Impact Reflection | August 19, 2022
Investors evaluate a wide range of data when crafting a portfolio. Some investors look beyond publicly available financial data and consider future risks such as climate change as well as social values when selecting investments. The earliest version of this investment style began with religious groups such as the Quakers who shunned investments in things like alcohol, weapons, and gambling. In 1971, the Pax World Fund was launched as the first US mutual fund to embrace a “socially responsible investing” approach. Investor appetite has grown steadily in the decades since and is now applied to a broad range of both publicly and privately managed assets.
The term “ESG” was coined in 2004 by a United Nations team led by Paul Clements-Hunt and was rapidly adopted across the industry. Using Environmental, Social, and Governance (ESG) factors in financial analysis re-oriented investment screening away from difficult to quantify values and towards identifying measurable risks to financial outcomes. This new framework created an improved landscape of choice for investors, though it also steered research efforts away from earlier practices that were more altruistic in nature. Bloomberg phrased it this way: “ESG ratings don’t measure a company’s impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders.”
Recently there has been an explosion of newcomers to the ESG strategy, including all the big names in global finance, which has created a backlash from several quarters. In their report “Does ESG Really Matter—and Why,” consultants from McKinsey & Co. conclude that regardless of the current turbulence and whether the ‘ESG’ acronym survives, the importance of the underlying investment approach has not yet peaked and will remain a core strategic focus for companies far into the future.1
One criticism of the growing ESG movement is the prevalence of greenwashing. Companies exaggerate the environmental benefits of their actions, and fund managers re-orient their websites to imply a long and deep commitment to sustainability and social justice. These efforts intend to promote the image that they are responsible corporate citizens who care for the environment and important social causes. However, without a regulated standard for ESG reporting, these companies are free to make their own claims. For consumers who want to support sustainable brands and investment managers, the varied definitions of “green initiatives” or “social progress” undermine the value of ESG reporting.
The industry has arguably grown so quickly that definitions and criteria have been muddied along the way. Our view is that this warrants regulation and ESG standardization, not abandonment. In the US, the SEC proposed new reporting rules to do just that. Unlike more conventional research in the financial sphere, ESG ratings vary widely. According to McKinsey’s paper, while credit ratings from Standard & Poor’s and Moody’s are in sync about 99% of the time, ESG scores from six of the most prominent ESG ratings providers are found to be comparable only 54% of the time.2 The SEC’s rules follow on the heels of similar new regulations in Europe and may require some money managers to disclose the greenhouse gas emissions of companies they’re invested in.
Another growing pain for the adoption of ESG comes from the ongoing politicization of climate change and social norms. States with large fossil fuel industries have launched a broad rebuttal of climate policies that they fear are de-facto efforts to steer private capital away from oil, gas, and coal. Kentucky, West Virginia, Utah, and Oklahoma have all enacted or proposed bills that prevent state funds or retirement plans from investing with companies that “discriminate” against energy companies.3 Historically it is not unusual for established economic interests to wield considerable power over the conversation and arc of change. Recently, Florida’s governor proposed a broader bill that would prohibit the Florida State Board of Administration from engaging investment managers who consider ESG criteria when managing state assets, including state-sponsored pension funds. This limits the ability of their investment managers to consider risks from future externalities such as climate change – an issue that all those states, their residents, and their traditional energy industries are already facing.
Progress Over Perfection
There are multiple points of progress, such as investor pressure on companies to take actions that may include reducing their plastics use, addressing workers’ rights, and performing civil rights audits. Investors also succeeded in replacing directors on Exxon Mobil Corp.’s board to help the oil giant position itself toward cleaner fuels. This highlights where much of the real change happens – through individual investors and mutual funds voting on shareholder resolutions and flexing their power as partial owners of these large public companies.
It is estimated that more than 90% of S&P 500 companies now publish some sort of ESG report. While many companies are genuinely working hard to create change, there remain factors beyond their control that limit the impact of their efforts. Consider Coca-Cola’s recent voluntary efforts to reduce one of its most material ESG risk factors: water usage. These efforts helped Coca-Cola’s ESG rating via MSCI to reach “AA,” or market leader. However, the company’s chosen boundary for achieving water neutrality is the water used in manufacturing, distribution, and cooling – areas in which they’ve made substantial progress in reducing usage – but not the more than 90% of water it estimates that it uses in its agricultural supply chain, primarily in the fields to irrigate farmed sugar. Improved sustainability and resiliency in corporate supply chains, particularly in light of climate change, is a key frontier in ESG analysis as companies try to future-proof their current profits.
The addition of ESG considerations to the traditional investing process may allow better assessment of investment risks, but alone it will not save the planet or create social equity. Fighting climate change is entirely different than measuring and assessing the climate risk to a firm’s profits. Still, changes such as improved measurement of emissions and an emphasis on bringing more diverse perspectives into management positions are foundational steps. A blend of policy and behavioral changes is needed to achieve lasting progress.
For individual investors, there are also real benefits to aligning your portfolio with your values unrelated to quantitative measures. Many investors are simply uncomfortable owning or supporting companies whose businesses run counter to their own moral compass on environmental and social issues. The continuing growth of ESG is reflective of a simple truth: a lot of people want to have a positive impact with their choices, including their financial choices. The market is responding to consumer demand and signaling that, despite political noise from both sides about imperfections and growing pains, the long-term trajectory for sustainable investing is on solid footing. We see that as a positive – for investors and citizens alike.
1 Does ESG really matter—and why? McKinsey
2 ESG’s ‘Social License’ Will Endure Even If the Letters Don’t Bloomberg
About Brian Kozel, CFP®
Brian Kozel is a Partner at North Berkeley Wealth Management. Brian helps clients feel confident as they navigate their financial journey.
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