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Jun 2, 2022

What ESG-Focused Investors Need to Know in 2022

There’s no escaping the growing interest in environmental, social and corporate governance investing, but not everyone agrees on how to define, measure or report the variety of factors considered under ESG. Professor Laura Starks of the University of Texas McCombs School of Business spoke on the subject in May at the Alternative Investments Conference, sponsored by the Institute for Private Capital. Starks’ keynote speech, highlighted here, examined the knowns and unknowns of ESG investing as well as new regulations that may be coming.

What Does ESG Mean?

ESG is used to describe a wide range of factors and activities. The environmental part of ESG covers everything from a firm’s environmental policies to the amount of energy and natural resources consumed. The social portion examines the effects of a company’s actions on society and stakeholders. This might include charitable initiatives, how it treats employees, impacts on local communities, and employee diversity. The governance part looks at factors such as board diversity, accounting policies and executive compensation.

When using ESG criteria for investing, it is important to understand the difference between ESG values and ESG value. Values arise from people’s preferences, which tend to be based on nonfinancial factors. Investors may select companies they perceive to have ESG values because of their own beliefs on animal rights, human rights, climate change or a host of other issues.

ESG value, however, involves using ESG as a lens to examine a company’s financial performance. This is based on the view that ESG activities can influence operating characteristics, including risk, and thus offer a path to higher returns. Investors have looked at firms’ governance values for quite some time, but environmental and social aspects are now receiving more emphasis.

What Are the Investment Strategies?

For those who use ESG to guide investments, two main options are to employ a positive tilt or a negative screening. Some investors simply want to avoid owning, supporting or receiving profit from firms with behaviors they don’t agree with while supporting companies they believe are making a positive impact. Although this negative screening or divestment strategy avoids complicity, it doesn’t allow investors to vote or engage with management to influence changes. A positive portfolio tilt, however, weighs problematic firms less without completely divesting from them. This strategy allows diversification across sectors and retains the investor’s ability to vote and engage with companies to pressure them toward better behavior.

A more controversial option is to actively short-sell firms with poor ESG records. Research has shown that divesting often has little effect because another investor will usually replace the one that left, but if enough investors short a firm, it can affect stock prices and influence management decisions. Some also argue that shorting can be used to hedge against ESG risk. For example, investment managers can get closer to net zero carbon dioxide emissions by holding more responsible fossil fuel companies while shorting the less responsible ones. However, European regulatory bodies have not yet decided whether this strategy will be allowed in net zero calculations.

The effects of ESG are felt beyond public firms. Many investors are focusing increasingly on ESG value in private equity and real estate investments to mitigate long-term risk. Globally, the Asia-Pacific region tends to be the most focused on implementing sustainability in private equity assets, while North America is a laggard. A similar pattern is seen for several other asset classes, including infrastructure, private real estate, multi-asset, and listed real estate.1

How Does ESG Affect Performance?

Measuring ESG investment performance is complex because it depends on how ESG is being used and measured. Two large meta-analyses of ESG impacts examine the relationships between ESG factors and both operating and investment performance.

Specifically, an analysis of over 2,200 studies between 1970 and 2014 found that 57% of the firms studied showed a significant positive relationship between ESG and firm-level operating performance while most of the rest were neutral or mixed.2 Similarly, an analysis of over 1,000 studies between 2015 and 2020 found that 58% of firms studied showed a significant positive relationship for operating performance.3 In contrast, the relationships between ESG factors and investment returns are more mixed, with roughly an equal number of studies documenting significant positive and significant negative relations. A caveat to the findings in the empirical literature is that individual studies in this space can be hard to interpret since ESG criteria are not understood and measured in the same way across studies (often conflating values and value). Consequently, it’s unclear whether good ESG behavior leads to good performance or whether better-performing firms simply have more resources to conduct ESG activities. But overall, the research suggests that ESG investing is unlikely to bring serious negative effects.

Are More Regulatory Requirements on the Horizon?

In the next few years, we’re likely to see more regulations that might affect ESG investing. The number of finance policies and regulations related to sustainability has quickly risen in the past few years, reaching over 700 policies across 86 countries by August 2021.4 In Europe, the EU Commission on Sustainable Finance is looking at oil and gas as well as nuclear issues, standards on green bonds, corporate disclosure of climate information, and sustainability-related disclosures for some asset managers. In the U.S., an SEC proposal on mandated climate disclosures is being hotly debated. One big question is whether it will include requirements for private firms.

Even without mandates, research shows that investors are increasingly interested in ESG issues such as climate risk. A study involving more than 10,000 firms in 34 countries showed that analysts’ questions about climate risks during investor conference calls have increased significantly in recent years.5 In response to interest from investors, customers and employees, many U.S. corporations are issuing sustainability reports voluntarily. According to the November 2021 Governance & Accountability Institute report, 92% of S&P 500 companies voluntarily issued sustainability reports in 2020, a striking rise from 20% in 2011.

Overall, considerations on how to measure ESG quality, how to understand its relationship with performance, and the optimal investment approach to use come down to what ESG context is most important to the investor.

1 https://content.ftserussell.com/sites/default/files/sustainable_investment_2021_global_survey_findings_from_asset_owners.pdf

2 Friede, Busch and Bassen (2015) Journal of Sustainable Finance & Investment. https://www.tandfonline.com/doi/full/10.1080/20430795.2015.1118917

3 Whelan, Atz and Clark (2021), NYU Stern Working Paper. https://www.stern.nyu.edu/sites/default/files/assets/documents/NYU-RAM_ESG-Paper_2021.pdf

4 PRI Regulation Database. https://www.unpri.org/policy/regulation-database

5 Sautner, van Lent, Vilkov, and Zhang (2021) Firm-level Climate Change Exposure. https://ecgi.global/sites/default/files/working_papers/documents/sautnervanlentvilkovzhangfinal_1.pdf

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