, it's not a dichotomy, approached the right way, ESG will lead to more sustainability and better returns over the long run.
Here's something else to think about. Susan Murphy of GreenBiz reports that amid plunging stock prices, ESG leaders are holding their own:
If there’s anything the novel coronavirus pandemic has shown us, it’s how deeply interconnected so many of our basic survival systems are. This comes as no surprise to investors who incorporate environmental, social and governance (ESG) analysis into their strategies. In expert hands, an ESG investment lens teases out all sorts of risks that aren’t necessarily apparent in conventional financial analysis.There's a lot to think about and even though I don't agree with everything in this article, I agree with a lot and her conclusion.
It’s not just theoretical: Amid plunging stock markets, ESG investments have fared better than the overall market. During March, 62 percent of ESG-focused large-cap equity funds outperformed that index, according to Morningstar.
So far this year, 59 percent of U.S. exchange-traded funds focused on ESG performance are beating the S&P 500 Index, according to Bloomberg Intelligence. That outperformance could spur further demand for ESG funds — an area already attracting growing investment before the pandemic hit.
What might be behind this? One of the fundamental aspects of fully integrated ESG analysis is a recognition that most issues that affect the business world (and the world in general) are interrelated and cannot be evaluated in isolation. This truth rises in stark relief as infections spread exponentially across the globe and basic economic systems falter under increasingly stringent containment measures.
Supply chain clarity
Global supply chains present an excellent example. ESG investors regularly focus on supply-chain transparency as they consider how companies manage human rights abuses in commodity mining and environmental damage associated with deforestation and overfishing, among other concerns. These challenges often occur many steps up a supply chain, and when companies struggle to address them, it’s often because they simply don’t know much about where their raw materials really come from and who provided them.
In a similar vein, as this pandemic started to disrupt supply lines from China as its authorities began to shut down economic activity, many companies were caught by surprise when their own products or services were affected.
According to Jennifer Bisceglie, CEO of risk management platform Interos, most companies never really have thought about their supply-chain risk, and even those that do often go only as far as their direct suppliers. Few understand or consider the complex web of interactions that must occur in order for those direct suppliers to fulfill their commitments.
Harvard Business Review (HBR) recently echoed this sentiment, noting how critical it is for companies to know their suppliers. While the scale of this pandemic is unprecedented, it is far from the first occurrence of supply-chain shocks. The HBR reminds us, "After the 2011 Sendai earthquake in Japan, it took weeks for many companies to understand their exposure to the disaster because they were unfamiliar with upstream suppliers. At that point, any available capacity was gone."
ESG questions, data-driven answers
Jeff Meli, global head of research at Barclays, said companies should expect more questions from investors about their resilience and contingency planning, according to a recent Wall Street Journal article. For example, investors necessarily will want to know more about employee sick leave policies, disaster preparedness and the like.
Such questions come at a time when innovations in artificial intelligence (AI) and machine learning allow third parties to provide data-driven intelligence on companies that well could contradict their public reporting.
For instance, AI-powered data providers are capable of scouring social media posts around the world to see how companies’ employees are talking about their company’s response to the pandemic, allowing investors to determine how well the results stack up against company disclosures. As one financial analyst (who asked that their name be withheld) told GreenBiz: "The data will pick up the hypocrisy."
Truvalue Labs, which uses AI to uncover timely ESG data on a variety of asset classes, already has identified the emergence of material issues that are specific to COVID-19, including employee health and safety, labor practices and supply-chain management.
Outperformance factors
Many observers believe that strong ESG performance indicates better management, which translates into stronger long-term returns. The idea is that management teams that do a good job of minimizing their environmental footprint, promoting good employee relations and creating resilient governance structures are more likely to be adept at running all other aspects of a company’s business.
“ESG funds tend to be biased towards higher-quality companies with a stronger balance sheet, companies that are run better and operate more efficiently,” Hortense Bioy, director of passive strategies and sustainability research at Morningstar, told the Financial Times.
An additional, complementary explanation has emerged recently. Adrian Lowcock, head of personal investing at Willis Owen, explained that funds with strict ESG selection criteria are the ones that have held up the best because they tend either to be under-invested in oil and gas or to exclude the sector entirely.
Indeed, sustainable investors have long been concerned about climate change and the prospect that fossil-fuel companies will lose value as the world eventually makes a concerted effort to address it. Oil and gas companies have been among the worst hit in the current downturn for a variety of reasons, not least because many of them are overleveraged and drowning in debt. But that, too, is connected to sustainability and climate considerations, and the whole point of deep ESG analysis is to understand the complex ecosystems within which companies operate.
Many investors have questioned how much climate change truly will present a material investment consideration anytime soon, given many world leaders’ reluctance to tackle the risk at a regulatory level. Here too, the current pandemic ultimately may prove to be a game-changer. Mark McDivitt, global head of ESG at State Street, told GreenBiz:
The United States plan to spend $2 trillion, or 10 percent of GDP, for economic stimulus has been critical to addressing this acute Black Swan event as it relates to the negative impact on our economy. What’s equally imperative but less obvious is the need to spend $2.4 trillion per year globally over the next decade to keep temperatures from rising 1.5 degrees C above pre-industrial levels — also a Black Swan event but on a "slow burn," and with a demonstrably greater adverse impact than the fallout from COVID-19.Science — which does not concern itself with political expediency — points to an ever-growing risk that climate change fallout will be at least as disruptive to society as the current pandemic, the more so the longer the world drags its feet on the sort of massive structural adjustment the Intergovernmental Panel on Climate Change says we need to make.
Some traditional investors have framed their resistance to ESG investing in terms of fiduciary duty, arguing that they are charged strictly with maximizing returns, not with pursuing environmental and social aims. Perhaps this pandemic will highlight the fact that ESG analysis, as McDivitt noted, is really just about evaluating 21st-century risks and opportunities.
If this pandemic demonstrates anything, it’s the need to pivot and begin addressing these long-term sustainability factors. Investment strategies that fully integrate ESG analysis surely will benefit.
Below, Kara Mangone, Chief Operating Officer of Goldman Sachs’ Sustainable Finance Group, discusses how the global pandemic is impacting the way corporations and investors approach ESG.
And Mark Wiseman, former CEO of CPPIB and former investment executive at BlackRock tells investors to "stay the course", with ability to re-balance their portfolio. He also offers his economic outlook, and thoughts on the growing importance of "resiliency in supply chains". Click here if it doesn't load below.
Mark provides sound advice to investors but I remain very cautious on the economy and markets and think the world will change irrevocably once we get through this pandemic (follow me on Twitter here).
Lastly, Mark Wiseman posted this on LinkedIn:
So, keep in mind on Thursday, April 16 at 12:00 pm, he will be moderating a virtual discussion with the Canadian Club Toronto featuring Blake Hutcheson, Jane Rowe and Kevin Uebelein.You can register for free here.It should be a great discussion.
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