ESG: Is It Time for a Better Name?
A Brief History of ESG
The idea of moral and ethical assessments of investment decisions dates back centuries. In different forms, the religious tenets of Judaism, Islam, and Christianity created fundamental rules for investing. In an 18th century sermon called “The Use of Money,” for example, John Wesley, the founder of the Methodist church, explains that while we should seek to gain wealth, we shouldn’t do so at the expense of the health and well-being of ourselves or our neighbors. In the modern economy, the concept later manifested in the approach known as Socially Responsible Investing (SRI), through which investors could screen out and therefore avoid investment in tobacco, alcohol, gambling, and other “sin” sectors.
The now ubiquitous acronym “ESG” (which stands for environmental, social, and governance issues) didn’t enter the lexicon until 2004, when UN Secretary General Kofi Annan launched an initiative under the UN Global Compact to find ways to integrate such issues into capital markets. The initiative, called Who Cares Wins (WCW), was endorsed by 23 financial institutions collectively representing more than $6 trillion in assets. The concept of ESG was an offshoot of SRI. But while SRI was rooted in ethical choices the ESG approach focused on profits.
Initiative participants were in agreement that ESG wasn’t just about avoiding investment for ethical or moral reasons. Instead, the initiative’s report argued that companies that effectively managed ESG issues might better navigate regulations, reduce future costs, and protect reputation–therefore materially increasing shareholder value over the long term. Put simply, ESG investing by its initial design suggested “doing good” was good for business.
Since then, UN PRI (Principles of Responsible Investing) signatories have grown rapidly to exceed 3,800 managers with assets under management of over $120 trillion. Overall, about 6,000 fund managers around the world incorporate ESG considerations. The US SIF (Sustainable Investment Forum) reports that 33% of the $51 trillion of assets under management in the US use sustainable investment strategies.
When Did Things Get so Confusing?
What was intended to be a general term has become a catch-all, used liberally across the industry. The proliferation of ESG-labeled investment products has created mass confusion for investors. Such products, only labeled with the term “ESG,” may have a light or heavy sustainability focus or more targeted sustainable-themed products. To make matters more complex, ESG is used across active and passive strategies, as well as varied asset classes, from equity, credit, hedge funds, and private equity.
ESG is misunderstood in the same way that “organic” food lacks a common definition. Take eggs for example – they can be labeled as “cage free,” “organic,” and “free range.” Are these all the same things? Similarly, investment products can be called “responsible,” “sustainable,” “ethical,” “impact,” and “ESG integrated.” Often all of those terms seem to be inaccurately represented as subcategories of ESG. What’s important for advisors to know is that there’s often more nuance beneath the labels.
Varying Data Sources
Any form of ESG investing uses underlying ESG data related to company behavior. Unlike a purely mathematical piece of data (like a price-to-earning ratio, for example), ESG data requires an inherently qualitative process to first categorize a company’s behavior and related risks, and then to decide how to quantify those risks.
For example, MSCI provides ESG scores on 35 key issues. For environmental issues, categories include greenhouse gas emissions, air and water pollution impacts, use of recycled content, and amount of waste material sent to landfills. On the social side, data might include statistics on diversity and employee engagement, health and safety impacts of the company’s products, and how the company pays and treats its employees. Lastly, governance looks at the corporate governance structure and transparency over how leadership runs the company. Key components might include an assessment of organizational structure, ownership and control, policy transparency, business ethics, board oversight over ESG issues, and risk management.
The Bad and the Ugly Attaching to ESG
The Underperformance Myth
Perhaps the least understood aspect of ESG is the expected return profile. Early in its history, many people used the terms ESG and impact interchangeably. And yet while impact investing is sometimes associated with “concessionary” returns or higher risk exposure, ESG, dating back to its inception, is about delivering at least market rate returns. But, again, not all funds with ESG in their name are the same; in fact they may have wildly different approaches. Some will outperform and some will underperform, in the same way a “growth fund” might have significantly different returns versus other growth funds.
Partisan Narratives Taking Over
As politicians look to sway sentiment heading into midterm elections and ultimately the 2024 presidential election, ESG has become a political bogeyman. Elon Musk, for example, said that “ESG is a scam. It has been weaponized by phony social justice warriors.” Meanwhile, several republican politicians argue that ESG investing forces companies to spend time and resources on “woke” non-core issues such as climate change and diversity to appease a leftist agenda. At a recent conference, JPMorgan CEO Jamie Dimon responded to the misinformed critics, saying, “I’m not woke. And I think people are mistaking [stakeholder capitalism] for being woke.” In other words, it’s not just about doing what’s morally right. ESG fundamentally focuses on issues that are material to the company’s business. Many critics of ESG fail to appreciate–or purposefully obfuscate–that basic premise.
Advisors and Investors Need to Move Beyond the ESG Label to Understand What it Represents
Despite its ups and downs and detractors, the term “ESG” is most likely not going anywhere. There is almost 20 years of history behind the evolution of ESG, and thousands of asset managers incorporating ESG factors. Too much has happened to throw that away and start over. ESG is rooted in risk assessment and materiality, and it is apolitical. These are non-financial metrics, but still important to the investment decision process. The whole point is to focus on ESG issues that have a direct link to the company’s financial performance.
If a company is a big emitter of carbon dioxide and there is a carbon tax (19 countries in Europe have a carbon tax!) – would that seriously hurt profits? Of course. And if a company had poor governance resulting in a massive cybersecurity breach and loss of valuable customer data – wouldn’t that hurt the company’s reputation and probably result in massive lawsuits? Almost certainly. Lastly, consider an auto company that lies about its tailpipe emissions – could that result in billions of penalties for product recalls, fines, and lawsuits? Yes, for sure. These are generic examples (based on real companies) of how ESG insights can be used alongside traditional financial analysis. ESG simply provides a more robust set of material data points from which an investment adviser can make a decision. While use cases will vary, the point is to get better insights into issues that have a real financial connection to the company.
Let’s just call this good investing and stay away from the alphabet soup of confusing acronyms.
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