Is ESG Investing Just Marketing Spin?
The ESG Alphabet Soup Series #1. A look at ESG investing definitions and the money-spinning ESG ecosystem.
Hi there,
As I mentioned in my Sunday post, I’m starting this series that will explore the ESG ecosystem and all of the assorted acronyms and reporting frameworks. The goal is to build up an independent ESG investing framework as we go. Please respond to this note with any comments or queries you might have. If you enjoy it please feel free to share it using the button below.
Is Environmental, Social and Governance (ESG) investing meant for marketing funds or making more informed investment decisions?
Every asset manager in 2020 claims to have incorporated ESG considerations into their investment process. Asset managers direct trillions of dollars globally under ESG related restrictions or exclusions. You might even think there are clear, consistent, and globally applicable frameworks for ESG investing.
Defining ESG Investing
However, ESG investing is what I call an “alphabet soup” ecosystem. There are so many acronyms and standards that combining it all into a coherent framework for assessing the ESG risks and opportunities for each potential investment is hard work. The best definition of ESG investing I’ve found so far is in Matthew Sherwood & Julia Pollard’s book “Responsible Investing”.
“ESG investing is the research and investment strategy framework that evaluates environmental, social, and governance factors as non-financial dimensions of a security’s valuation, performance, and risk profile.” Sherwood & Pollard (2019)
The core concept seems simple: environmental factors, social factors, and governance factors are groupings of non-financial dimensions. A company can identify these risks themselves and manage them appropriately. Alternatively, a potential investor can identify them during their due diligence and research process and use those findings to inform their decision on whether or not to purchase a company’s securities or indeed continue to hold them in their portfolio.
Why is this important? Because building on the multi-decade triumph of the three lines of defence risk management framework, many ESG factors are now a key part of a firm’s risk profile. If a company has these risks and isn’t managing them properly, it is a reflection on the capability of their board and management. Companies want to make money and investors don’t want to lose money from unknown or poorly managed risks.
Investment valuation is still about the financials of a business. There will always be 3-statement valuation models assembled in proprietary tools or Excel. However, the non-financial factors in the ESG framework are increasingly important.
For example, if a company has high exposure to climate-change financial risks, that it isn’t managing appropriately or disclosing completely, how much does that shift the terminal valuation? What does it do to its valuation relative to its peers who might disclose more fully their climate-change financial risks?
The ESG Ecosystem
There are lots of people making money out of the ESG ecosystem. Asset managers, investment banks, research houses, global standard producers, banks, advisors, consultants, proxy advisors, rating agencies, market data providers, wealth managers, super funds, pension funds, administrators, law firms, asset consultants, ETF manufacturers, insurers, accounting firms, auditors, securities exchanges and the media. What a cost-benefit analysis for the ESG ecosystem looks like is a topic for a future article.
The complexity of the ecosystem and the number of actors involved makes it hard to judge the claims of asset managers claiming to incorporate ESG issues into their investment decisions. It also makes it hard to judge the companies themselves. Almost every annual report now includes many pages of sustainability reporting or even a separate sustainability report. There are also many pages of disclosure on executive remuneration, risk management, corporate governance, accounting standards and health & safety outcomes.
The rise of active stewardship means that many investors will happily pick up the phone, write a stern letter and tell the board of a company they’re not happy with a controversy and demand action to resolve it. This part of ESG investing is where I think some asset managers depart from their marketing literature. There is a growing expectation from investors that unless they’ve chosen an explicitly passive index-tracking option, they will get active engagement with boards and managers of companies their money is in, aligned to what you’d expect ESG aware investing to mean.
Is ESG Just Marketing?
The business of asset management is about generating risk-adjusted returns for investors and earning income from those assets under management that pays for the operating costs of managing a fund and makes a sufficient level of return on the financial and human capital involved in the process.
The key goal for asset managers is getting more assets under management because management and performance fees are a percentage of the assets as opposed to fixed prices. Once costs are covered, every extra million dollars in revenue drops into the bonus pool.
The marketing of funds in recent years has gravitated towards trumpeting anything that could help a fund jump on the ESG bandwagon. Did you buy a coal miner that also owns a solar farm? Press release. Did you divest from a shale gas producer that was never profitable and buy into a wind power equipment manufacturer? Press release. Did you vote for more climate-change disclosure at an AGM? Press release.
What investors think they’re getting from asset managers and what they get can be two different things entirely. For example, many people care deeply about taking action on climate change. Unfortunately, this doesn’t mean that a fund marketed as an ESG aware fund will vote for every climate-change-related shareholder resolution that might seem completely common sense as an expectation from an investor’s perspective.
Blackrock is the canary in the coal mine here. They announced at the start of the year that they would be doing much more to pressure companies to meet rising community expectations on ESG matters. However, some of their funds still aren’t supporting all climate change disclosure resolutions. They’ve attracted billions of dollars more in assets under management into sustainability strategies off the back of their announcement. However, tracking and holding them accountable for the follow-through in outcomes will be important.
What Is The Best Definition Of ESG Investing?
“ESG investing is the research and investment strategy framework that evaluates environmental, social, and governance factors as non-financial dimensions of a security’s valuation, performance, and risk profile.” Sherwood & Pollard (2019)
When I think of ESG investing, the above definition is what I’m putting at the heart of my mental model. I believe it is important to distinguish it from other similar terms used interchangeably. These terms are another aspect of the ecosystem that makes it harder to cut through to the issues that matter to investors. Asset managers, regulators, politicians and investors are often talking past each other because they all want different outcomes and think they’re going to get them.
When I write this newsletter, that’s my focus. ESG investing is about earning an appropriate risk-adjusted return while taking these factors into account. Every investment opportunity has both risks and opportunities. Because of ever-increasing expectations of stakeholders, many firms will need to improve the capability of their operating model to deliver the outcomes their stakeholders need and want, while still providing a sufficient financial return to shareholders.
These adjacent types of investing are defined below. Responsible investment, socially responsible investing, impact investing and mission investing are often used interchangeably with ESG investing. However, ESG investing is the framework that focuses on earning a market return informed by ESG factors as opposed to wholesale exclusion or divestment. This difference in definitions adds to the confusion of the ecosystem.
Over the course of this Alphabet Soup series, it will become clear why I want to focus on ESG investing as the definition I use most frequently. I simply think it’s a more coherent framework for investigating risk and reward. Social outcomes are almost a third dimension to be added to risk and reward.
Responsible Investing
The UN Principles on Responsible Investment group define responsible investment as an approach to investing that incorporates ESG factors into investment decisions. The goal is to manage risk better and deliver sustainable long term investment returns. Thousands of asset managers have signed up to the UN PRI, but many haven’t uplifted their investment processes capability yet.
Socially Responsible Investing
In his ESG Investing book, John Hill defines socially responsible investing (SRI) as focusing on the impact of companies in specific areas of interest. SRI funds usually have a negative screen, such as excluding companies with interests in tobacco or cluster-munitions manufacturing. He argues that these funds are generally unsuccessful at achieving their desired aims. Alternatively, the Forum for Sustainable and Responsible Investment defines SRI as using ESG criteria to generate long-term competitive financial returns and a positive social impact.
Impact Investing
Impact investing is usually a single-issue focus on a social or environmental problem. The Global Impact Investing Network defines impact investments as the intention to generate a social or ecological return alongside a financial return. An example of impact investment would be a water fund that focuses on building water infrastructure in developing countries to reduce water pollution or improve water quality alongside earning a return on the infrastructure investment.
Mission Investing
John Hill’s definition of mission investing refers to “the investing activities of charitable foundations or religious funds which have relatively specific social, environmental, or spiritual purposes.” An example of mission investing could be a religious investment fund that invests in alignment with Christian principles or a large charitable foundation such as the Ford Foundation.
What Will We Learn Next?
Thanks for getting this far. Tomorrow, I’m going to continue this Alphabet Soup series. The next topic is the “E” of ESG – the environmental factors. I’ll explore what risks and opportunities are in this area of the ESG investing framework.
ESG investing isn’t just marketing spin. It is a way of thinking about non-financial risks and rewards when it comes to investment opportunities. I look forward to sharing more with you soon.
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Regards,
Brennan