ESG Investing: Background, Trends, and Strategies

Summary

This is a presentation on Environmental, Social, and Governance (ESG) investing. It details the background, trends, and strategies related to the topic. Key aspects discussed include environmental concerns like climate change and social issues like workplace safety and ethical practices, along with governance topics.

Full Transcript

Never doubt that a small group of thoughtful, committed citizens can change the world. Indeed, it is the only thing that ever has. Margaret Mead, anthropologist H. J. T u r t l e s l i d e s f o r E G B G C h a p t e r 2 5 , a l s o sDr. e e H.J. Turtle 2014, 2020, and 2023 (not for redistribution)...

Never doubt that a small group of thoughtful, committed citizens can change the world. Indeed, it is the only thing that ever has. Margaret Mead, anthropologist H. J. T u r t l e s l i d e s f o r E G B G C h a p t e r 2 5 , a l s o sDr. e e H.J. Turtle 2014, 2020, and 2023 (not for redistribution) B K M , I nv e s t m e n t s , C h a p t e r s 2 4 , a n d 2 7  ESG Background and context  High levels of interest by investors suggest ESG will continue to     be an important area for years to come ESG investing now accounts for an increasing and substantial percentage of managed assets in both the US and globally Younger investors emphasize ESG objectives (relative to older generations) Large inflows to ESG investments continue New ESG funds continue to be introduced  What is ESG?  Environment  Climate change, pollution, greenhouse gas, carbon footprint, water availability, sea-levels, renewable energy, biodiversity, reduce, reuse, recycle  Social  Employee pay, benefits, engagement, turnover, diversity, inclusion, ethical supply chains, corporate social responsibility, social justice issues  Governance  Executive compensation, use of golden parachutes, board diversity and independence, voting structures  ESG related strategies  Socially responsible investing  Positive and negative filters  Risk management  Impact investing  Engagement and activism  ESG integration  Economic underpinnings  Understanding externalities  The Pigou Club  The Coase Theorem  How to accomplish change  Available resources BACKGROUND, CONTEXT, AND TRENDS ESG investing has seen tremendous growth and investor interest in recent years  Early religious roots  Judaism (avoidance of immoral industries)  Islam (avoidance of gambling, alcohol, pork products, immoral goods, gold & silver and weapons)  Quakers precluded investment in the slave trade. Two Quakers (John Freame and Thomas Gould, beginning in 1690) went on to form Barclays Bank, and another Quaker, John Lloyd was an original founder of Lloyd’s bank  A Methodist, John Wesley, suggested resisting investment in sinful industries such as tobacco, firearms, and alcohol  Socially responsible investing prevalent in the 1960’s through negative filters related to tobacco, and companies related to the Vietnam war effort  Global disinvestment and pressure against Apartheid (a structure that included racial segregation) led to change in South Africa  In the 1980’s SRI continued with renewed emphasis on environmental disasters like the Exxon Valdez, and Chernobyl  US SIF (US Sustainable Investment Fund) established in 1984  Standard approaches at this time were based on negative filters  By the 1990s, we began to witness the development of social indices (such as the MSCI KLD 400 Social Index, originally the Domini index launched in 1990)  In 2004 Kofi Annan encouraged over 50 financial institutions to integrate ESG into capital markets  2005 paper by Ivo Knoepfel (Who Cares Wins)  Later led to the development of the Principles for Responsible Investment in 2006, and the Sustainable Stock Exchange Initiative in 2007  Interest and growth has continued, with ESG related issues becoming mainstream and giving rise to many future opportunities  Sustainable Finance is closely linked to a variety of terms  Climate risk  Socially Responsible investing  Impact investing  Green finance  ESG investing  Corporate social responsibility  We will tend to use the current ESG, or sustainable investing  We will also discuss the traditional SWM (shareholder wealth maximization) and stakeholder wealth maximization as these frames of reference arise  Firms face material risks related to ESG exposures  Climate risks may dramatically damage a firm’s prospects (e.g., ocean rise and property values for at risk locations)  Legal litigation risks around governance failures  Firm value may, or may not be impacted, by ESG related risks under a pure shareholder wealth maximization (SWM) view of the world  ESG investors may care about broader issues as reflected in stakeholder wealth maximization, BUT the environment/biodiversity is often not reflected in these broader views  Impact investors may explicitly care about more than SWM and may be willing to sacrifice value, or risk adjusted return for nonfinancial outcomes (such as carbon reduction)  The Friedman doctrine (1970) suggests corporations should maximize shareholder value Firms should maximize value Shareholders can then give to support non-value related causes with created surplus gains Oft-claimed views:  In the long run, bad behaviors will be revealed and SWM will create best social/economic outcomes  If more than one objective is present, than no objective can truly be followed Source: Global Sustainable Investment Review Source: Global Sustainable Investment Review (Asset values are expressed in billions of US dollars) E, S, AND G Understanding the components of ESG  Climate change Change of climate, directly or indirectly attributed to human activity that alters the composition of the global atmosphere and ecosystems in addition to natural climate variability observed over comparable periods ( proposed era name, the Anthropocene) Risks include  Transition risks as we shift to new low carbon energy sources  Risk of stranded assets in coal, oil, gar, petrochemical industries  Physical risks related to, for example, sea rise, tornadoes, and hurricanes  Pressure on available natural resources such as water, fuels, and related agriculture impacts Pollution, waste  Linear and circular economies Biodiversity  Business and the environment Climate change Physical risks to the business such as extreme weather (tornadoes, hail, hurricanes), rising sea levels, acidification, crop damage Natural resources have direct impacts on the firm and also indirectly through the supply chain Related disclosure requirements are increasing Supply chain knowledge is important for firms to understand Climate risks have an impact on the overall economy and the financial system (both physical risks and transition risks)  Solutions to climate change problems Mitigation and reduction of greenhouse gas Limit greenhouse gas growth Mitigate agriculture impacts Sustainable economic development in energy, buildings, transportation, land, agriculture, and manufacturing Adapting to climate change (which may be inevitable) Protect coastlines against sea rise and flooding Scarce water resources (irrigation, residential lawns) Drought resilient crops (e.g., new hybrid wine variants) Improved heating and cooling systems  E factors also provide opportunities Recall your corporate finance discussions regarding both static NPV and real options Circular economy related opportunities Emphasis of many economic regions New product opportunities as a result of lost existing businesses E.g., new hybrid agricultural products, new clean technology to respond to scarce resources New financial products Green bonds, ESG mutual funds, activist ESG hedge funds  Social issues Workplace safety, conditions of employment, minimum wages Diversity and elimination of bias Labor relations and unionization Community development Avoidance of harmful products, product liability, consumer protection Human rights, avoiding controversial sourcing  Implications can be important Violations to best practice social norms can also negatively impact business outcomes Impacts include employee turnover, retention problems, hiring costs, training costs, potential loss of customers, loss of brand reputation, loss of customers  Social impacts are not viewed similarly by all in society Lack of consensus in measures (e.g., what is the correct minimum wage, hours worked per week, remote vs face to face work decision) Differences in how metrics should be aggregated differ between individuals These issues combine to impact differences in S scores, and even ESG scores  Corporate political contributions  Executive compensation  Board diversity and independence  Shareholder rights, shareholder proxies  Anti-corruption policies  The agency relationship between managers (agents) and shareholders, and other stakeholders (principals) may not be fully aligned. This can cause the company not to behave in the principals’ interests  Governance problems can have serious negative outcomes E.g., Theranos board independence and lack of specific expertise Recent guilty outcome for both Elizabeth Holmes and Ramesh (Sunny) Balwani  Like social impacts, governance impacts, are not viewed similarly by all in society Lack of consensus in measures (e.g., what is fair executive compensation, what is the correct firm orientation SWM vs stakeholder wealth maximization) Differences in how metrics should be aggregated differ between individuals These issues combine to impact differences in G scores, and even ESG scores  Filters  Positive or negative  Shareholder activism  Shareholder proposals  Hedge fund activists (may be for or against ESG initiatives)  Impact investing with a focus on more than financial returns  A related concept, conscious capitalism, also focuses on other stakeholders such as employees, customers, communities, and the environment.  Studies of pure ESG financial performance offer mixed results  Merton (1987 JF) suggests there should be a premium on neglected stocks that could apply to non-ESG investments (see also Hong and Kacperczyk, 2009 JFE, Pastor, Stambaugh and Taylor, 2021 JFE, or Zerbib, 2022 RevFin)  Bolton and Kacperczyk (2021 JFE) find a carbon risk premium paid to carbon risk owners  Edmans (2011 JFE) shows value in employee satisfaction  Eccles, Ioannou, and Serafeim (2014 MgtSc)  Aggregate changes in preferences and realized macro risks associated with non-ESG stocks may give rise to performance benefits in some periods  Whelan, Ulrich Atz, Tracy Van Holt and Casey Clark (2020 NYU WP) meta-study finds ESG improves operating efficiency, stock performance and lowers cost of capital  A reduction in the investment choice set must produce a weakly poorer set of mean-variance choices  The risks of ignoring ESG can be catastrophic  PG&E recently filed for bankruptcy after large impacts around climate change related California wildfires  It may be difficult to measure ESG impacts beyond purely financial metrics given the set of available investment tools  Many ESG metrics may be poor measures of ESG issues  Interpolation/estimation of data is common as we develop better metrics  Different investors have very different ESG perspectives that can conflict  Different ESG metrics are not closely correlated  Greenwashing is the practice of presenting guidance suggesting an ESG perspective when the majority of data suggests a contrary perspective ECONOMIC UNDERPINNINGS The economic underpinnings of ESG investing are important Externalities matter  An economic externality is a cost or benefit that is unrelated to any behavior of that party  Externalities can be positive or negative  Universities may provide positive externalities to a region through economic spinoffs, research and development, an educated workforce, or cultural events  A coal plant may produce a negative environmental externality to residents in the region around the plant in the form of pollution  A common solution to negative externalities is taxation, and most commonly a Pigovian tax  Another category of solution relates to the Coase Theorem  Named after Arthur Pigou  Widely supported by many economists around the world  Greg Mankiw (Harvard economist) has coined the phrase, the Pigou Club to foster support for the idea of using a tax to more accurately reflect social costs  Membership is broad and includes politicians, economists, legal scholars  The unadjusted private market equilibrium does not reflect all social costs and therefore results in prices that are too low and a quantity of output that is too large, if all costs were accurately captured Price, P Marginal social cost Marginal private cost + tax Marginal private cost Price = marginal revenue Q* new Q* original Quantity, Q  The Coase theorem (1991 Nobel prize) says that when there is a conflict of property rights, the affected parties can negotiate an efficient outcome  Assumes transactions costs are zero  A mutually beneficial bargain can be reached between the polluter and victim if the damage from pollution is greater than the polluter’s return from polluting  If property rights are owned by victims, polluters may be able to pay for the right to pollute  There remains an important role for government in assigning property rights  Difficult to implement when there are many agents, large transaction costs, and enforcement costs (e.g., one coal plant impacting thousands of nearby residents).  Adrian, Bolton, and Kleinnijenhuis (2022 IMF WP) propose a Coasian bargain they call the great carbon arbitrage  Estimated costs of coal $78 trillion (1.2% of GDP, $125 per tonne of coal)  Public/private funding model where developed nations pay the required estimate of $29 trillion to switch away from coal to developing nations (that are highly reliant on coal) CHANGE IS DIFFICULT  How does change happen?  What forces are necessary at the interpersonal, societal, and institutional levels?  Spheres of interest  Your personal life  Habit formation (small changes might occur through habit)  Psychology of change (convincing with logic vs emotion)  Your workplace  Society at large  Global disinvestment and pressure against Apartheid (a structure that included racial segregation) led to change in South Africa  Vietnam protests and defense contractor firms  Recent protests around race and policing SOME CONCLUDING REMARKS, ISSUES AND RESOURCES This is an emerging area that will experience tremendous growth and change as it evolves in the coming decades  A prudent person/expert acting as a fiduciary managing other people’s money must follow best practices in terms of horizon, risk tolerance, and expected return.,  ERISA rule under the DOL governing private sector company pension plans (e.g., 401(k), and deferred compensation plans), but also broadly sets parameters for best practices  An important consideration: Can ESG funds can be selected as the QDIA (Qualified Default Investment Alternative)  Important because many participants, by default, select the QDIA  Can ESG considerations limit the risk/reward tradeoff if impact is sought by investors? Do ESG considerations impact risk and improve risk/reward tradeoffs?  Typical practitioner opinion: ESG can be used as a tie-breaker. ESG investors choose investments that provide better risk/reward trade-offs, and their clients compare ESG investments relative to unrestricted benchmarks  At the firm level, managers/Directors must act in the best interest of the company (not as strong as SWM). The business judgment rule provides protections for boards’ decisions not perfectly aligned with SWM.  Various ESG scores are not highly correlated due to differences in inputs and their weightings within the aggregate scores  Globalization  Social media, and data privacy  Automation, AI  need for labor and capital in the production function  potential for decreased hours worked  impact on inequality  Diversity focus  Urbanization has increased from 30% in 1950 (projected to 70% by 2050)  Increased global population  Demographic changes suggest that ESG issues will be an important consideration for any participant in financial markets as an investor, corporate manager, or as a financial institution manager  “Investors Seek Consensus on ESG as a Fiduciary Duty” Institutional Investor, October 12, 2015, Kate Gilbert.  James Andrus ($286B CalPERS portfolio manager) As a practical matter, the definition of fiduciary duty has not changed … But … if you are a long-term investor, you have to take environmental, social and governance factors into consideration because of the adverse implications of not doing so.  Mark Carney (while Governor, Bank of England) The combination of the weight of scientific evidence and the dynamics of the financial system suggest that, in the fullness of time, climate change will threaten financial resilience and longer-term prosperity  ESG provides an excellent opportunity for you to hone your thoughts around the integration of your values, career plans, and life choices  US SIF -- The forum for sustainable and responsible investing (https://www.ussif.org/)  ESG company ratings  Bloomberg (https://www.bloomberg.com/impact/products/esg-data/)  MSCI (https://www.msci.com/esg-investing)  Morningstar Sustainalytics (https://www.sustainalytics.com/)  TCFD (Task Force on Climate Related Financial Disclosures)  https://www.fsb-tcfd.org  Sustainability reporting  Sustainability Accounting Standards Board (https://www.sasb.org/)  Global Reporting Initiative (https://www.globalreporting.org/information/aboutgri/Pages/default.aspx)  United Nations supported Principles for Responsible Investment (PRI) https://www.unpri.org/  Sustainable Stock Exchanges Initiative (https://sseinitiative.org/)  NASDAQ ESG reporting guide (https://www.nasdaq.com/ESG-Guide)  NASDAQ ESG Investing resources (https://www.nasdaq.com/education/esginvesting%3A-put-your-money-where-your-values-are)

Use Quizgecko on...
Browser
Browser