ESG Evolves

Sustainable investing and the consideration of environmental, social, and governance factors have become part of the investment mainstream over the past few years. The rapid growth has been spurred by the need for investors to consider nonfinancial risks posed by problems ranging from climate change to natural resource depletion, treatment of workers throughout the supply chain, corporate ethics, and wealth inequality. We live in an age of transparency, and stakeholders are demanding better corporate accountability around these types of issues. More end investors want their investments to make a difference.

These are complex problems, and the field is still evolving. I spoke with three researchers whose work is shedding light on the issues and setting standards for the future. Cary Krosinsky is an author, consultant, and university lecturer on sustainable investing; Tensie Whelan leads the NYU Stern Center for Sustainable Business; and Hortense Bioy is Morningstar’s global director for sustainability research on the manager research team. Our discussion took place on Sept. 15; it has been edited for length and clarity.

Jon Hale: To clarify terms, ESG refers broadly to data about nonfinancial issues and is widely used in the investment world. Sustainable investing encompasses the idea of delivering a competitive return alongside positive outcomes for people and planet. What should investors know about these concepts?

Cary Krosinsky: In my classes, we talk about the “seven tribes of sustainable investing,” which are seven distinct categories of investment strategy. These include negative screening, avoiding companies you don’t want to own for an ethical reason, which is where the field started. The reverse is positive/best-in-class approaches, used by firms like Generation Investment Management, which has beaten benchmarks after fees over time, and Parnassus Investments and others that aim to invest in financially viable companies trying to solve problems.

Impact investing is often focused on services for the poor, usually through private investment. Thematic investing encompasses the rise of things like climate tech venture capital and renewable energy project finance. There’s ESG integration, and then there’s shareholder engagement; some pension funds do nothing but engage with companies, for example. Last but not least is minimum standards, where engagement and divestment advocates come together. For example, funds like the New York State Common Retirement Fund do what New York City does with restaurants—put a letter on the window so you know you can trust the food.

Tensie Whelan: There are many different strategies with different reward/risk profiles depending on different goals. Some investors are willing to take lower returns for higher environmental/social returns, others absolutely not.

Another thing creating confusion is that investors, and therefore corporates, are focusing on a check-the-box approach to ESG metrics. Those are process-based metrics—they have to be, because these are very broad standards that need to work for everybody. But if a company manages to reporting metrics as opposed to having a strategy to hit performance targets, it won’t get there. While reporting metrics are useful, understanding the underlying dynamics and how well a company has identified these material issues and is executing against them while embedding sustainability into its corporate strategy is critical for understanding performance.

Hortense Bioy: All investors have to start with the question, Why should I look at ESG data? What motivates me? Cary, you mentioned seven approaches. I can group some and narrow it down to three, with this question: What’s my primary objective? Is it financial performance, value alignment, or impact? With each approach there can be tradeoffs in terms of risk, cost, or returns.

One reason this is a complex topic is because it’s difficult to assess the impact of each approach on the real world. We often say that impact-oriented people surely care more about real-world outcomes than those who are risk-oriented. But risk-oriented investors can also have a positive impact on the world. We also often hear that value-aligned investors who don’t want to invest in certain companies have zero impact on the cost of capital of these companies. But if there are enough investors collectively that divest, surely that will have an impact. It’s much more nuanced than the arguments that you often hear.

Pushing Back on the Backlash

Hale: Some of the pushback we’ve seen from the political right in the U.S. is predicated on the assumption that ESG is having an impact.

Whelan: More investors and corporates are beginning to confront a set of risks and opportunities that, while they’ve existed for a long time, have never been as pressing as they are today. If a coffee company does not focus on climate change, they are not going to stay in business. If a property and casualty company doesn’t have some understanding of the risk of climate change and the impact it’s going to have on their policyholders, they are going to have significant financial problems.

One of the challenges we see on the risk side is that people don’t have enough information to be able to identify the probability and monetize the risk, they’re unwilling to invest in what’s needed to avoid them, and they’re not assessing the cost to them of not making those investments.

In terms of the backlash, if you look at BlackRock BLK or J.P. Morgan JPM, they’re still investing in oil and gas companies. They haven’t divested. There’s a lot of unwarranted thunder and lightning, at least from the right. The left is upset that BlackRock is continuing to invest in oil and gas. They are caught between a rock and a hard place!

Krosinsky: I think there’s been confusion in the media about ESG. ESG isn’t one thing, it encompasses a wide variety of specific environmental, social, and governance issues.

A brief example: Asia is half the world’s economy, and governance is an extremely important dimension in knowing if you can trust your investment. Are we supposed to not invest in Asia because we can’t look at ESG considerations? Are we going to miss the rise of Asian economies as investors? There are some basic starting points that get lost in this political pushback.

We’re hosting a happy hour in New York in November that we’re calling “The Backlash to the Backlash.” I haven’t seen a single asset owner or a single financial institution slow down its ESG efforts. We see more students getting hired into ESG positions, and more job openings that can’t be filled.

Bioy: As part of the backlash, there are people—I would include Tariq Fancy in that camp—who think that sustainable investing has no impact whatsoever on the world. While impact can be hard to evidence, the situation in Texas and this whole backlash against ESG in the U.S. are evidence that sustainable investing has an impact. Otherwise, why boycott pro-ESG companies and try to discredit the ESG movement? ESG is a threat to some people and industries. ESG is clearly an existential threat for the oil industry.

Whelan: As you know, virtually every day The Wall Street Journal has been publishing some type of anti-ESG investing article. But they also feature anti-ESG funds, like a MAGA fund or a VICE fund. These funds’ fees and their performance is far worse than the equivalent BlackRock ESG funds, for example. They’re charging a lot of money without a lot of performance to embrace “anti-woke capitalism.” It’s fascinating to me that one approach to this idea that we shouldn’t be investing in ESG is to say that we should be investing in anti-ESG. That sort of justifies ESG.

Hale: Global capitalism is evolving away from the shareholder primacy paradigm. It feels like virtually all corporates have burgeoning ESG programs.

Whelan: Investor pressure has been part of that shift. It’s not the only one. We do research around consumer purchasing of sustainable products. There is a 32% real premium and growth associated with more-sustainable consumer packaged goods, for example. There’s also significant pressure by employees. If you want to win the war for talent, this is an increasingly important way to do that.

Unfortunately, that investor pressure sometimes results in corporates ticking the box on a bunch of ESG metrics as opposed to developing a strategy to drive better impact and better financial performance. Investors that understand the underlying dynamics—like Generation, Parnassus, Brown Advisory—offer more robust engagement.

Bioy: I’d add regulation to this. Some of these companies operate globally, in markets that have their own regulation and culture. Companies that don’t comply with local environmental and social standards automatically lose their license to operate in that particular market.

Krosinsky: The SEC’s proposed climate disclosure rule has, in our view, woken up companies and investors to thinking about strategy. There is a pathway from requiring data, reporting, and transparency to more action.

The existing ESG data is also helpful for ensuring that companies know they’re being observed by the market. That makes them think about issues they need to manage for if they haven’t been doing so, such as diversity, equity, and inclusion. The aggregate of ESG data is something of a potential red-flag indicator for investors.

And the race for talent is real. Companies know that if they’re going to attract and keep talent in a time when young people are bouncing from job to job, then they better provide an environment where people feel like their jobs have meaning and purpose. I think this is true at a country level also. If the United States goes in the wrong direction on ESG, we may well become less competitive economically going forward.

Hale: There is a generational component to this. The leading edge of millennials are pushing 40. They’re becoming decision-makers at corporates and institutions. What do you see from the college campus?

Whelan: Stern did not have a sustainable-business program seven years ago, and now I have students from all over the world. And I get a lot of executives who are trying to make a pivot or want additional skills for the work that’s needed today. Material ESG issues are relevant for all industry sectors, for all positions, whether you’re in accounting or procurement or marketing or brand management. For example, we worked with activewear company REI to understand the impact of their sustainability orientation on employee productivity and retention. We found that their robust focus there led to about $34 million of benefit in terms of increased productivity and retention, which is about 5% of payroll.

Addressing Challenges

Hale: What are the main issues and challenges that ESG and sustainable investing face going forward?

Krosinsky: It’s going to get harder to figure out who is a sustainable investor as firms like BlackRock integrate considerations of ESG issues into everything they do. Capital Group has long said they consider corporate governance. But are they a sustainable investor?

Another issue that’s extremely important is the need for a global low-carbon transition and acceleration of other environmental and social positive outcomes. Where is the money for this transition going to come from? Do we have country-specific road maps? I did some training for a development bank with 26 country members. Prime Minister Narendra Modi showed up in Glasgow and said, We know what to do in India for our transition—just give us a trillion dollars and we’ll take care of it. Indonesia doesn’t have the money to get off coal, which is their cheapest option. And we above all need to build a global consensus to act.

Bioy: A key challenge, as always, is the data. In emerging markets, data disclosure is far behind developed countries. We still don’t have a common ESG disclosure framework. We also need for the green transition to a global taxonomy of green activities. In Europe, we know how challenging it is to develop a credible taxonomy, one that is based on sciences. There are many green taxonomies in the world, but they’re all very different, which can lead to greenwashing claims. Investors investing in different countries will be judged in different ways. I guess we all agree that coal is a dirty energy source, but there are other things that need to be codified globally.

Whelan: I would add a lack of understanding of sustainability and ESG among asset managers. We had a postdoc who interviewed a number of different financial institutions’ asset managers. She found that they were very comfortable pushing back with companies around governance issues, as that’s something they’ve been doing for a while, but on the environmental and social issues, they just accepted what the company said.

At the corporate level, until recently, the sustainability folks have tried to put programs in place without the backing or understanding of the CFO in terms of the investments needed to improve sustainability performance. That is beginning to change, as we see regulations make the CFO responsible for the metrics that are being reported and CFOs begin to understand that this is a strategic imperative with financial outcomes.

Another problem is that investors and board members are asking for ESG metrics and financial metrics but not how the two are interrelated. That means companies are making decisions with inadequate information. One quick example: A pulp and paper company that we talked to works in the southeastern U.S., where water is free. Why should they bother about water? But all that water needed to be moved around and heated and cooled, using an enormous amount of energy, and they had to pay to process the wastewater. All that “free” water was costing $1.5 million annually per mill.

Hale: What about performance?

Whelan: As you know, we did a meta-analysis of more than 1,000 academic studies published between 2015 and 2020, looking at the correlation between corporate financial performance and sustainability or ESG investing financial performance. We found that 58% of the studies found a positive correlation between corporate financial performance and sustainability. Only 8% found a negative correlation.

On the investor side, 33% of the studies found an outperformance, 26% found that ESG funds performed at the same level as conventional investing, and about 14% found a negative correlation. The problem with our study and all studies like ours is this is correlation—we cannot establish causality. But 1,000 academic studies is, I think, a good place to start.

We keep coming back to correlation studies because corporates are not tracking the return on their sustainability investments, and investors are not asking them to. At Stern, we’ve identified nine mediating factors under our ROSI—return on sustainable investment methodology—that drive better performance, such as innovation, or operational efficiencies, or employee engagement, or supplier loyalty and resiliency. These are not currently tracked, and the financial benefit of sustainability strategies is not aggregated. We worked with an automotive company that had waste-reduction strategies like recycling paint. They no longer had waste-disposal costs, and they were selling some of the recycled product. That didn’t show up in their financials. The total benefit to the company was a $235 million annual contribution net to EBITA. They had no idea.

Bioy: That’s why frameworks and methodologies are so important. How do you measure avoided carbon emissions and costs? It can be done in several ways. You can cook the numbers.

Krosinsky: Most active fund managers have underperformed benchmarks for quite some time now, regardless of ESG. That’s driven a lot of money into passive. Yet most of the activity in sustainable investment is in the active space. That’s an interesting dynamic. People paint the field of ESG investing with a broad brush. But when you look specifically at these seven different categories of strategy, they perform differently. Often, positive/best-in-class approaches outperform their benchmarks after fees. This has almost never been true of negative approaches.

Bioy: It’s extremely difficult to assess the performance of ESG funds in general because they aren’t a homogeneous group. They represent a wide range of sustainability and risk/return profiles. Some strategies hug the benchmark because some investors want very low tracking error. At the other end of the spectrum, thematic strategies, like those focused on renewable energy, are riskier, but they can also offer better returns.

Timing is an important factor, though. You can invest in a great business, but if you invest at the wrong time, you’ll get poor returns. Also, no investment strategy works all of the time, so investors shouldn’t expect ESG to thrive in every market environment. ESG screens cause divergence from the market, which will inevitably lead to good performance in some environments and underperformance in others. That said, we have found that ESG screens have led to resilience in down markets, even in brutal downturns like in March 2020. Morningstar and Sustainalytics have also documented links between ESG and factors like corporate quality and financial health. So, in the long term, there are reasons for investors to be encouraged about the prospects for ESG investments.

Walk the Talk

Hale: Climate change is an existential problem. Do you see specifically climate-aware investing evolving—will there be an overwhelming focus on that and less on other issues?

Krosinsky: It’s important to think holistically about climate change. Supply chains and consumption are a big component of ongoing carbon emissions. Supply chains are often the majority of a company’s footprint. I believe Unilever UL claims that two thirds of their footprint comes from the use of their products and services, and the use of their cars and trucks is 90% of the footprint for Ford F. The decisions people make using the products that companies make have a big impact.

We need to push on all cylinders when it comes to climate change. We need full corporate engagement, strategy, and transformation, which will look different sector by sector. We definitely need more intentional capital. We also need more innovation. There’s a lot of energy and capital flowing into climate tech VC—$40 billion last year. We need more consumers to make better decisions, which includes voting and making sure that policymakers don’t have their plans overturned. And we need a global consensus so that policymakers can act.

Whelan: Climate change is a systemic and intersectional issue. So was COVID. COVID has had profound impacts systemically, globally. Learning from that experience and the extreme weather events we are confronting, business is beginning to understand the existential nature of an issue that transforms our relationship to natural resources, transportation, human health, biodiversity, access to water, and so on.

We are already seeing companies losing the ability to run facilities because of competition over water. You see the inequitable impacts of climate change, on garment workers in Bangladesh or Black and brown communities in the United States. Climate is a top-tier strategic issue for virtually every business leader and investor because of its systemic, comprehensive, intersectional impacts. That does not mean that you don’t need to understand and work on the other elements of what is going to make you a sustainable and competitive business or investor, because they are connected. It does mean that you might prioritize climate differently depending on your industry.

Bioy: Morningstar publishes annual studies on climate-focused funds. This year, we reported a proliferation of such funds and a doubling of their assets in the U.S., in Europe, and in Asia. The Chinese climate fund market has grown significantly in recent years—let’s not forget that China is the biggest renewable energy market.

Here in Europe, driven by the ESG disclosure agenda, more and more investors are considering climate risks and opportunities in portfolios. Increasingly, asset owners request that asset managers and index providers create strategies that incorporate climate-related performance indicators. It could be, for example, an objective to lower carbon intensity in the portfolio by 20%, or 50%. There is a lot of innovation in that space.

Whelan: Just one additional data point from the consumer research that we do with IRI in the U.S., where we review actual consumer purchasing of sustainability-marketed products annually. In 2021, $3.4 billion of carbon-labeled product was sold in the consumer packaged goods space. In 2020, it was $1.3 billion. And in 2019, it was next to zero. So, there is clear demand. As to the broader sustainability opportunities: One out of every two new products introduced in CPG in the United States last year had some type of sustainability attribute. While climate is the major driver, there’s opportunities in the other aspects of sustainability.

Hale: Given everything we’ve talked about, what will sustainable investing 2.0 look like?

Bioy: There will be full data transparency. Companies will disclose consistent and comparable ESG data, which will allow investors to make better-informed decisions and allow for personalization. At Morningstar, we’re big on the theme of personalization because when it comes to values, people care about different things. We talk about the E, the S, and the G of ESG and how these three pillars work together. Sometimes there can be a conflict between the three letters.

Krosinsky: For me, the question is what does 4.0 look like? I teach that 1.0 was a phrase you never hear anymore: socially responsible investing. Version 1.0 was applying your values to your money, then 2.0 was connecting sustainability to financial value. The 3.0 is this desire to understand the impact of investing. For me, the 4.0 is fully integrated considerations of ESG issues as business as usual for investors writ large.

Whelan: What do we need for that 4.0? Investors who are well grounded in material ESG issues and best-in-class practices for industries and regions. Another key element is that investors need to look beyond the process-based reporting metrics and ask companies for their performance-based ESG goals and for the ROSI. What have they done to project and monetize potential risk? Do they understand what kind of operational efficiencies can be driven by reduction in waste and circular strategies? Are they tracking and understanding the impact of retention on their financials? A more comprehensive approach to financial analysis that’s tied to sustainability metrics will be critical.

Finally, investors need to walk the talk. I hear from corporates that if they make ESG investments, investors start squawking about how they’re not making their short-term numbers. There needs to be commitment from investors willing to look at the potential positive impacts of longer-term strategies that may not show up in a quarter-by-quarter perspective.