gesrey
NEW YORK (September 24) – ESG – Environmental, Social and Governance – investing seems to have become ubiquitous in the last few years.
ESG has become fashionable, particularly as concerns about climate change grow (the “E”); in light of the murder of George Floyd and increased awareness of other perceived social inequities (the “S”); and some outrageous managerial malfeasance has come to light. (the “G”). But among C-Suite executives, it appears that ESG is largely performative; a means to enhance corporate reputation or attract young recruits more than to improve corporate performance.
A 2019 survey by McKinsey & Co. asked C-Suite executives who thought ESG improved financial performance why they had embraced ESG. Of the responses, an amazing 71% said it was because it maintained brand equity or reputation. Another 45% said it was to attract, retain, and motivate good workers. (Respondents were apparently allowed to answer more than one question.)
In B2B and B2C organizations, nearly 50% of respondents said that, in their ESG activity, the most important things were complying with regulations and meeting industry standards. Only about a quarter of respondents said “making long-term strategic investments to address ESG investments.”
In other words, those C-suite executives were doing their ESG activity mostly because they felt compelled to by regulatory or industry standards or because they were expected to by industry competitors. Insofar as investment performance is concerned, though, a recent op-ed in the Wall Street Journal stated that “[o]ver the past five years, global ESG funds have underperformed the broader market by more than 250 basis points per year, an average 6.3% return compared with a 8.9%.
Why every stock is “ESG” (“Traditional ESG”)
A holistic approach to investing, particularly among large mutual or private equity funds, requires fund managers to “kick the dirt”; to evaluate independently the environmental, social, and governance — the ESG — aspects of portfolio companies. (We’ll call this “traditional ESG”)
Let’s presume we, as prospective investors, are looking at investing in a railroad.
We would evaluate these kinds of “environmental” factors:
- easements, terms and conditions
- quality of roadbeds
- access to multi-modal transport depots
Our evaluation of “social” factors would include:
- labor relations
- governmental regulation at the federal, state, and even local level
- the condition of the economy in the railroad’s marketplace
Our “governance” review would include
- the corporate charter
- evaluation of poison pills, golden parachutes, anti-trust compliance, etc.
- the backgrounds and expertise of non-executive board members
Distinguishing the “branded” ESG product
But in the now popular conception of “ESG”, what we’ll call “branded ESG”, the version heavily marketed, our evaluation of the same railroad would focus our evaluation on factors less closely honed to business operations and more closely related to extraneous considerations.
For environmental considerations, we would discuss the railroad’s reliance on carbon-based fuels; for social, we would examine whether railroad easements — which traditionally pass through more economically disadvantaged neighborhoods — should be distributed more equitably. In governance, we would look at things like the racial and gender diversity of the railroad’s board of directors and key executive positions. See the difference? Inevitably, the branded ESG product measures against a performance score that is largely subjective and extraneous; things that are not readily and clearly identifiable in the performance of the business. For example, the S&P Global methodology for assessing a branded ESG “score” excludes companies engaged in legal activities like arms manufacturing or sales, oil and gas, or tobacco if their “level of involvement” exceeds single digit thresholds or if a company owns a certain percentage of such companies.
S&P Global also excludes companies that are not compliant with the relatively benign “Ten Principles of the United Nations Global Compact”, that address things like child labor, corruption, human rights and the environment. But even those seemingly universal values are measured in a subjective context. Human rights enforcement in places like China and Singapore have significantly different standards than the United States. Who fairly evaluates those standards in those countries?
What about companies like Apple (AAPL) or Levi’s (LEVI) that utilize third-party, unrelated, parties as contractors to manufacture their products who have been accused of labor rights violations for their production in China and, for Levi’s, around the world?
Finally, S&P Global’s “Index Committee” can exclude “controversial company activities” related to “the composition of the indices“…
which includes a range of issues such as economic crime and corruption, fraud, illegal commercial practices, human rights issues, labor disputes, workplace safety, catastrophic accidents, and environmental disasters.
S&P relies on information provided by RepRisk.com, a company that captures big data (news, social media, government releases, newsletters, etc. across multiple languages) to screen Environmental, Social, and Governance matters identified in their “28 ESG Issues” together with “78 topic tags” to search out company involvement on these issues. Then, using machine learning to sort and prioritize the data, RepRisk uses a team of human analysts to “assess (their) severity, reach, and novelty.”
Again, there is subjectivity. Legal products and processes, like semi-automatic firearms, tobacco, alcohol, fur, and oil and gas fracking are listed. So are what appear to be entirely subjective matters, like “Economic impact” which, in summary, purports to assess “the negative effect business activity has on the economy or livelihoods of a community.” (So if a new Walmart opens in a small town and (WMT) destroys the town’s downtown retail main street, does that count as a “negative effect… on the economy or livelihoods of a community”? Asking for a friend…)
Ironically, for a scoring system that purports to be concerned with environmental issues, there are also concerns with “[c]onventional hydropower, or hydropower derived from dams, (because it) is often blamed for massive environmental destruction or the forced relocation of nearby communities.” Forced relocation is, indeed, tragic (it happened for example, to the Seneca Nation of Indians in Western New York in the early 1960’s with the building of the Kinzua Dam, although the Senecas were compensated financially, somewhat). But societies often need to choose from bad choices: flood protection of a major city, Pittsburgh and power generation one of the cleanest available technologies or flooding Native ancestral territories.
Equities Vs. Bonds
It’s important to distinguish these new branded ESG standards as respects equities versus them as respects bonds.
Bonds, particularly those issued by municipalities and states, can sometimes be “pure play” branded ESG investments. Bonds to finance environmental causes (hazardous site clean-up, park construction), social goods (e.g., a hospital in an underserved area, schools, historic preservation, etc.), and governance (e.g., financing a new DMV computer system) should all do well in ESG scoring. They are largely unencumbered by the kinds of subjective determinations we see in equities.
But how well private entity bonds could be measured as a pure-play would depend on circumstances and is, again, subjective. Does a company’s new “green” corporate headquarters qualify high on the ESG score if it is located on a suburban office campus accessible only by cars when the old headquarters that was readily accessible by mass transit?
Inputs Vs. Outputs
Stuart Kirk, who formerly headed responsible investment for HSBC Bank (until he made some comments his employer viewed as controversial) has, perhaps, offered a more rational, objective, data-driven, means for investors to invest in ESG in a Financial Times guest editorial.
Kirk divides the traditional ESG evaluations and the branded ESG evaluation into those driven by what he calls “inputs” and those driven by “outputs”. respectively, and suggests the funds industry and investors do the same.
Kirk’s proposal makes a good deal of sense. It allows investors to select between the kind of investments that are close-honed to the kinds of operational, value, and investment performance used in traditional ESG evaluations and those that address the branded form of ESG, as well as those that both. Kirk’s ideal would also reduce the likelihood of so-called “green-washing“, where a company conveys “a false impression or provides misleading information about how a company’s products are more environmentally sound”.
Investment Thesis
As more and more light is shed on “branded ESG” vs. traditional ESG, it seems almost assured that investors will choose between the two. Investing in “branded ESG” shares likely comes with a higher cost, but also a higher risk premium, not least because falling short of its branded ESG objectives — like falling short of earnings — reduces their premium. On the branded ESG side, fund managers like Larry Fink of BlackRock, with $10 trillion (with a “T”) in fund under management, has clearly embraced branded ESG in his annual letter to CEOs of his portfolio companies. So influential a cheerleader — with assets under management equal to nearly half of US GDP — cannot help but enhance the value of companies in the branded ESG space.
Outside government-issued bonds with a specific, identifiable, environmental, social, or governance objectives, as detailed here in the ICMA Pre-Issuance Checklist for Social Bonds, it is nearly impossible to discern a clearly defined meaning of what we’ve called branded ESG. Despite millions spent on technology, and tens of thousands of hours spent by some of the world’s finest minds on grading and standards, branded ESG remains opaque. The terminology is nebulous, the standards subjective, and comparability virtually impossible.
As the public learns this truth, and recognizes that “branded ESG”, while perhaps well-intended, is mostly a fashionable artifice it will step away the way they stepped away from bell-bottoms and platform shoes. And they’ll hold their investment advisors, their brokerages, and their public officials accountable for the money they have lost.
Investors and fund managers should evaluate their portfolios strategically sell off holdings of branded ESG stocks and funds unless there are other performance metrics that make them worth holding on to. The purported “good” that come with the sub-optimal returns of branded ESG really doesn’t merit investors’ sacrifice.
___________________________________________________
Note: Our commentaries most often tend to be event-driven. They are mostly written from a public policy, economic, or political/geopolitical perspective. Some are written from a management consulting perspective for companies that we believe to be under-performing and include strategies that we would recommend were the companies our clients. Others discuss new management strategies we believe will fail. This approach lends special value to contrarian investors to uncover potential opportunities in companies that are otherwise in a downturn. (Opinions with respect to such companies here, however, assume the company will not change).
Be the first to comment