Boards are being urged to identify strategies and outcomes as greater focus is placed on environmental, social and governance principles for ethical investing.
It started more than a decade ago when a minor United Nations body called the Global Compact published a report entitled Who Cares Wins: Connecting Financial Markets to a Changing World. The report argued more responsible investment leads to more sustainable societies. Soon, it had inspired environmental, social and governance principles (ESG).
Last year, the value of Australian ESG assets under management (investments that satisfy ESG criteria, such as sustainable logging) nudged $1 trillion. It’s “definitely the only game in town” for investors who want to engage with big international shareholders, says Dr Ulysses Chioatto, former head of research for Australia and New Zealand for proxy advisor Institutional Shareholder Services, now an associate professor of law at Western Sydney University. How should boards manage ESG?
Calls to action
The ESG idea upends the traditional view that, within certain limits, social and environmental considerations are best left to governments, philanthropists and community groups. Instead, it puts corporations front and centre in social and environmental decision-making. As Chioatto notes, until recently, not many directors were considering these issues regularly.
ESG’s ascendancy to the mainstream occurred in January 2018, when Larry Fink, founder of international investment corporation BlackRock, issued a clarion call to investors to support ESG principles. Fink’s argument was founded on the fact that BlackRock can’t sell out of many investments — so it must stay in and do what it can. At the heart of Fink’s letter are three separate but related arguments:
- Behave or lose your licence: In an age of intangible assets and choosy consumers, Fink says, companies have to embrace wider responsibilities or risk being punished by society. “To prosper over time,” he argues, “every company must not only deliver financial performance, but also show how it makes a positive contribution to society.” By doing so, it wins points not just with legislators, but with customers, employees, regulators and consumers. In short, it boosts its reputation. Along the way, it may also cut costs and create profitable new services.
2. ESG boosts returns: Fink’s second concern was that backing the use of ESG principles was good investment practice. Companies that do it outperform companies that neglect it. Why? Because, as JPMorgan European equity quantitative strategist and lead ESGQ analyst Khuram Chaudry put it last year, “The composite returns are higher, Sharpe ratios [the return of an investment compared to its risk] or risk-adjusted returns increase dramatically, but drawdowns are significantly lower.”
So far, a number of studies back this up. Coal, for instance, may prove to be a stranded asset. It’s not clear as yet how far those advantages will continue into the future.
3. Step up: A third concern of Fink was that many governments are “failing to prepare for the future” — which meant that “society increasingly is turning to the private sector” to respond to social challenges. Companies need to “take responsibility”, as former McKinsey global managing partner Dominic Barton has said. This last argument is the trickiest; people who discuss it often move quickly back to the other two.
All three of these arguments take you quickly to the questions: How much do you need to step up? In which areas? How do you know? At what point does a focus on ESG start removing value?
At the moment, all those questions are being trumped by this reality — many big investors are pushing Australia’s major companies in relation to ESG factors. As well as BlackRock, notes Chioatto, there are firms such as CalPERS, manager of the largest pension fund in the US. Australia’s big ESG investors include AustralianSuper, the country’s largest superannuation fund, as well as Macquarie Group and AMP. Financial industry firms, in particular, appear to be muscling up on the issue.
Independent director and former Regnan CEO Pauline Vamos says ESG concerns currently apply more to Australia’s top 100 companies. Over time, they are likely to spread.
How big is ESG?
The Global Sustainable Investment Alliance (GSIA), a collaboration of membership-based sustainable investment organisations around the world, says ESG in sustainable responsible investing accounted for US$22.9 trillion, or 26 per cent, of professionally managed assets in Asia, Australia, New Zealand, Canada, Europe and the US at the start of 2016, up from 21.5 per cent in 2012. In Australia alone, at the end of 2017, according to RIAA, assets managed under an ESG approached $866b, up 37 per cent on the year before.
What boards can do
In the past, it might have been enough to stay clear of the very worst industries, such as tobacco, and act on other issues if you were approached. These days, that may not be sufficient.
A tougher approach is norm-based screening that excludes companies not conforming to global rules. The Australian Council of Superannuation Investors (ACSI) represents 39 international and local asset owners and institutional investors. CEO Louise Davidson AM MAICD says her organisation is talking to different organisations about different issues — from climate change to corporate culture.
Another approach is ESG Integration, which presents ESG as one of the core factors in investing. That means even staying in an investor’s profile could well result in under-representation due to a poor ESG score.
Studies indicate that high-sustainability companies are more likely to have established processes for sustainable engagement at home and abroad. So you should already be talking to your big investors and proxy advisors about any concerns with your current ESG stance, says Chioatto. If they have worries, you may want to move forward quickly to address them. If your investors are not yet worried, you have more time. But as ESG spreads, more, investors in Australia and overseas want to see some action.
Where possible, boards should identify the right metrics early on. Executive compensation experts Seymour Burchman and Barry Sullivan say few firms yet have clearly articulated business cases and specific plans. Without it, they say, “Sustainability becomes a vague goal that’s easy for executives to game — often with unintended consequences.” Some boards run into their biggest problem here as the right metrics are hard to tie down.
If you can tie down some metrics, you can then look at tying executive pay to ESG outcomes. Burchman and Sullivan say separate studies of US, Canadian and German firms have found executive incentives boost firms’ environmental and social performance. Their research found that in 2017, five per cent of companies had given executives safety metrics, and only two per cent had provided environmental metrics.
If metrics are too hard, boards can explicitly retain the right to reduce executive incentives when companies incur substantial damage to their reputation. For most boards, such penalties are implicit, but Burchman and Sullivan suggest spelling them out so that an oil company boss, for instance, knows money will be lost in the event of an oil spill.
However, a better approach might be for the board to identify the top social and environmental issues that could potentially damage it.
Steven Münchenberg, a managing partner at consulting firm Blackhall & Pearl, says companies that don’t want to take on social or environmental issues should still be asking management to identify and manage “social risks” — the risks likely to cut through to public consciousness in some way and endanger a company’s future.
That should go beyond the corporate affairs function, he says, to look at the underlying themes in areas such as consumer complaints or regulatory disputes, and at their social context. Münchenberg lists AMP, IOOF and Adani among the companies suffering from exposure to social risks that are “significant destroyers of value”.
If you want to pursue ESG, you might also want to ensure all your major investors are on board — and if they’re not, you may want to change your investor base. There are now a great many investors wanting to invest in companies with high ESG ratings.
While few companies get all of this right, BHP stands out from the crowd (see below).
Impression management
Fund managers may matter most in the short run, but there’s less point to doing any of this if your ESG efforts don’t earn you brownie points with the general public. Indeed, according to George Serafeim, a professor of business administration at Harvard Business School, research suggests sustainability exercises may produce the best results only if the general public recognises them.
This is where impression management comes in. The board should ensure there’s a plan for giving its actions an appropriate profile through the media. Here, BHP appears to be out in front: its home page pushes its support for the Uluru Statement From The Heart, while TV commercials explain electric cars need four times as much copper as standard ones.
More than ever before, according to global communications marketing firm Edelman, many consumers want companies and their CEOs to act properly. Princeton psychologist Professor Susan Fiske has shown people employ the same psychological mechanisms to judge a brand or corporate “personality” as we do to judge other people. Moral philosophers and lawyers alike will mostly tell you companies are not in fact people for most legal or moral purposes. But more often, most people refuse to see it that way.
You may also want to avoid attracting too much attention. Having led the charge in 2018, BlackRock has come under attention this year from major international responsible investment group ShareAction for “its own poor contribution to environmental goals”, including “voting for the reappointment of all directors at many companies that are failing to address climate risk”.
The trick, it seems, is to garner enough attention — without it being too much.
The metrics puzzle
Rather like the three questions Larry Fink asked in early 2018, BlackRock’s trouble with ShareAction leads back to the question: How much ESG? ShareAction’s answer was: not enough.
Others — including Robert Eccles, professor of management practice at Harvard Business School, and Ioannis Ioannou, assistant professor of strategy and entrepreneurship at London Business School, along with Serafeim, who helped identify the earlier gains — say the correct amount of ESG to maximise shareholder value is yet to be established.
For instance, ESG’s different values can easily pull in opposite directions. Tesla is a case in point. The company produces electric cars, batteries and solar panels under the autocratic leadership of Elon Musk. Different evaluators could, and recently did, put Musk at opposite ends of the ESG scale. AustralianSuper, which has hundreds of millions of dollars in Tesla, voted against his remuneration.
Investors are still working out these problems. The UN-supported Principles for Responsible Investment, for instance, has released guidance for investors. Nevertheless, Janine Guillot, director of capital markets policy at the Sustainability Accounting Standards Board, said in December 2018 that ESG standards are still in their infancy compared with financial statements. Many in the field agree, including some in the US who want to remedy that by laying down rules that ESG investors must follow.
In the meantime, according to Responsible Investment Association Australasia, 49 per cent of surveyed Australian investors say the biggest factor deterring further growth is the “lack of understanding and advice” in the area.
ESG might well be a growth area, but it also remains, at least for the moment, an area of continuing confusion.
Malkiel’s misgivings
Burton Malkiel, a Princeton economics professor, is holding out against ESG enthusiasm. His take: most companies can’t be clearly classed as good or bad, and buying the ones you like most will quickly make them too expensive relative to their peers.
Malkiel is a seminal figure in personal investing. His A Random Walk Down Wall Street (1973) ushered in the era of index funds by pointing out that funds beat the market less often than a monkey with a bunch of darts.
Malkiel is suspicious of investments that can make him pure. He doesn’t want tobacco or firearms in his portfolio. But he doubts the credibility of people who want to remove things like genetically modified organisms (GMOs) from it as he can’t find any science that suggests they’re bad, and they’ve helped cut poverty in Africa.
Perhaps more importantly, investors increase volatility, and hence risk, when they take companies out of their portfolio. “For me, indexing means you hold everything,” he says. And if everyone sells off non-ESG stocks, at some point they will become very attractive to own. “Even if it were the case that ESG [stocks] outperform, they will then get overpriced at some point relative to the others and their outperformance will not continue,” says Malkiel.
If that is true, ESG outperformance is a temporary phenomenon, although it will make capital cheaper for ESG stocks relative to non-ESG ones.
Malkiel says he wins the intellectual battle with his peers on ESG, but then they say, “I just feel better with an ESG fund.”
