A Review of the ESG Landscape
August 31, 2021
As time has progressed, institutional and retail investors have made it increasingly clear that they expect their investments to place more emphasis on being socially responsible, which can be measured with ESG (Environmental, Social, & Governance) factors. While there are potential monetary benefits to allocating capital to companies that grade well on ESG metrics, this is still an evolving area of investing, and there are challenges to navigating it. In this missive, we hope to provide a brief overview of ESG investing, some of the current challenges, and potential applications of various research findings.
What is ESG investing?
ESG investing is focused on finding companies that score highly on ESG factors and avoiding companies that do not. From an environmental standpoint, investors are looking for companies that do not have a negative impact, whether that is avoiding toxic waste spills, causing forest fires, or trying to maintain a small carbon footprint. From a social standpoint, companies are encouraged to pursue what is viewed as socially good. For example, a company may try to improve diversity within its ranks or pursue initiatives that build up the local economies. Human rights abuses and occupational safety issues also fall under the social category. From a governance perspective, the goal is to ensure that corporate malfeasance and fraud is avoided, and that incentives are aligned with the interests of shareholders, among other things.
Why do people use an ESG framework to invest?
First and foremost, investors often choose to invest with an ESG focus because they want to invest in a manner that aligns with their values and principles. Much like how investors choose to invest in a faith-based way, or with a socially responsible focus, investing can be done in a way that aligns with an individual’s belief system.
However, more recently, there has been research that indicates that an ESG focus may boost long term investment returns. According to research by Simon Glossner of the University of Virginia, there is evidence that poor ESG practices negatively impact long-term value. For example, he concludes that a value-weighted US stock portfolio with high ESG incident rates is associated with a significant negative alpha of about −3.5% per year from January 2007 through December 2017. By comparison, in Europe, the negative alpha was -2.5% per year. The severity of negative ESG events also seems to impact price movements.
Glossner also claims that past ESG incident rates predict future incidents, weaker profits, and lower risk-adjusted stock returns. A main driver of weakness may be that companies with poor ESG practices are also short-term thinkers and look to maximize profit for themselves, at the expense of long-term value creation.
What are some challenges with ESG investing?
Not everyone agrees that ESG investing is important. In fact, PWC’s 2020 Annual Corporate Directors Survey found that only 38% of board members think ESG issues have a financial impact. Some investors believe that businesses should focus on profit above social welfare. After all, shareholders can choose to invest or not to invest in a company and they should also be able to decide if they want to put their own money (or not) towards helping social issues.
Furthermore, there is substantial disagreement between ESG rating providers on how sustainable a company is or how ESG friendly it is. Conventional ratings aggregate hundreds of ESG criteria into one company score using very different approaches. Some rating services use negative screening to remove stocks with unfavorable traits from a portfolio (e.g. tobacco & alcohol), while others may use positive screening to search for positive traits like having sustainable supply chains. Further complication comes from the fact that tabulating scores differs from provider to provider. As a result, we can run into scenarios where providers like FTSE Russell, MSCI, and Sustainalytics all have ESG rankings that differ on how they view companies.3
Clearly, ESG data lacks standardization, especially for Social and Governance factors, though many companies have adapted the international Greenhouse Gas Protocol4 on the environmental front, providing some common ground.
More disagreement may arise because companies tend to offset their ESG weaknesses with strengths in other ESG criteria. Corporations are aware that investors care about ESG issues, so they may take steps to pretend to be more sustainable than they are, often referred to as "greenwashing," to influence their ESG ranking.
Another caveat is that while research shows there could be merit to an ESG framework, there is a lack of good long-term data. There is also a bit of a “chicken and the egg problem” where it is hard to tell if ESG strategies have done well because the underlying companies were aligned with recent market trends, or if companies have performed well primarily due to ESG factors. As an example, many technology companies often score favorably on ESG factors, while energy and manufacturing companies have had had less success over the past decade and scored lower on these factors. Given this, it would be helpful to see performance through additional market cycles before passing judgment. Lastly, ESG strategies tend to carry slightly higher investments costs, and are likely less diversified than a standard index, increasing potential for risk.
How does TMG facilitate ESG investing?
At TMG, we believe that current research supports the possibility that there could be merit to ESG investing, and that it does not necessarily mean you must sacrifice returns. Furthermore, we remain committed to following a globally diversified, risk-appropriate, index-based philosophy. As a result, we have constructed portfolios that replicate our standard portfolio exposures but do so through the use of ESG index funds, where possible, that are created by some of the largest fund providers. When we cannot find an ESG fund for a portfolio exposure, we use our standard model securities instead.
We recognize that there is still room for improvement and standardization for the ESG industry. Given the current limitations and the healthy debate around the definition of ESG factors, we believe that the most reasonable course of action is to use the largest, established, and low-cost ESG indexes to construct the ESG versions of our portfolios.
By following this course of action, we remain committed to our core philosophy, while offering another solution that may be more aligned with a client’s belief system and preferences. Our team at TMG is happy to investigate and discuss if this could be an appropriate resource in pursuit of achieving your personal and financial goals.
1Glossner, Simon. ESG Incidents and Shareholder Value. 2021. University of Virginia – Darden School of Business
2PwC's 2020 Annual Corporate Directors Survey, PwC
3Is Tesla or Exxon More Sustainable? It Depends Whom You Ask, The Wall Street Journal, 17 September 2018
4Greenhouse Gas Protocol
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