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Is ESG a threat or the future of finance?

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Rod Lohin

Today's companies are increasingly expected to explain their purpose beyond economic prosperity. Yet for many business leaders, this remains unfamiliar territory. Many wonder "Is it worth our time and effort to wrangle with issues that complicate the already tricky job of making a profit?" 

A growing body of evidence shows that it is. The promise of two approaches — corporate sustainability strategy and sustainable finance — has been delivered over the past 30 years. Research shows that both are good for business and better for society. 

Sustainable finance is not new. For centuries, investing practices have sometimes been led by considerations relating to specific social or environmental issues. For example, the Quakers were leaders in the anti-slavery movement, choosing not to do business in slavery and, later, actively seeking to abolish it; and in the 1980s, social advocates succeeded in shifting investment funds away from apartheid-era South Africa.

Since that time, a whole range of investment opportunities have been developed for those who wish to avoid certain industries or prioritize others. There are four major groupings of sustainable finance offerings for institutional and retail investors:

1) Ethical investing typically "screens out" investments that are considered to be objectionable by some, such as tobacco, gambling and guns. Early adopters of this approach were religious orders’ pension funds and university endowments. These faith- or values-based screens were generally applied informally among public equities (e.g., by avoiding specific stocks that did not meet the ethical test) because there were few actual ethical investment products prior to the rise of responsible investing in the late 1980s.

2) Responsible investing provided easier access to ethical investments by creating funds that screened out or emphasized particular companies or industries. For example, some mutual funds were created that removed "sin stocks" or focused on "green stocks." These kinds of products are now increasingly available through exchange-traded funds (ETFs). A vast array of green bonds are also available to institutional investors, sometimes offered to consumers via mutual funds or ETFs, and even money markets funds that emphasize or exclude certain countries based on perceptions of their political behaviour. Responsible fund managers have also tended to become more involved in corporate governance, intervening on key social or environmental issues through ‘active management’.

3) Sustainable investing or ESG investing is an approach in which an analyst considers environmental, social and corporate governance (ESG) data to understand a company’s exposure to risks that go beyond traditional financial analysis. ESG analysis assesses the company’s relationships with key stakeholders, compliance with social and environmental regulation, and the adequacy of a company’s governance processes. Strong ESG performance is often an indication of a well-managed company. Sustainable investing can also refer to an investing approach that seeks out ‘best-in-class’ companies in an industry, even if that industry might otherwise be considered to have ESG risks (such as oil).

4) Impact investing is done with the intention of generating measurable social and environmental impact alongside a financial return. They comprise investments across asset classes, for example, through equity, debt or other more complex structures, in impact-driven companies. They can be made in both emerging and developed markets and target a range of returns, from below market to market rate, depending on investors’ goals.

As of 2021, US$121.3 trillion in assets of all types were under management using sustainable investment principles. In terms of global capital markets, at least 35.9 per cent of global assets are reported to be sustainable investments. This amount grew particularly quickly in Japan (which is late to reporting and so have likely re-categorized a portion of previously unrecognized funds) and in Canada. Although an early market leader, Europe’s numbers have fallen recently as their reporting regimes have become stricter — a phenomenon likely to be seen in the future elsewhere.

Beyond equities, sustainable bonds have also been developed for investors. Green bonds, issued by organizations looking to make major investments to improve their environmental performance, have also grown rapidly. The Climate Bonds Initiative shows they have grown to about US$1 trillion cumulatively in 2022, with projections suggesting continued growth. And in 2020, global impact investment assets under management had grown to US$715 billion (and continue to expand rapidly).

But many traditional market commentators, following the tenets of the concept of "shareholder capitalism" and economist Milton Friedman, have remained unimpressed with responsible investing for decades. The hue and cry: that it threatens the fiduciary duty of fund managers because returns to shareholders are reduced. This is because, they argued, fund managers are forced to choose companies that are not necessarily top performers across sectors (say, no oil companies) and might be less likely to achieve high returns (because "responsible" companies attempt to meet goals that distract them from maximizing short-term returns).

In some ways this criticism seems sensible, at least in the context of commonly held (at least since the 1970s) ideas of shareholder capitalism. However, interestingly, these arguments have not borne out in reality. Over time, companies chosen as part of many ESG-driven market indices have outperformed their underlying benchmarks. As an example, the MSCI Canada ESG Leaders Index outperformed the MSCI Canada Index by 34 per cent between 2007 and 2020, even during the initial crash caused by the COVID-19 pandemic.

Multiple studies show similar results across markets and indices. A huge meta-study (“Sustainable Investing: Establishing Long-Term Value and Performance”) reviewed the relationship between CSR, ESG and corporate financial performance, concluding: “There is overwhelming evidence that firms with higher ratings for CSR and ESG factors are lower risk in a fundamental sense... [This] firmly puts the issue of sustainability into the office of the chief financial officer.”

Recently, there has been renewed backlash against ESG investing, notably by Mike Pence during his run-up to the U.S. presidential election in 2024, and by Elon Musk due to Tesla’s de-listing by the S&P ESG Index. Both argue that ESG investing is a tool of radical left, promoting a politicized agenda in the capital markets. Pence recently raised concerns about a group of activist investors associated with Engine No 1 (an investment firm that uses an ESG investment approach). This group used the most recent ExxonMobil shareholder meeting to engage in a proxy battle to place three of its favoured candidates on Exxon’s board. According to Pence, “Those three are now working to undermine the company from the inside” and are pursuing a “left-wing agenda.”

Like many other traditional capital market players, Pence apparently still believes that ESG analysis is synonymous with anti-market politics. The implication is that ESG analysis destroys value when a good deal of evidence shows that the reverse is true. In fact, he should be lauding the fact that strong ESG performers tend to outperform those who do not. Why are he and his allies arguing against higher returns? Politics.

With respect to Tesla, Margaret Dorn, senior director of the S&P Dow Jones Indices, reported that it was dropped from the S&P ESG Index because its overall ESG score had declined relative to other auto companies due to “poor working conditions at its U.S. Fremont factory, claims of racial discrimination and its handling of a U.S. government probe into multiple deaths and injuries linked to its autopilot technology”. Musk’s response was a series of tweets including the statement “ESG is a scam. It has been weaponized by phony social justice warriors.”

Musk is correct that Tesla is not being rewarded by ESG analysis for potential impact—but that’s not what ESG analysis does. Instead, it seeks to identify and reduce investment risk by steering clear of exposure to environmental, social and governance problems. It is an investment approach that seeks to identify and manage risks in order to maximize returns.

Those who are concerned that ESG analysis doesn’t highlight impact are confusing ESG analysis for impact analysis. There is undoubtedly a good deal of overlap in these ideas, but technically they are different domains. Nevertheless, since this recent backlash, at least 17 U.S. states, led by Texas, have enacted bans on the use of ESG funds in pension funds and firms offering ESG investments, notably BlackRock, the world’s largest fund manager and an advocate for increasingly aggressive sustainable finance approaches. The result of these bans may reverse the flow of investments away from companies with significant ESG risks (such as those in fossil fuels, weapons, or with poor labour management practices).

More and more of the world’s capital markets are now managed with some form of ESG analysis in mind, and it seems likely that strong sustainability performance will continue to be considered by the world’s biggest investors. However, these are uncertain times.

Going forward, it seems likely that there will be a struggle between those who believe that managing risk involves avoiding companies exposed to social and environmental risks, and those who feel that these risks are less relevant in a free market or due to other priorities.

It’s a striking paradox that’s at the heart of sustainability (and sustainable investing): Do immediate challenges and potential profits (and their costs) outweigh long-term, sustainable returns? Recent evidence suggests they do not, but in a period of change it’s possible that further evidence will show otherwise. The capital markets — and indeed the world — will be paying close attention.

Want to learn more about ESG? Check out Rotmans' ESG Designation course, designed for professionals seeking a thorough understanding of how to align business models with responsible practices to unlock innovation opportunities, mitigate risk, meet rising standards for accountability and transparency, and to ensure long-term organizational performance.

This article first appeared in the Winter 2023 issue of Rotman Management magazine. Published in January, May and September, each issue features thought-provoking insights and problem-solving tools from leading global researchers and management practitioners. Subscribe Today.

Rod Lohin is executive director of the Michael Lee-Chin Institute for Corporate Citizenship at the Rotman School of Management. This article has been adapted from his report “Key Concepts and Terms in Corporate Sustainability Strategy, Sustainable Finance and Sustainability Reporting,” commissioned and published by the Canadian Centre for the Purpose of the Corporation.