ESG Investing, A Shortcut to Social Responsibility
Socially responsible investing has been an increasingly popular practice for American individuals and companies. Global climate change has influenced one of the most famous social activist movements in the history of the United States, putting fossil fuel emitting companies under fire as well as their investors. This movement has caused a surge in investment in companies’ environmentally conscious practices. A more popular form of this investment has been termed “ESG” investing, or environment, social and corporate governance. This movement is an attempt to change the perspective on government and corporate investment in the United States. Essentially, this type of investing aims at improving both the images and functions of companies. This happens by spending money on helping fight climate change, improving social capital by ensuring their products and services bring safety and innovation to everyone involved and finally, by having a strong corporate governance that builds innovative culture.
The term “ESG” is actually derived from a formerly known type of investment, “Socially Responsible Investment,” or SRI. SRI was still focused on bringing a more morally sound investment strategy for global financial institutions, however, it focused on the negative screens of financial investing. Negative screening is when investors focus on excluding companies that don’t fit socially responsible criteria into their portfolios. So, instead of putting financial capital toward companies that identified as socially responsible, they would pull financial capital out of those who didn’t. For example, socially responsible investing would include divesting in tobacco, alcohol or firearms companies. Over time, SRI developed into a more organized strategy of investing, which is now managed by the United Nations.
ESG was introduced in 2005 for the purpose of giving this practice of environmental consciousness financial relevance. Leaders all over the world gathered to discuss a global initiative to integrate ESG investing into the capital markets. Sure enough, the United Nations delivered a report titled, “Who Cares Wins” persuading leaders that integrating socially responsible investing into investment strategies would lead to more sustainable growth, all while making complete business sense. From then on, financial institutions adopted this practice as a serious investment strategy, realizing that increasing concerns and scrutiny for irresponsible investment implied that this was a forward thinking concept and worth it in the long-run.
The Principles for Responsible Investment (PRI) program was the first initiative to come out of the United Nations’ meetings and reports. PRI was created by the UN with the objective of setting out six principles that comply with the best practices of carrying out ESG in financial institutions and governments. The way they gathered participants in this program was by collecting signatures from these two types. Guidelines for this program were set to go beyond the scope of promising socially responsible investing to clients. They also vowed to provide advocacy for ESG similar to what the UN does itself. For reference, the first principle involves the promise to incorporate ESG issues into investment analysis and decision making processes, while the fourth principle involves promising to promote acceptance of all principles to the entire investment industry. The other principles refer to separate depictions of the first and fourth that aren’t as relevant.
Bank of America is among many signatories of PRI. They have even included articles on their Global Wealth and Investment Management pages practicing the fourth principle. They go about explaining environmental, social, and corporate governance as key responsibilities for the well-being of a company’s operating systems. A key focus of theirs is demand drivers. Bank of America suggests that companies with a robust ESG focus will be put at an advantage because 94% of Gen Z and 86% of the General Population demand it. Their program rolls out important advice for addressing stakeholders, external pressures, risk and opportunity, etc. They appear to fully immerse their business in the ESG practices suggested by PRI.
While world renowned financial institutions like BofA step into the ESG game, companies will listen and follow. However, there are many skeptics. Although it sounds like there is no downside risk, and every company should become a signatory of PRI, there are certain ESG characteristics that might not lead to abnormal profitability. This causes concern over whether ESG’s role in the capital markets will absolutely transcend investment strategies. In this case, we must learn the metrics that ESG companies look at to realize their potential, and if there are any abnormalities in their gains compared to non-ESG fund investing.
Scoring companies based on ESG is important to consider when investing in them because there is a wide range of ESG taste preferences and expected return factors. Based on their nuanced Capital Asset Pricing Model theory, Eugene Fama and Kenneth French provide evidence that investors use their sustainability taste preferences to evaluate what expected returns they are willing to work with (Fama and French, p.27). If an investment scores high on sustainability, they might be inclined to accept a lower expected return, but if the investment scores low on sustainability, they might look for a higher expected return. In 2019, Olivier David Zebib used an asset pricing model to analyze sustainable portfolios by measuring their underperformance in relation to negative screens and taste preferences (Zerbib, p.5). In his study, he analyzed U.S. stock data from 2000-2018 and found a 2.5% exclusion effect and 1.5% taste effect per year. Moreover, 2.5% and 1.5% of stocks underperformed due to being ESG-exclusive and having more dispersed taste preferences, respectively. The underperformance of these portfolios greatly affected their premiums and led to lower returns, proving that investors are willingly taking on these risks. Higher scoring ESG companies are being invested in no matter the risk of return, whereas lower scoring companies need higher premiums to attract investors.
By definition, ESG portfolios with higher preferences will be less diverse and more concentrated portfolios will have greater risk. Higher preferences for ESG criteria limits the amount of companies one can fit in their portfolio since they all have to be similar, and the more concentrated these companies are in terms of their criteria, the less diverse and more risky the portfolio is. This has not only made investing in ESG funds frustrating for environmental activists, but it has also put their values into question. In order to maximize their returns while practicing sustainable investing, they would accept ESG funds with lower preferences and more diverse portfolios. This has already been seen in practice. BlackRock’s iShares ESG MSCI USA ETF claims to track companies with good ESG scores. However, it includes Exxon Mobil Corp. which is a company under scrutiny for misleading investors about climate change regulation. This is just one of many examples of ESG funds that include non-ESG companies in their ESG portfolios.
Even though this joint relationship between investor preferences and return on risk has become an important trade-off in ESG funds portfolios, the disparity between the two brings even greater scrutiny to “ESG” practices. We discussed earlier that signatories of PRI abide by six specific principles that explain ESG criteria, however it is possible for some signatories to make a mistake and lower their ESG scores. Since these companies are signatories nonetheless, they still qualify for ESG funds. So, we might see similar cases to BlackRock above.
It has become increasingly difficult to trust ESG funds for their ratings, especially when ESG investors are so specific about their preferences. In the case of their preferences and expected returns, investors cannot properly gauge the level of risk they are willing to take if ESG funds are unreliable with their ESG scores. Underperformance of non-ESG stocks doesn’t matter in this case either, since there is virtually no effect to make ESG stocks see abnormally higher returns (Zerbib). Based on this evidence, we cannot conclude that ESG investing recognizes abnormal gains or losses compared with normal investing. With that being said, the future of ESG investing will definitely be interesting to track, so I’ll be looking to see how it evolves and if ratings become more transparent to investors.
Works Cited:
F., E., & R., K. (n.d.). The Capital Asset Pricing Model: Theory and Evidence. Retrieved from https://www.aeaweb.org/articles?id=10.1257/0895330042162430
“Sustainable Investing (ESG, SRI).” YouTube, 8 Feb. 2020, https://www.youtube.com/watch?v=weVAN2HxXjk
Zerbib, & David, O. (2019, September 20). A Sustainable Capital Asset Pricing Model (S-CAPM): Evidence from Green Investing and Sin Stock Exclusion. Retrieved from https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=3455090
