The “S” Does Not Stand for Social Anymore: The Growing Importance of ESG

The “S” Does Not Stand for Social Anymore: The Growing Importance of ESG
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ESG is an abbreviation used to identify investing priorities that do not fit into traditional financial metrics: environment, social, governance. But it is increasingly clear that traditional financial metrics miss a lot of what goes into assessing risk and creating long-term value and that ESG factors are an essential element in predicting investment risk and return. “ESG is the best signal we have found for future risk,” says a new study from Bank of America Merrill Lynch. “What if we told you how to avoid stocks that go bankrupt?” It concludes that “US corporates may be behind the curve… but investors are ahead of it & PE multiples are responding.”

And so, ESG investing has moved into the mainstream. A recent survey commissioned by State Street Global Advisors found that eighty percent of global institutional investors have an ESG component as part of their investment strategies, with seventeen percent reporting more than half of their assets based in part on ESG factors. More than two-thirds said that integration of ESG has significantly improved returns and that pursuing an ESG strategy has helped with managing volatility. Significantly three-quarters of respondents said they had the same performance expectations for ESG as they do for other investments.

John Goldstein, co-founder of Imprint Capital and a managing director in Goldman Sachs Asset Management has said that investing for ESG requires the same rigor and discipline as “traditional” investing, and the distinction between the two is growing increasingly irrelevant.

Signs of this trend include continued growth in the volume of managed assets that incorporate ESG research, increasingly sophisticated investor tools, more ESG information providers, more ESG information gathering frameworks, more indices incorporating ESG data, and the use of ESG factors across asset classes, including fixed income and alternatives. According to data collected by the Global Sustainable Investment Alliance, ESG investment strategies, broadly defined, currently account for 22.9 trillion dollars in managed assets worldwide, up from 13.3 trillion dollars in 2012.

The G in ESG is for governance. My former firm, GMI Ratings (now part of MSCI) developed a governance rating system based on board decisions (not rhetoric), like CEO pay and financial reporting. It was such a reliable predictor of litigation and liability risk that it was used by D&O insurers as well as investors and law and accounting firms.

Increasingly sophisticated tools for understanding ESG issues are used by those who hold stock as well as those who buy and sell it. Index funds have to manage risk and return without trading those shares that remain in the index. The exercise of ownership rights – proxy voting, litigation, and engagement on ESG issues including climate change, compensation, and board composition – has very attractive cost-benefit potential.

Just a few years ago, shareholder proposals relating to environmental concerns were a long way from majority support. This year, three climate change proposals at energy companies came close to getting support from nearly two-thirds of the shareholders. I serve on the board of the 5050 Climate Project, which provided support for these proposals which were submitted to ExxonMobil, Occidental Petroleum, and PPL (another proposal, at Chevron, was withdrawn following successful negotiations with the company).

S is for “Social,” which has been something of a catchall category, often been dismissed as non-quantitative, even a distraction from the business of business. But in a world where a video shot on a cell phone of a passenger being dragged off an airplane can go viral and cause a drop in the stock price, it is clear that “social” is no longer an adequate description for indicators of management vulnerabilities and blind spots. One telling recent example was also based in an online complaint that went viral. For years, concerns were expressed about the “bro” culture at Uber, but the attitude of analysts and insiders seemed to be “boys will be boys.” Perhaps there was a rueful headshake now and then, but apparently the board believed that the same qualities that made co-founder/CEO Travis Kalanick brash and boorish made him visionary and dynamic. That was until a programmer Susan J. Fowler wrote about her “one very strange year” of virulent mistreatment, ultimately leading to the departure of Kalanick as CEO (though he remains on the board, for now). A male director who made a sexist joke (Women sure do talk a lot! Funny!) at a meeting about sexism also resigned. A new CEO with a very different reputation has just been named.

“Social” concerns about respectful treatment of customers and a diverse workforce are not “nice to have.” Like environmental and governance excellence, they are “have to have.” Failure to address these issues in a robust and transparent manner presents risks, as the Uber experience shows, at the very highest levels. If “social” suggests actions irrelevant or even detrimental to financial performance, S should now be understood to stand for “strategy,” “sustainability,” and, of course, “shareholder value.”

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