Long Read

ESG Strategies: inevitable

In mid-August, the US Business Roundtable released a statement that, in retrospect, will be remembered as a fundamental inflection point of historic significance: most of its 180 members, comprising some of the best known American CEOs, publicly affirmed that increasing shareholder value is no longer their unique business objective. Beyond the core function of wealth creation, they said that respecting the environment, supporting their communities and taking good care of their employees are all integral components of their companies’ mission. In short, stakeholder value now goes hand-in-hand with shareholder value.

Those who denounce the US Business Roundtable declaration as purely symbolic and political pandering miss the underlying trend and the broader picture: it is part of a ‘regime change’ that is altering fundamentally the way in which companies do business and how investors look at corporate value.

It also underpins the recent, but considerable and fast-growing, interest in ESG strategies. The ESG acronym—which stands for Environmental, Social and Governance—is a shortcut for sustainability. It simply signifies that, more and more, companies are aware that they must measure their activity not only in terms of the profits, but also in terms of the ‘corporate externalities’ that they produce. This covers a large set of issues, ranging from pollution and CO2 emissions to social inequalities, conditions of employment, communities’ welfare, and even impact on human rights.

Sooner than many CEOs realise, measuring the impact that corporate activity has on environmental and social sustainability will thus become the norm. Already, large companies as different as Nestlé, Infosys, BASF, Novartis, McKinsey, and some of the most prominent banks, private equity groups and strategy consultancies are developing new accounting systems that will provide them with a detailed understanding of the impact of their output, which in turn they will use to make operating decisions.

What has happened to provoke such a radical change and shift in attitudes? It results from two concurrent crises that are posing massive challenges.

Social Tectonic Shift

The first is social. More than ten years after the great financial crisis erupted, capitalism seems exhausted and incapable of addressing some of its most glaring deficiencies, like rising social inequalities. In high-income countries, the middle class is ‘like a boat in choppy waters’: over the past 10 years, its earnings have stagnated or shrunk while its cost of living has skyrocketed (particularly housing costs and often health and education).

This is a tectonic shift – the economic losers are now mainstream and no longer a marginal fringe of society, a phenomenon that is favouring anti-establishment and protectionist policies. It is telling that prominent American financiers (like hedge fund billionaire Ray Dalio and JP Morgan CEO Jamie Dimon) now argue that unless it reforms itself, American capitalism is on a path to extinction.

Environment: new urgency

The second is environmental. The science according to which we have little more than 10 years to mitigate the most catastrophic effects of climate change is by now incontrovertible. Climate change is a systemic, existential risk like no other that is accelerating. A spate of recent research concludes that greater severity and intensity of extreme weather, with potentially catastrophic second-round effects (like rising waters) is not only happening, but on the increase. Some central bank governors (most notably Mark Carney from the Bank of England) have exhorted financial regulators, banks and insurers to “raise the bar” if a climate catastrophe is to be avoided, coupling with warnings about an impending “massive reallocation of capital”.

In light of this, it comes as no surprise that more ‘sustainable’ ways of doing business are in high demand. Until very recently, being ‘sustainable’ was perceived as a CSR (Corporate and Social Responsibility) issue, which, as such, had no bearing on operations and business strategy. This is no longer the case. Now environmental and societal issues have become core not only for risks managers, but also for those professionals in charge of client and investor relations, government relations, product development and marketing, all the way up to the board and the most senior ranks of large companies.

However, actions have yet to catch up with words. There is still a striking dissonance between what is expected and needed and what is actually happening. ESG strategies remain tiny, with a pool of assets amounting to roughly US$52 billion in the first half of 2019 (according to Fitch Ratings) – to be compared with the total US$6 trillion universe of the money market sector. Many business leaders and financiers have not yet priced the cost of climate change (let alone the cost of social disintegration), still believing that fears of a ‘climate Minsky moment’, when extreme climate could brutally re-price assets, are overblown.

However, two reasons will compel those who remain in denial to shift their attitude. First, the action of central bankers and regulators. Their concerns are such that much sooner than anticipated, those investors who do not think about and act upon the risk of stranded assets could find themselves accused of and liable for not doing their fiduciary duty. Second: activist investors. They are becoming increasingly vocal and forceful when dealing with businesses that are too slow at taking into account stakeholders’ interest. As an example, activist long-term investors like Climate Action 100+ – a group of asset managers and investors with US$33 trillion in assets – are encouraging the world’s largest greenhouse-gas emitters to take more decisive action to reduce their carbon footprint and to set targets to do so. They are also asking companies beyond oil and gas and coal to think strategically about how climate emergency may alter entire industries and lines of business. What if tomorrow large cities decide to ban diesel cars? What if a movement like Extinction Rebellion reduces air traffic by a significant percentage? What if faster-than-expected sea level rise threaten coastal cities and other assets?

Until now, two major stumbling blocks have prevented or hindered the wide adoption of ESG strategies: first, the perception that ESG returns are lower than those of more ‘traditional’ investment strategies; and second, the fact that the ESG ‘business’ is beset by a dearth of high-quality metrics, which in turn makes it arduous and complex to integrate ESG strategies into investment decisions.

The Myth of Lower Returns

The statement that sustainable strategies underperform is a myth. Many investors wrongly continue to believe that investing sustainably entails a sacrifice in terms of returns. Yet a growing corpus of evidence, complemented by countless reports and studies, now demonstrates that there is no financial trade-off when investing in ESG strategies compared with traditional investment funds. A recent piece of research published by Morgan Stanley even shows that ESG funds offer better downside protection during periods of market turbulence and also experience lower volatility^[1].

Take the example energy, the industry at the epicentre of concerns about climate emergency. When projecting into the not-too-distant future, or adopting the perspective of long-term investors, it is hard to imagine that the economics of energy will not favour renewables (solar and wind have a short-run marginal cost of zero with infrastructure costs that are plummeting) to the detriment of oil and gas. According to Bernard Lewis of BNP Paribas, as electric vehicles proliferate, the long-term breakeven point ensuring that gasoline remains competitive in the mobility industry will evolve around $9 to $10 a barrel. No beating around the bush: cold financial logic supports ESG strategies.

Defective Data

It is true that the methodology underpinning ESG strategies is still in its infancy, and that practices and standards need to improve, but progress is emerging fast. The greater availability of better data and information (often enhanced by artificial intelligence); new tools to properly define what is ESG and what it is not; new standards to measure and manage climate- and social-related risks are being developed at a frantic pace and when they work satisfactorily are quickly replicated. Different initiatives like the Financial Stability Board’s task force on climate-related financial disclosures (led by Michael Bloomberg) and the Impact Weighted Accounts Initiative (led by Ronald Cohen, the founder of Apax Partners) drive the agenda.

A more coherent and unified system to properly report about ESG issues is in sight and in the not too distant future the problem of defective ESG data will be a thing of the past for investors. Is such optimism warranted? Yes, for two reasons. Activists and investors are becoming more demanding and getting savvier by the day. This forces more scrutiny and suggests that market discipline will work its magic. The most compelling argument for greater and faster progress is the action of regulators: they are forcing the change in a way that puts a lot of wind in the sails of ESG strategies.

Where will it go from here? As noted above, the absolute amount of money market funds that incorporate environmental, social and governance metrics in their offering remains very small, but the progression in relative terms is impressive. According to Fitch Ratings, the pool of money invested in ESG strategies grew by 1 per cent in 2018 and 15 per cent in the first half of 2019. Anecdotal evidence shows that ESG demand is exploding in Europe and the Asia Pacific region. The direction of the trend is unmistakable: ESG strategies will go from strength to strength and there will be no reversing the trend.

Thierry Malleret
August 2019

Footnotes

1. https://www.morganstanley.com/pub/content/dam/msdotcom/ideas/sustainable-investing-offers-financial-performance-lowered-risk/Sustainable_Reality_Analyzing_Risk_and_Returns_of_Sustainable_Funds.pdf ↑