Environmental, Social, and Governance (ESG) Investing

A Balanced Analysis of the Theory and Practice of a Sustainable Portfolio

John Hill

• Publisher: Academic Press
• Year: 2020
• ISBN:
  9780128186930
• Topic: Betriebswirtschaft
• Subtopic: Finanzwesen

Environmental, Social, and Governance (ESG) Investing: A Balanced Analysis of the Theory and Practice of a Sustainable Portfolio presents a balanced, thorough analysis of ESG factors as they are incorporated into the investment process. An estimated 25% of all new investments are in ESG funds, with a global total of $23 trillion and the U.S. accounting for almost $9 trillion. Many advocate the sustainability goals promoted by ESG, while others prefer to maximize returns and spend their earnings on social causes. The core problem facing those who want to promote sustainability goals is to define sustainability investing and measure its returns.

This book examines theories and their practical implications, illuminating issues that other books leave in the shadows.

• Provides a dispassionate examination of ESG investing
• Presents the historical arguments for maximizing returns and competing theories to support an ESG approach
• Reviews case studies of empirical evidence about relative returns of both traditional and ESG investment approaches

Chapter 1

Introduction

Abstract

This chapter provides a summary and overview of the organization of the book. In the last decade, the amount of assets being invested in socially responsible investment products has increased dramatically, and with the growing importance of the Millennial generation and the emergence of Generation Z, this trend is likely to accelerate. Roughly one-quarter of all global assets under management (AUM) are now being invested with a consideration of environmental, social, and governance (ESG) factors. It’s estimated that ESG AUM global totals are over $23 trillion. In the United States, ESG-focused AUM were estimated to be $12 trillion at the start of 2018. This is about 26% of total assets under professional management. One Wall Street firm found that 75% of individual investors sought to include ESG considerations into their investment choices. The objectives of this book are twofold: first, provide an overview of the competing theories and empirical evidence underlying ESG investment and second, summarize some of the most interesting forms of ESG investment vehicles and modalities themselves.

Keywords

Business roundtable; climate change; Mark Carney; ESG; Milton Friedman; principles for responsible investing (PRI); sustainable development goals (SDG)

Chapter Outline

Outline

• Principles for responsible investing 5
• Sustainable development goals 6
• The scope of this book 7
• Chapter 2: ESG, SRI, and impact investing 8
• Chapter 3: Theories of the firm 8
• Chapter 4: Fiduciary duty in investment management 9
• Chapter 5: Overview of financial institutions 9
• Chapter 6: Financial markets: equities 10
• Chapter 7: Financial markets: bonds 10
• Chapter 8: Shareholder engagement 10
• Chapter 9: Defining and measuring ESG performance 10
• Chapter 10: ESG in managing institutional investor funds 11
• Chapter 11: ESG in managing college and university endowments 11
• Chapter 12: ESG in managing sovereign wealth and government sponsored funds 11
• Chapter 13: ESG in managing family foundations and family offices 11
• Chapter 14: Faith-based investing 11
• Chapter 15: ESG investing-organizations having direct impact 12
• Chapter 16: What’s next for ESG investing 12

Individuals and institutional investors alike have increasingly expressed their concerns about the environmental, social, and governance (ESG) practices of companies they invest in. In annual surveys asking institutional investors to rate the characteristics of a company that they most respect, “ethical business practices” has risen to the top, over other categories such as “strong management.” In the last decade, the amount of assets being invested in socially responsible investment products has increased dramatically, and with the growing importance of the Millennial generation and the emergence of Generation Z, this trend is likely to accelerate. Roughly one-quarter of all global assets under management (AUM) are now being invested with a consideration of ESG factors (GSIA, 2017). It’s estimated that ESG AUM global totals are over $23 trillion. In the United States, ESG-focused AUM were estimated to be $12 trillion at the start of 2018. This is about 26% of total assets under professional management. As impressive as these totals are, interest in ESG seems even more widespread. One Wall Street firm found that 75% of individual investors sought to include ESG considerations into their investment choices. These trends are not going unnoticed. All the large investment managers have developed funds oriented to investors concerned with ESG issues. Undoubtedly, some of these offerings have more to do with marketing the concept than rigorously pursuing ESG goals, but the fact that they exist points to recognition of growing investor interest.

Some key takeaways on the growth of ESG investing:

• • Growth of AUM in ESG investments will continue and be even more significant in the coming years.
• • ESG portfolios can have financial performance like conventional portfolios, but this requires attention to the risk and return characteristics of the portfolio components. Simply divesting “sin” stocks is likely to result in portfolio underperformance, which can have substantial risks, including insufficient returns to support retiree and other beneficiary income requirements, and may result in employment risks to fund managers.
• • Significant issues remain in defining ESG factors, measurement of impacts and reporting.
• • While ESG is growing, it is still the focus of a minority of investors; 75% of US investing is in conventional portfolios and 80% of university and college endowments similarly follow conventional investing prescriptions.

One of the world’s largest fixed income investment managers identified the following factors as drivers of the increased focus on ESG investment (PIMCO, 2017):

• • Good governance is systemically important.
  The global financial crisis of 2008 brought a renewed awareness of the importance of improved corporate governance.
• • Public–private partnerships are expanding.
  Public–private collaboration has grown to tackle broader social and environmental issues.
• • Growing recognition that climate change is a reality.
  Climate change is now (almost) universally acknowledged. Public and private initiatives include sustainable investment portfolios and more disclosure of climate-related financial risks.
• • Energy sources are shifting.
  Natural gas usage is increasing and renewable energy sources are becoming cheaper and scalable.
• • Technology is changing what we demand and how we consume.
  Technology is driving widespread change, and most sectors of the economy are seeing paradigm shifts in the way business is conducted. Companies unwilling or unable to change are falling behind and are likely to put investors at risk.
• • Social media is influencing social norms.
  With its borderless nature, and dominance by Millennials and Gen Xers, social media has been effective in communicating new values and norms in responsible consumption and investing.
• • We are living longer.
  By 2050, there will be 2.3 billion people in the world over age 65. Sustainability issues will directly affect financial security of these retirees.
• • Demographics are changing.
  Millennials have become the largest population cohort and are increasingly changing business, financial, and political landscapes. For example, younger generations are driving the fast growth of the “green bond” market and the field of sustainable finance in general.
• • Regulation is providing tailwinds.
  ESG considerations have driven new regulations in a growing list of countries. Examples include the shutdown of nuclear power in Germany, the Supervisory Review and Evaluation Process (SREP) in Europe, which governs subordinated financial debt, and France’s mandatory reporting of climate risk, which raises the bar for financial institutions. In the United States, regulatory support is not as aggressive, but may be growing.
• • Value chains are global.
  Large corporations’ value chains are increasingly global. Global investors can be quick to punish companies for child labor practices, human rights issues, environmental impact and poor governance.

While ESG investing is growing in importance, it is also clear that most investing today is done with little if any concern about ESG factors. In the quarterly earnings calls that companies hold with investors ESG issues rarely if ever are brought up. If 25% of global AUM are invested with at least some reference to ESG factors, then 75%, a very large majority, still do not consider these factors. In many academic communities, ESG issues are strongly and fervently supported. Yet university endowment ESG investments are estimated at less than 20% of total AUM, leaving 80% of endowments to be invested using more traditional criteria. It would be naïve and counterproductive to think that all these investors are ill informed, or unconcerned about ESG issues. An important perspective of this book is to fairly consider the point of view of those investors who are not yet convinced of the relevance of ESG factors to their investment decision-making.

Until recently, the popular wisdom has been that ESG investors would have to accept a lower return from their “virtuous” portfolios. This assumption is no longer universally accepted and empirical evidence, although mixed, seems in most cases to support the contention that ESG investing does not have to underperform traditional portfolios. Early studies looking at simple divestment strategies found that those funds often underperformed. But more nuanced strategies are seen to support the conclusion that ESG investments need not result in subpar financial performance.

Morningstar, the highly respected rater of investment funds, in its review of ESG fund performance in 2017 concluded that “sustainable funds are competitive on price and performance” and “performance skews positive over both the short term and the long term.”

There have also been several thorough reviews of meta-studies of ESG performance. These reviews support the conclusion that companies with strong ESG performance also score highly on traditional financial metrics (Morningstar, 2018).

There is an increasing belief that sustainability and profitability are two complementary sides of the same coin. But there are several challenges to investing both profitably and responsibly, or “doing well ...