ESG Takes Over Wall Street: But What Do Those Letters Mean?

In a year when most stocks struggle to attract  investors with signs of purely financial progress, many executives are turning to the factors of their corporate footprint that they can control, manage and even demonstrate real progress. References to "ESG" principles doubled last quarter and a full 35% of S&P 500 constituents talked about injustice and equality on their earnings calls.

Shareholders themselves drive part of this interest in Environmental, Social and Governance reform. When companies have a negative reputation along any of these axes (utilities and oil producers managing an environmental footprint, for example), some degree of reputation repair reflects a degree of realism and willingness to compete for potential investors who would otherwise be unwilling to even consider allocating funds to such an enterprise.

This dynamic is mirrored in the advisory environment as well. When real returns are compressed, adroit wealth managers need to find other value levers to justify fees while performance recovers. Aligning the portfolio with the client ethos is a great place to start.

And of course a body of research suggests that companies that score highly along ESG parameters are positioned to outperform in the long term. Here's a bit of how Andrew Little from Global X lays out the argument behind the E, the S and the G:

Sustainable investing is an investment approach that considers environmental, social, and governance (ESG) factors, alongside financial ones, in the pursuit of competitive returns and positive impact for people and planet. Companies and individuals alike recognize that corporate behavior impacts society and the environment. Some of these impacts are plainly visible, while others rear their heads as quantifiable positives or negatives on the broader economy and corporate balance sheets.

As such, sustainable investors assess the ESG factors that they deem material to prospective investments alongside traditional financial analysis to inform their investment decisions. Sustainably managed assets have grown consistently in recent years, riding a tailwind powered by changing consumer demands and an influx of new investment products. Increased recognition of SI as a bona fide investment approach helps too, as investors realize that doing good with your capital doesn’t have to be synonymous with sacrificing returns. Rather, it can be additive to capturing long-term value in their portfolios.

Looking Beyond the Balance Sheet

The triple bottom line (3BL) is an accounting framework that considers environmental and societal impacts alongside the traditional profitability metrics.

The 3BL serves as a lens for assessing how sustainable a company is and reveals that sustainability considerations and financial value are inextricable. Below, we explore the 3BL’s environmental and social components and how they can relate to financial performance.

Environment: The relationship between corporate behavior and its effect on the environment predates the Industrial Revolution. But until recently, investors largely ignored the relationship. Today, the investment community increasingly recognizes the irrefutable, causal dynamic between the two.

One example where corporate behavior had direct effects on the environment is the Deepwater Horizon oil spill that started when a BP-operated oil rig exploded. More than 4.9 million barrels of oil emptied into the Gulf of Mexico over 87 days, damaging over 1,300 miles of coastal habitats and irreversibly altering deep-sea ecosystems. Economies suffered: according to one estimate, Gulf fisheries lost out on $8.7B in revenues from 2010–2020. The Gulf’s tourism industry reportedly lost $22.7B from 2010–2013.

A government commission found that “time- and money-saving decisions” contributed to the accident. Some of these decisions include, but are not limited to:

  • Not running cement evaluation logs – cement is key in controlling pressure levels, a key contributor to the explosion
  • Improperly interpreting negative pressure tests – these tests help indicate cement-job integrity
  • Not installing additional physical barriers, outside of cement

BP paid over $70B in fines and settlements in the 10 years after the spill. The company’s shares have yet to fully recover. As of February 10, 2020, they remained 29% lower than their pre-spill value.

Society: Companies are essential threads in society’s fabric. They provide jobs, income, and training while producing the goods and services that people consume. Increasingly, society demands that companies respect the communities in which they operate. Not fulfilling this obligation can have devastating consequences, whether intentional or not.

For example, inadequate safety procedures and general negligence at aerospace manufacturer Boeing contributed to multiple fatal crashes involving its 737 MAX airplane. One such error, among several others, included not teaching pilots how to override the automated plane stability system (MCAS) that malfunctioned and led to the crashes. A Boeing engineer eventually revealed that, to cut costs, the company forwent the installation of a safety system that could have mitigated the malfunction, a clear violation of stakeholder interests in the name of short-term profitability.

Boeing’s short-term thinking could harm its long-term profitability. Families lost loved ones, communities lost valued contributors, and because of its negligence, Boeing lost a meaningful share of its reputation. The stock tumbled almost 22% from previous highs following the second crash. In 2020, Boeing reported no January jetliner orders for the first time in over 50 years. And the effects of a tarnished reputation don’t just hurt shareholders. Because Boeing is a major employer, both directly and through its suppliers, the societal impact of Boeing’s oversight could result in significant lost wages or lost jobs for thousands of workers who depend on the company for their livelihoods.

Optimizing 3BLs with Good Governance: How can companies – and investors – ensure that the right mechanisms are in place to minimize exposure to environmental and social risk? It starts with good governance.

The examples above highlight extreme negative outcomes that resulted from short-termism, a mindset where achieving short-term profits takes precedence over other considerations. Often, short-termism manifests as cost-cutting designed to boost earnings rather than build long-term value. Good governance rejects this idea. Instead, it focuses on being a good steward of shareholder capital by making decisions oriented toward the long term, also known as long-termism. The Harvard Business Review lists a number of features a company with healthy governance exhibits:

  • A strategic, and not overly financial, approach to resource allocation
  • Concern for corporate citizenship and ethical issues beyond what legal and compliance requires
  • Attention to environmental and political risks
  • Links between executive compensation and strategic goals
  • Staggered board terms to facilitate continuity and transfer of knowledge

Companies that adopt these behaviors may outperform those with short-term oriented governance structures. In their academic study, “The Impact of Corporate Sustainability on Organizational Processes and Performance,” Harvard researchers identified 90 high sustainability companies that had long-term oriented policies and 90 low sustainability companies without such policies. Tracking $1 invested in value-weighted portfolios across the two groups from 1993 to 2010 revealed that the high sustainability portfolio outperformed by almost 47%. And even more telling, the analysis period predates today’s keen focus on sustainability-oriented corporate governance.

So, sustainability doesn’t just refer to a zealousness for the environment or social good, though both are certainly welcome. Seemingly, sustainable companies are those built for the long haul.

Investing for Good—and Long-Term Value

Prudent investing entails careful consideration of the factors that paint companies’ risk/reward profiles, and it’s becoming increasingly clear that E,S and G factors can be financially material. Their inclusion in investment processes paints holistic investment rationales geared to capture long-term value and generate positive impact. This approach falls under the sustainable investing umbrella and is aptly termed ESG integration. Different than exclusion, where investors blacklist certain sectors or business activities, those who practice integration analyze ESG factors to find high quality companies across sectors and industries.

How can investors integrate ESG factors process-wise? First, investors contextualize quantitative and qualitative ESG data to establish a set of factors. Then they weight the factors depending on how relevant they are to companies’ respective sectors and industries – this relevance is also known as materiality. Some investors develop their own data methodologies and materiality schemes. Others rely on external providers for all or parts of their processes. As long as asset managers demonstrate a process-driven consideration of ESG factors without compromising their investment processes, there is no wrong or right approach to integration.

The Global X Conscious Companies ETF (KRMA) is an example of a fund that utilizes ESG integration in its investment approach. KRMA tracks an index that considers the impact companies have on stakeholders that are critical to the companies’ success: customers, employers, suppliers, stockholders and the community at large, alongside traditional financial metrics. The index relies on a wide breadth of qualitative and quantitative information to gauge positive stakeholder outcomes, the materiality of which varies by stakeholder group. A composite analysis then generates a single score for each company by weighting outcome metrics and factoring in more traditional financial research. Lastly, top names go through a screen to identify which companies met inclusion standards in the three years prior.

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