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Confusion or clarity?

Cut through the ESG hype

Paul Markham and Lloyd McAllister, Newton1

For Newton’s Paul Markham and Lloyd McAllister, ESG is more than just a buzzword: it opens the door to sustainable investing with the potential for superior risk-adjusted investment returns. But to get there does take effort.

These days, ESG2 is everywhere. From global corporates belatedly committing to gender equality, or asset managers launching ‘sustainable’ ETFs, the three-part environmental, social, governance mantra has become the new normal.

But look behind the headlines and how much of the buzz around ESG is meaningful and how much is hype? For Newton fund managers Paul Markham and Lloyd McAllister the reality of ESG is a complicated one. On one hand there are significant challenges we all face. Whether that’s the threat of climate change or the harvesting of personal data by social media companies or a lack of diversity at work – the problems are real and pressing and they affect how companies conduct their business each and every day.

What’s also true is how a growing body of academic research suggests companies engaged with ESG can offer better shareholder returns. This was the unequivocal conclusion from a paper published by The Centre for Endowment Asset management (see Figure 1 below), part of the Cambridge University Judge Business School3. The report concludes that companies that had actively and successfully engaged with ESG, provided superior returns versus peers that had failed to do so.

Research by economists Gunnar Friede, Timo Busch & Alexander Bassen published in 2015 drew similar conclusions. Here, evidence from more than 2,000 empirical studies found a clear link between ESG and positive financial performance4. More recently still, a report from the IMF underlined how diversity in the workplace – from bringing women into the labour force, for example – can create economic benefits over and above those resulting from simply having more workers.5

Figure 1: Newton Centre for Endowment Asset Management : Cumulative abnormal returns after engagement

Source: Dimson, Li and Karakas (2015), Newton centre for Endowment Asset Management.The study involved 613 US companies between 1999 and 2009.

For Markham this kind of research underscores the fundamental importance of taking a sustainable path to investing6. At the same time, though, he notes how many companies and asset managers make mileage out of genuine concerns about ESG principles to portray themselves in a better light than their actions merit.

“We’ve seen numerous examples of this – companies using ESG to burnish their image even if their actual credentials on that score are questionable,” he says. “That’s everything from car manufacturers selling the benefits of ‘clean diesel’ to oil companies using imagery from the natural world for their logos.”

The problem with rankings

Perhaps this is unsurprising. Markham notes how effective ‘greenwashing’ can be. Consider the question of corporate ESG rankings. Here, Markham highlights how data companies compiling these rankings often rely on artificial intelligence and algorithms susceptible to manipulation. “If, for example, a company adds ESG buzzwords to its communications with shareholders, or devotes extra space to ESG in its annual report, the chances are its ESG score will improve even if it hasn’t actually made any improvements on the ground,” he says. “In this sense, the ESG scores can become systems to be gamed by companies.”

For investors, this illustrates a key challenge: understanding a company on its commitment to ESG concerns is sometimes as much an art as a science. Take the example of US electric vehicle maker Tesla (see Figure 2). Here, depending on which of three ESG data providers you believe, Tesla is either woefully lacking, slightly better than average or ahead of the game on its environmental commitments. Or consider Warren Buffet’s investment vehicle Berkshire Hathaway which could be either terrible or average in its social impact – again depending on which data provider you believe. “

Figure 2: As clear as mud? Company ESG rankings according to three different data providers

Source: Newton, accessed December 2018

 

In this sense, the many data providers that supposedly shine a light through the fog of corporate responsibility often create as much confusion as clarity. Says Markham: “We’re not saying the data providers are useless: far from it, they definitely have a place and they do add value. The issue is more with the lack of agreement on what constitutes E, S and G in the real world. This underscores how arbitrary this kind of approach to ESG ranking can be.” Instead, Markham argues for the personal touch. This begins with having a far more focused investment strategy with a manageable portfolio of just 50 companies. “If you’re serious about really understanding what you’re investing in you can’t take the same tack as an ESG tracker fund. You need to move away from that passive catch-all approach and really drill down to understand what each of the companies in your portfolio is doing. Are they really making progress on ESG or just putting on a show of doing so? Are they fobbing you off or telling the truth? It takes time and effort but it’s a fundamental question that determines whether or not a company should have a place in a sustainable portfolio.” For the future, Shant believes the industry is only just beginning to get to grips with the question of ESG. “For all the changes we’ve seen and as much as ESG has become a buzzword in its own right I firmly believe we’ve barely scratched the surface,” he says. “In 10 years’ time what’s considered ground-breaking now will be absolutely normal. We won’t be having these conversations about why sustainable investing makes sense.”

 

Three approaches to ESG

 

So, how has the asset management industry traditionally addressed the question of ESG? Shant highlights three types of responsible investing that have gained traction in recent years: exclusions and screening, active ownership and sustainable investing. With screening, says Markham, there are as many different approaches as there are clients. You could consider ethical screening, for example, where you avoid companies whose products or services are considered detrimental to society. Or you could screen for energy companies producing hydrocarbons and thus adding to the world’s CO2 burden. He explains: “In one sense, this kind of approach works quite well since the values of the client and the underlying investments in the strategy are very closely aligned. At the same time, though, we’d argue this kind of negative exclusionary approach does nothing to actively promote ESG goals or engage with companies to create positive change.” Another approach, and this is the most common one in the investment industry, is often called ‘integrated ESG’. Says Markham: “This is probably the vast majority of assets managed in the global industry, and that’s certainly the case at Newton.” In this approach, any material non-financial ESG factors are considered alongside the more traditional financial metrics. Clearly, this allows the investor to develop a more holistic view of a company. However, the mandate is usually to maximise returns and so investors may sometimes find their portfolio owning companies with poor ESG profiles, because the stock was deemed to be cheap enough to compensate for the ESG risks. A third approach is active sustainable investing, which seeks to elevate the importance of the ESG factors so that they are at least as important as the financial considerations. This combines screening out companies with the worst ESG profiles, active ownership and the desire to identify companies likely to benefit from ESG engagement. Active ownership, that is, to engage with management of a company with a view to influencing behaviours can help drive more positive ESG outcomes which are a benefit to both society and investors, says Markham (see Figure 1). Engagement can take the form of voting against poor governance by management, for example, or opposing measures likely to cause environmental damage. (See Cobalt mining: A case study, below, for a practical example of how Newton has engaged with the management of a company in which it invests to create positive outcomes.)

Concludes Markham…

“We want to go beyond just avoiding companies that may be problematic but to actively choose those that can make a positive contribution through the application of ESG principles and improve profitability by doing so.”

Figure 3: Types of responsible investing

1: ESG: Environmental, Social and Governance. 2: SRI: Socially Responsible Investing

ESG: A timeline

1Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.

2Environmental, Social and Governance (ESG) has become shorthand for a more sustainable approach to business where environmental concerns, greater diversity and equality and shareholder value are a priority.
3The Centre for Endowment Asset Management is a research and education centre dedicated to further scholarship and understanding of long-horizon investing. Newton was an early supporter of the Centre.
4Journal of Sustainable Finance & Investment: ‘ESG and financial performance: aggregated evidence from more than 2000 empirical studies’, by Gunnar Friede, Timo Busch & Alexander Bassen, Taylor & Francis, 15 December 2015.
5IMF: ‘Economic Gains from Gender Inclusion: New Mechanisms, New Evidence’, October 2018
6For additional research-based evidence of the links between sustainable investing economic value see Corporate Sustainability: First Evidence on Materiality, Harvard Business School, 2015 (Khan, Serafeim & Yoon); A Tale of Values-Driven and Profit-Seeking Social Investors, Journal of Banking and Finance, Vol 35, 2011 (Derwall, Koedijk & Ter Horst) and The Economic Value of Corporate Eco-Efficiency, Kellogg School of Business 2010 (Guenster, Derwall and Koedjik)

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