Every company has an impact in the real world. Companies provide valuable goods and services, employment opportunities, and help people build wealth over time. But there is also a history of companies behaving poorly by dispiriting workers, disregarding human rights in their supply chain, and polluting the environment.
That said, many investors want to understand the positive and negative attributes of the companies in their portfolios to ensure they are comfortable with what they are investing in while benefiting from incredible stock market growth.
The Origins of Socially Responsible Investing
This desire materialized into the Socially Responsible Investing (SRI) movement in the 1960s as a way to screen out sectors and companies that conducted unethical business practices and did not fundamentally align with certain values. Traditional SRI screens exclude companies involved with the production of alcohol, tobacco, gambling, adult entertainment, military weapons, and fossil fuels, but can also be very personal based on each individual’s values.
Historically, SRI investing has been criticized for generating inferior returns as this method simply removes companies from the universe, including potential outperformers. However, SRI investing has paved the way for more constructive, holistic methods of ESG integration and impact investing found in the market today. Impact investing is the practice of using capital market power to address key social and environmental issues, and now involves a broad set of tools investors can use across asset classes to manage risk, find opportunities in the market, and align portfolios with clients’ values.
ESG Investing
ESG refers to environmental, social, and governance factors that can be integrated into portfolios alongside traditional financial metrics. These factors can help investors understand key risks a particular company may face.
Environmental factors might include carbon emissions, resource depletion, deforestation, water use, and waste management; social metrics cover employee satisfaction, diversity of management and employees, gender pay equality, health and safety, and working conditions; governance can be understood by analyzing executive pay, board diversity, board oversight, and corruption.
Each of these issues can be seen as risks a company is exposed to and may translate into regulatory burden, social pressures, and lawsuits. It is important, then, for investors to understand how companies mitigate these risks.
Pressure from Investors
Investors today have more access to information than ever before, and ESG data is just another tool investors have in their toolbelt to paint a fuller picture of the risks and opportunities companies may face. For example, companies in energy intensive industries may face a regulatory and financial burden to offset or lower their carbon emissions as the world transitions into a low carbon economy. Similarly, companies with a history of discriminating against certain racial or gender minorities may face lawsuits as social pressure rises around equality and diversity. These are some ways ESG metrics may prove to be financially material to investors.
Understanding Data and Authenticity
Companies have responded positively to investor demand for impact reporting and ESG data. In 2011, only 20% of S&P 500 companies issued ESG reports, but by 2017 85% of companies issued an impact report-1].
Given this growth in available ESG data, it becomes increasingly important for investors to understand which data are useful and relevant and what is produced to simply make the company look good. The practice of producing ESG information merely for PR purposes (i.e. without any substantial backing of real action) is referred to as greenwashing. Greenwashing is harmful not only because it is misleading, but also because it undermines the integrity of truly relevant ESG information.
Even information that is not technically greenwashing still may not be financially material or relevant to a particular company. For example, an investor may not benefit from understanding the carbon emissions directly produced by a financial company, but that same company may provide financing for projects that produce significant carbon emissions which could be relevant to investors.
The Sustainability Accounting Standards Board (SASB), a nonprofit organization, has created a framework for determining which ESG metrics may be relevant to companies within a specific industry, and is encouraging the SEC to adopt material sustainability metrics as part of mandatory disclosure. This framework helps investors decide where to focus their efforts when trying to identify relevant risks and opportunities for a given company.
Shareholder Engagement
Another major component of impact investing in the public markets is shareholder engagement. As shareholders, investors have the right to share their opinions with the companies they are invested in. This can be done through direct conversations with company management or by filing shareholder resolutions that fellow shareholders can vote on during the company’s annual shareholder meeting.
Shareholder resolutions may ask companies to provide disclosure around a certain issue, to make changes to their governance structures, or to implement key policies that may impact various stakeholders. While shareholder resolutions are technically non-binding, board members risk being voted out if they ignore resolutions with significant shareholder support. As such, shareholder engagement represents the best opportunity for investors to have direct impact in public markets to drive real world changes while improving shareholder value.
A Heightened Interest in ESG Investing
As ESG investing has matured over the last decade and investors are increasingly considering ESG factors material to their investment decisions, assets invested with an ESG focus have grown significantly. In 2012, ESG funds in the US totaled just over $25bn but has quickly risen tenfold to over $250bn AUM in 2020[2].
With growing assets and increased investor interest, there is also increased scrutiny from regulators. In Europe, the EU has developed an official taxonomy for categorizing funds with different levels of ESG integration. Here in the US, the SEC recently issued an investor bulletin to help investors navigate the landscape of ESG funds, and also announced the creation of a Climate and ESG Task Force to regulate both company disclosure of climate risks and the disclosure and marketing of ESG investment funds.
While ESG investing has evolved significantly from the Socially Responsible Investing primarily focused on negative exclusions, it’s still a relatively new and nascent field – one expected to evolve and mature as companies improve the quality of ESG disclosure, investors become increasingly sophisticated in their use of ESG data, and regulators formalize the standards around ESG disclosure and ESG investment products.
References:
[1] The Governance & Accountability Institute. Flash Report: 85% of S&P 500 Index® Companies Publish Sustainability Reports in 2017. March 2018
[2] A Broken Record: Flows for U.S. Sustainable Funds Again Reach New Heights, Morningstar. January 2021
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