As trillions of dollars of capital begin to recognize the importance of external stakeholders and environmental, social and governance (ESG) factors for long-term sustainable returns, asset managers, asset owners and the investment community should consider whether Sen. Elizabeth WarrenElizabeth WarrenDemocrats confront 'Rubik's cube on steroids' The Trojan Horse of protectionism Federal Reserve officials' stock trading sparks ethics review MORE’s (D-Mass.) Accountable Capitalism Act is an ally rather than an obstacle.
Over the past few years, investors have already begun to act as if they understand the importance of a broader set of interests beyond short-term financial returns.
Warren’s bill has brought these issues to the fore more so than any moment since Larry Fink’s annual letter to shareholders. Will investors’ momentum and analysis be sufficient to tame unbridled capitalism, or would they benefit from the legislative nudge (or shove) she proposes?
A review of a decade of progress in ESG investing suggests a need for policy change such as Warren espouses.
A decade ago, ESG investors focused on values and developed lists of “exclusions” (i.e., companies or products that they would avoid on ethical or moral grounds).
At best, such strategies sacrificed only minor returns and allowed socially conscious investors to sleep better at night knowing their portfolios did not include munitions manufacturers, tobacco growers or private prison operators accused of human rights violations.
Subsequently, a small group of long-term investors began to identify governance, environmental or social issues neglected by management in large corporations and actively partnered with big firms to address these issues and the material risks they posed to shareholders.
For the narrow set of companies engaged by these investors, evidence of positive financial returns began to emerge.
Efforts to expand this strategy beyond a few hundred firms have foundered on the lack of credible data by which to assess what ESG risks are material for what firms and how they could best be measured. Most ESG data was disclosed voluntarily in sustainability reports or in response to surveys.
Not surprisingly, companies chose to disclose obfuscating data related to material risks and showcased data that put them in good light. Bloomberg reports that only 29 percent of investors are confident in the ESG data they receive and Ernst & Young reports that confidence is falling rapidly.
There are multiple reasons for this dissatisfaction. At the core, however, is the black box nature of each data provider’s methodology. What variables should I consider? With what weights? How do I manage missing data?
Each data provider makes their own choices and these differences lead to wildly different rankings for the same firm from different data providers. As compared to a 0.9 correlation among credit rating agencies, correlations among providers of ESG data are typically below 0.6 and, for S scores, as low as 0.05.
This gives rise to a legitimate concern that any link between ESG performance and financial performance could have more to do with strategic choices on information disclosure by firms or short-to-medium-term industry-specific returns rather than actual variation in firm-level ESG performance.
This gap between the demand and interest in ESG and the supply of reliable data necessary to build a diverse portfolio of companies taking into account ESG risks has triggered innovation and competition among data providers.
Recent advances in automating the collection and coding of news clippings, social media posts, government regulatory filings and other data sources using big data approaches and artificial intelligence to sift signal from noise have markedly improved the reliability, objectivity and coverage of ESG data.
I talked with @JimCramer about my new bill to hold businesses accountable to their employees – not just their shareholders. It starts by giving workers at big companies the right to select 40 percent of the company's board members. pic.twitter.com/SzTsiqMkAC— Elizabeth Warren (@SenWarren) August 16, 2018
A growing body of evidence highlights that portfolios that draw upon more accurate data substantially outperform benchmarks. The data reveals great opportunity:
- Independent research by, among others, Harvard Business School’s George Serafeim and his co-authors, show that portfolios of high performing ESG firms outperform benchmarks.
- Research by London Business School’s Alex Edmans shows as high as a 4 percent per annum return to investing in firms within an industry with above average employee satisfaction;
- Euler Hermes, Breckenridge Capital and Calvert Research and Management independently report a significant negative correlation between credit market spreads and ESG scores highlighting that better management of ESG risks is correlated with lower risk and more stable return profiles;
- MSCI reports that firms in the bottom quintile of ESG performance are twice as likely to suffer a catastrophic loss within three years as their peers.
The same tools can be used to identify risks of individual companies. For instance:
- Equifax received the lowest ranking from MSCI and was rated as an underperformer by Sustainalytics for their management of cyber risk months before the catastrophic data breach.
- Snap substantially underperformed its industry peers for over a year on diversity, human rights and data security and privacy in TruValue Labs data prior to the May 2018 collapse of its stock price in response to claims of rampant sexism and a toxic work environment.
- 3M lagged its industry peers in TruValue Labs data since 2016 due to repeated stories regarding water pollution in Minnesota, but the stock price only dipped in February 2018 with the announcement of an $850 million settlement to the $5 billion lawsuit.
While we are still in a period of ferment, ESG factors have entered the mainstream of the investment calculus. Firms that demonstrate an understanding of the potential risks and opportunities posed by environmental, social and governance factors are both less likely to experience catastrophic loss and more likely to generate sustainable financial returns.
New data providers are competing with more established counterparts to offer the best signal-to-noise ratio and a means to integrate ESG factors into traditional investment strategies. Asset owners and managers are taking note and so should individual investors.
Yet, absent greater transparency and voice over high-level decisions regarding capital allocation and distribution, there is a necessary limit to the current scope of change. The incentives to limit reallocation of returns from workers and communities to executives and financiers are weak at best.
The backlash against the current distribution is growing. Warren’s legislation would accelerate progress and assuage populist concerns by increasing the authority of employees, requiring supra-majority approval for corporate political activity and forcing executives to hold onto shares for longer terms after receiving options or undertaking buybacks.
Investors who desire more and better data on ESG factors believe that decision-making has underweighted these factors and that long-term sustainability requires greater attention to them should consider whether granting external stakeholders more formal power and executives less could well be consistent with the long-term returns of their portfolios.
Witold Henisz is a professor of management at the Wharton School, University of Pennsylvania and author of "Corporate Diplomacy: Building Reputations and Relationships with External Stakeholders."