Bright Future for ESG in Active Ownership


The 69th CFA Institute Annual Conference will take place in Montréal, Quebec. This event, held 8–11 May 2016, will feature top economists, prominent investors, bestselling investment authors, and governmental and regulatory leaders.
Michael Viehs

Michael Viehs, research fellow at the Smith School of Enterprise and the Environment at the University of Oxford, began his master class at the 68th CFA Institute Annual Conference by challenging his audience to think more broadly. In his presentation on “Understanding ESG Investing: Fundamentals and Implementation,” he asserted that “it’s not just about tree huggers.”

In fact, contrary to the often-stated view that the United States lags Europe in its enthusiasm for environmental, social, and governance (ESG) investing, US assets under management (AUM) incorporating ESG factors have now rocketed to over $6 trillion, according to the Forum for Sustainable and Responsible Investing (US SIF).

Confronting some of the muddle and misapprehension that can surround ESG in the minds of observers, Viehs set about sharpening definitions, reviewing academic literature, and providing a practical road map for accessing ESG.

Viehs began by noting that even a basic categorization of ESG prompts confusion about overlaps among ESG, sustainability — which comprises several dimensions, of which financial is only one — and corporate social responsibility (CSR). “We cannot find a common denominator with the various terms,” he said. “ESG sums up all these different terms.” Good ESG equals sustainability.

Sustainability should not mean giving up financial return, asserted Viehs, referring to landmark research by Michael C Jensen (2002). To further support this thesis, he highlighted the findings of a recent meta-study showing ESG can actually strengthen the competitive positions of corporations. For example, by enhancing operational performance and cutting the cost of capital — thereby reducing idiosyncratic risk — higher market valuations can be justified.

But measuring ESG at the firm level does not seem to be especially straightforward. “We know measurement of ESG can affect returns,” said Viehs, referencing the agencies that specialize in ESG ratings (often generating a range of ratings within sectors) and the commercial databases that help filter out “sin stocks.”

Viehs outlined three approaches to implementing ESG investing:

  1. Exclusionary approaches apply non-financial norms and values to determine and exclude controversial industries such as alcohol and tobacco. This approach is popular with religious endowments.
  2. Inclusion (best-in-class) strategies implement screening using extra-financial information with the objective of investing in good ESG firms only and underweighting any laggards.
  3. Viehs states a clear preference for the approach of active ownership and engagement strategies collaborating on ESG and strategic issues, both financial and non-financial. For Viehs, this is also the method most likely to earn the trust of investors. “You cannot be greenwashing if you are building a reputation for ESG investing,” he said. ESG investors must seek to create shareholder value as well as value for stakeholder groups, such as suppliers and governments.

And there are measurable stock market penalties for polluters, as occurred with the BP oil spill in recent years. One of the best examples Viehs highlighted links carbon emissions and the terms of corporate loans. His current research suggests that voluntary disclosure of CO2 emissions results in significantly lower loan spreads, whereas polluters pay significantly higher loan spreads. This can be quantified: a 1% reduction in CO2 emissions results in around $0.5 million in interest savings per year.

Effective tools for active investing include shaping an ESG agenda at meetings, proxy voting, on-site visits, letter writing, lawsuits (especially in the United States), and hedge fund activism. Viehs also spoke after his remarks about the costs of engagement in relation to payoffs, something currently being researched in a project at Cambridge University. He considers costs insubstantial relative to portfolio sizes — for example, the costs of research databases and hiring portfolio managers or analysts directly are relatively insignificant for large investors.

In the second part of the master class, Alex Money, program director and research fellow at the Smith School of Enterprise and the Environment at the University of Oxford, spoke on “Applied ESG: Corporate Water Risk and Return.”

Pointing to the unequal distribution of global water resources and skyrocketing global use of water, Money referenced OECD forecasts that suggest that infrastructure spending of $1 trillion per year is required by 2030 just to keep up.

What Money calls “corporate water risk” at the company level should concern investors. His own research focuses on the quality of corporate disclosure of water intensivity use among various companies (and their changes over time), helping identify variation and hence possible mispricing opportunities. But why are investors not pushing harder for improvements in water efficiency? Money’s research extends into an analysis of investor behavior and company management responses, aiming to measure and link the salience of issues to management responses.

On much-needed water infrastructure investment, Money cites real options theory — the present value in the optionality of the available projects to investors. New approaches are required to disrupt a status quo Money regards as unsatisfactory both for providing return to investors and in achieving green objectives. For example, where a developing country with a need for water infrastructure investment might face a high borrowing cost if it is considered risky by investors, this cost could be reduced if underwritten by an international consumer staples company (and water consumer) benefiting from a lower cost of capital. “Risk is a proxy for the option to defer; return is a proxy for the option to grow,” said Money.

While going green may not be to all investor tastes, especially around the potentially unmeasured risks at the portfolio level, a weight of fundamental evidence is now building behind ESG investing. CFA Institute recently launched the ESG-100 online course as an introduction to ESG issues in sustainable, responsible, and impact investing (SRI). Finally, with growing investor interest in green bonds, accurate and appropriate ESG benchmarking automatically assumes greater relevance for investors.

If you would like to know more about environmental, social, and governance (ESG) issues in sustainable, responsible, and impact (SRI) investing, please take the free eLearning course by CFA Institute: ESG-100: A Clear and Simple Introduction to ESG Issues in Sustainable, Responsible, and Impact (SRI) Investing.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: W. Scott Mitchell

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2 Responses to Bright Future for ESG in Active Ownership

  1. How is this different from active investing? What does ESG investing imply about efficient markets and it’s close relative passive investing? Lucky for those who are pressing on the current ESG fad, they will be long retired before the damaging effects on long term performance materialize. The losers will be those firms which are steered towards short term fixes and the beneficiaries of the asset pools who suffer from the long term penalty on long term performance from the experts who make ESG decisions.

  2. ESG is a form of active management. The implication is that the market is not efficiently pricing the variables that ESG proponents are interested in. The economic (not moral or ethical) justification is missing. Thiseans that asset owners (and their beneficiaries) will be worse off in the long run.

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