Investment strategies tied to environmental, social and governance factors have gained broad appeal and new critics in recent years.
Current thinking about ESG tends to fall into two categories: (a) corporate policies and disclosures and (b) investment products. The corporate application of ESG often focuses on a subset of indicators such as a company’s carbon emission, product safety and board composition. The application of ESG in asset management focuses on investment products that employ various strategies to mirror an index (passive) or outperform the market (active management).
First coined by the United Nations in 2004, ESG has faced a barrage of detractors recently. At its inception, then-Secretary-General Kofi Annan posited that corporations could become better citizens and strengthen long-term prospects by increasing focus on environmental, social and governance factors. His assertion anticipated the current-day challenges that companies face and will likely need to address to remain competitive, often described as “stakeholder theory.”
The dissension surrounding ESG, however, has never been wider. Detractors and supporters of ESG often conflate several related but distinct concepts — an understandable mistake given the complexity and confusion of the sustainable capitalism field. Conflating ESG with investments driven by ethical or moral inclinations unintentionally highlights the most relevant source of disarray: the failure of the sustainable capitalism field to convey its taxonomy of principles and priorities in an understandable way that sticks in the minds of market participants. Understanding the sustainable investment taxonomy is a necessary precondition to critiquing its strengths and weaknesses.
The unchecked misinterpretation of terms imprecisely paints ESG as a punitive response to perceived ethical lapses by companies or as an exclusionary (screening) tool.
Consequently, the unchecked misinterpretation of terms imprecisely paints ESG as a punitive response to perceived ethical lapses by companies or as an exclusionary (screening) tool. Consider, for example, socially responsible investment (SRI) strategies, which seek to avoid companies that generate revenue from arguably objectionable sectors such as tobacco, private prisons, spirits and gaming. SRI is a values-based investment approach attributed first to the Quakers, a religious group that avoided investments incongruent with their social and ethical values dating back to the 1800s. While SRI is a values-based investment approach; ESG, on the other hand is a value-based investment approach focusing on the long-term gains that can accrue from capitalizing on material ESG-related risks and opportunities.
ESG has attracted academic interest across several disciplines and remains a compelling research topic for students and scholars of law, business and public policy. Amid friction between ESG’s advocates and detractors, there are areas where agreement is both possible and necessary — even across the political spectrum. Indeed, there are three key areas where agreement can be found.
1. Agents must uphold their fiduciary duty. Those obligated to provide investors and beneficiaries with the maximum investment return at a prudent level of risk are restricted from allowing their personal beliefs or self-interests to interfere with stewardship responsibilities. According to the U.S. Federal Reserve, climate risks can cause instability in the financial markets. Although many perceive climate change as a long-term investment risk, its aggregate perils — that is, its magnitude, timing and precise outcomes — are largely unpredictable. Investors take note of the cost of large-scale physical risks from floods, cyclones, droughts and other weather-related shocks. Similarly, the transition from hydrocarbons to cleaner energy sources highlights the risk of stranded assets from regulatory, competitive and market pressure. Several public pensions have taken a long-term view by documenting climate action plans to address environmental investment risks and opportunities. Short-term outperformance of any sector is seldom a justifiable reason for long-term investors to make sweeping reactive changes — an ill-advised action often referred to as “market timing,” which can be value-destructive.
2. A shared understanding of terminology reduces confusion. The alphabet soup of ESG-related acronyms can be dizzying and generate misconceptions among investors, asset managers and corporate decision makers. ESG is often misinterpreted as a catchall for anything good or bad. Three interrelated sustainable investment classifications — SRI, ESG, and impact investing — are neatly outlined by Pitchbook, a data and research firm. ESG itself is not an investable entity or asset class, but rather a tool anchored by three distinct categories of data that can be used to assess the sustainability of a company’s business activities. Sustainability is defined broadly as a company’s ability to address the needs of the present without negatively affecting long-term growth prospects. For example, movie rental companies, such as Blockbuster, that were idle to changing consumer needs and desires ultimately shuttered due to streaming services offered by Netflix and other companies that acted on the digitization of entertainment. To believe that E, S and G factors have a homogenous effect on companies, particularly across sectors is carelessly simplistic. For example, a company may have a stellar environmental report card, but score poorly in other ESG categories, such as health and safety or shareholder rights.
3. Investors with fiduciary responsibility should target risk-adjusted, long-term returns. Endowments, foundations, colleges/universities, pension funds and insurance companies have long, and in some cases perpetual, investment horizons. Institutional investors are aware that short-term gains or cyclical returns can quickly vanish. Moreover, while short-term trading gains are attractive, market timing, in the long run, tends to be a fool’s errand. Such strategies are different from the domain of institutional investors who need to manage their holdings to meet long-term financial obligations.
The material nature of key ESG factors only heightens its application as a practical investment tool.
In the distant future, assessing ESG factors is anticipated to be an inherently standard step in the investment process. The material nature of key ESG factors only heightens its application as a practical investment tool. Today, ESG is table stakes across the mainstream investment community. The SEC is finalizing its proposed regulation of ESG-themed funds; the forthcoming rules should allow investors to make better-informed decisions. The existing regulatory environment and expected compliance expenses will invariably discourage firms from developing mediocre investment products intended to mostly grow firm assets and not necessarily generate returns for investors.
Until then, divergent viewpoints and healthy friction in discourse hold managers with ESG-themed investment products accountable to stated claims and ambitions. Unsurprisingly, everyday citizens are confused about ESG when they hear inflammatory comments that lack investment merit. Furthermore, viewing ESG as an exclusionary investment approach or purely as an environmental proxy (which overlooks two-thirds of the ESG framework) can lead to flawed conclusions. Abuses such as “greenwashing” (unsubstantiated or deceptive environmental claims) can be detrimental to investors, particularly those less familiar with sustainable investments. The SEC issued a “risk alert” last year to highlight concerns about ESG investing and is currently considering disclosure rules intended in part to curb greenwashing.
The years ahead will see ESG-related successes as well as ESG-related failures. From a performance standpoint, sustainable investment strategies, like all investment strategies, will have top performers, as well as laggards. Intuitively, the lack of substantive data may disadvantage investors and managers in both efficient and inefficient markets. Acquiring an investment at a discount to its intrinsic value, identifying value drivers that can be enhanced as well as risks that can be avoided, and exiting an investment before its value dissipates are all examples of where properly interpreting material ESG data can be meaningful. As ESG continues to evolve, the proof of its value will face greater expectations and scrutiny that should ultimately benefit investors and shareholders.
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