A Guide to ESGs in 2021
A basic breakdown of the new “Wall-Street darling”
The acronym “ESG” has been popping up quite frequently throughout the finance world as of late. Just last Tuesday on March 16th , State Street Global Advisors, the world’s third largest asset manager, reported billions in net inflows into one of its new ESG-screened, exchange traded funds (ETF) for the month of January. The same day, a Wall Street Journal piece entitled “The Tidal Wave of ESG Funds Brings Profit to Wall Street” made the charge that “sustainability has been good for Wall Street’s bottom line”, citing data from FactSet that showed ESG-focused ETFs had higher average fees than standard ETFs. Yet another ESG-related article was released on Tuesday on USA Today. Running contrary to the former two, however, this one scrutinized the so-called “Wall Street darling”: “in truth, sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community,” former BlackRock CIO of sustainable investing Tariq Fancy argued in the op-ed.
What are ESGs? What’s with the recent ballyhoo surrounding ESGs? What does the future hold for ESG investing? Why are ESGsimportant to companies? If you’re interested in learning the answers to these questions — as apparently simple as they are important questions — read onwards.
What Does ESG Stand For?
ESG stands for the three categories of non-financial criteria companies must be deemed passable in to receive investment from ESG-conscious exchange traded funds, mutual funds, brokerage firms, robo-advisors, etc.
E for Environment
The environmental criteria relates to how much a company is doing to conserve the natural world in its production and distribution activities. Among a plethora of other environment-related criterion, a business’ recycling practices, use of natural resources, greenhouse gas emissions, and composition and quality of products and goods are taken into consideration
S for Society
The societal criteria, on the other hand, is used to gauge the social integrity of business. The company in question is assessed on the merits of the types of suppliers and corporations it associates itself with; whether it is donating a portion of its profits to its local community or prompting its workers to perform volunteer work; whether its working conditions are humane and reasonable, etc.
G for Governance Structure
The corporate governance criteria, widely considered the least related to sustainability of the three, revolves around the activity of the company’s leadership and board. Investors looking at how a given company stacks up against the governance criteria are curious about accounting methods, the gender and racial composition of its board of directors, and its political and social affiliations.
The Sudden Rise of ESG Investing
ESG investing has enjoyed somewhat of a meteoric rise in popularity in recent years, so you may be surprised to learn that its origins trace as far back as 2005. This was the year the term was first coined by Ivo Knoepfel in a landmark study entitled “Who Cares Wins”, which argued for the integration of environmental, societal, and governance principles into the capital market system. Around the same time, UNEP/Fi produced the “Freshfields Report”, which elucidated the link between companies taking strong ESG propositions and their financial valuation. Together, these two reports — building atop the already-alighted Socially Responsible Investing (SRI) movement — launched the ESG movement.
2020, the “year of” many things — COVID-19, the election, violence, the economic downturn — has also been called the year ESG “came of age”. Indeed, according to Bloomberg, 2020 saw ESG bond issuance reach a record-breaking $732 billion in 2020.
Equally a driver as it was a symptom of intensifying investor optimism, ESG-screened funds enjoyed astounding success in 2020. According to S&P Global Market Intelligence, 14 of 17 ESG-minded exchange-traded and mutual funds had higher returns than the S&P 500 in 2020 through July 31st. Later analysis done in May 2020 found that all 17, but two of those funds had lost value in the year to date.
What made ESG stocks so resilient to 2020’s bear market? How can the recent investor hype be explained? Like nearly all trends in the financial world, the “why” is a cocktail of reasons. Below are two of the most commonly cited ones.
A Generation of Millennial Investors
According to research done by The Economist Intelligence Unit (EIU), 76% of the younger generations in the UK believe it is important to consider ESG factors when making investment decisions; this is compared to 37% of older generations. As for the youth of the U.S., a survey conducted by Morgan Stanley’s Institute for Sustainable Investing found that 86% of Millennials are interested in sustainable investing, and 90% claimed that they wanted sustainable investing as an option in their 401(k) plans. The spike in ESG excitement, thus, can be seen as the cumulative result of wealth landing in the hands of more and more Millennials, whose proclivity towards sustainability has had them encouraging and making ESG investments.
The Future is ESG investing
According to projections by Bloomberg, assuming 15% growth, which is half of the rate of growth witnessed over the past five years, global ESG assets under management (AUM) will reach $53 million by 2025. With the impetus of the Paris Agreement of 2015 — the signatory countries of which are legally bound to working to limit global warming to well below 2° C — and the added force of the United States’ planned reentrance, we may very well overshoot this forecast. Such must be thought by investors alike, as the world’s largest investment banks, including Citigroup, BlackRock, Deutsche Bank, and Goldman Sachs, have pledged to massively expand their ESG assets under management.
Why Companies Should Care.
Given the enormity and luminance of the future of ESG investing, it is no longer just morally imperative, but now financially advisable that companies up their ESG ratings. Among the various frameworks of justification offered for companies to take into consideration such non-material factors, the one offered by Henisz, Koller, and Nuttall in 2019 in the McKinsey quarterly was most notable in my subjective opinion, and for this reason will be largely referred to in the remainder of this piece.
According to Henisz, Koller, and Nuttall, there are five links between ESGs and value creation that make it worth a company to become ESG-conscious.
The First Link: Top-line Growth
Governing authorities are more likely to entrust companies that promote ESGs with access, approvals, and licenses — the use of which would allow said companies to tap into new, previously unexplored markets.
The Second Link: Cost-Reduction
Promoting ESGs have been shown to serve the secondary function of limiting a company’s operating expenses (raw-material, water, and carbon costs). Indeed, studies by Mckinsey have found a correlation between focus on resource efficiency — a natural consequence of being ESG-conscious — and better financial performance.
The Third Link: Greater Freedom from Regulatory and Legal Bodies
Across sectors and geographies, a strong ESG proposition was shown to help reduce a company’ risk of being inflicted with adverse governmental action and inversely, increased its likelihood of receiving government support.
The Fourth Link: Increased Employee Productivity
Companies that supported the ESGs not only found it easier to attract and keep quality employees, but also enjoyed increased employee productivity. The sense of purpose and peace of mind that employees working at openly ethical corporations, in other words, proved immensely salutary to efficiency and work quality.
The Fifth Link: Investment and Asset Optimization
ESG-aware companies have been shown to be more likely to optimize return on its investments because they allocate money to more sustainable ventures (for example, renewables, waste reduction, and scrubbers).
