ESG: E and S are driving G

The recent United Nations Climate Conference (COP26) brought greater attention to the “E” in ESG—investing for improvements in the environment. The “S” (social investing) is also front and center as kinked supply chains, labor’s frustrations around stagnant income and work-life stress, and pressures to ensure equality of opportunity are pushing companies to acknowledge stakeholder and not merely shareholder responsibility. “E” and “S” are driving changes in “G” (governance), forcing company management and boards to establish structures that are better able to deliver the broad returns that stakeholders want from firms.

Unlike other issues buffeting capital markets, such as the debate about whether inflation will prove transitory, the changes embedded in ESG are secular and are likely to permanently change the corporate landscape. It will drive fundamental changes in business organizational structure and management. Its impact on shareholder returns will only grow. Accordingly, it is important to understand the implications of ESG for investment decision-making.

Cost of “E” will be large, but there is demand

It is tempting to believe that ESG—and perhaps especially “E”—will impose heavy costs on businesses that will ultimately be borne by their owners and customers. While it is true that the costs—especially of a makeover of energy sources—are significant, in the long run the financial benefits—including for shareholders—may be even greater.

To take one example, estimates from Bloomberg’s New Energy Finance group (BNEF) indicate that spending of US$5.8 trillion per annum through 2050 will be necessary to shift energy supply and infrastructure to mitigate climate change. Governments cannot fund that alone. The private economy and businesses will have to participate. Over US$3 trillion of green, social, sustainability, and sustainability-linked bonds have already been issued year to date, indicating that private capital is already shifting and investors are clearly eager to participate. Yet even these enormous sums represent the tip of the proverbial iceberg. While approximately 64% of new bond issuance in Europe is “green”, the numbers are far smaller elsewhere. In emerging markets, the corresponding figure is about 25%. In the United States, total green bond issuance is a paltry 3% of all new corporate bonds brought to market thus far in 2021.[1]?

The pressure on “S” will shift labor dynamics

COVID-19 has accelerated many trends that were already underway, but none so large as the changes underway in labor markets and the related importance of labor and capital. The politics of populist grievance arose from the economic factors and policies that for decades had resulted in stagnant living standards for the middle class, such as offshoring production, outsourcing jobs and accelerating technological change. The pandemic piled public health insecurity onto a citizenry already economically insecure, forcing drastic changes in labor markets and public policy. Labor participation rates (the percent of the eligible population working) collapsed in the pandemic and are yet to recover.

As firms have scrambled to hire back workers, wages have risen and many employers are offering other inducements, such as flexible working arrangements. The past 10 years have seen the beginnings of a shift upwards in wage conditions, reversing the downward trend of the last 70 years (as seen in Exhibit 1). Firms will be forced to rethink how to retain, motivate and make their workers more productive, while ensuring efficiency and adequate return on capital.

?The “G” has the votes to push forward

As noted, environmental, social, and political pressures are also forcing a rethink about corporate governance. Some of that is reflected in the boardroom, but pressure is also growing from regulators, suppliers, customers, employees and even the broad public. The voice of younger generations is reverberating around the executive suite, demanding changes to hiring practices, carbon footprints and community engagement. Corporate behaviors are increasingly being held to account on social media, in the halls of Congress and in some cases by shareholders. “E” and “S” are having an impact on “G.”

Research shows that better governance can be consistent with improved shareholder performance.[2] Brand impairment via fraud, corruption or bribery damaged many firms in the energy, defense, and financial services sectors. As these companies have improved their governance, their share prices have benefitted. The same is apt to be true for carbon emissions. As more firms are “graded” on their carbon footprints and their efforts to reduce them, markets will reward those that improve and punish the remainder. A sea of capital is moving toward firms that are adopting policies across the spectrum of environmental, social and governance criteria. Indeed, “good governance” data has been compiled for longer than the social and environmental factors, and the research has shown that there is a correlation to returns. Importantly, the companies that distinguish themselves as highly graded on environmental and social factors will also benefit from active investment strategies looking for new sources of excess returns.

What investors want, they will get?

Investors have already begun to shift rather dramatically toward ESG investing. For example, a survey done by PricewaterhouseCoopers Global found that 79% of global investors indicated that ESG risks are an important factor in investment decision making.[3] As ESG criteria are standardized and more widely adopted, these trends are only likely to accelerate.?

ESG reflects fundamental shifts in how people want to live, work and invest, and the choices they are making about the world they want to leave to future generations. These changes in preferences play an enormous role in the workings of the economy and the way that companies will be profitable in the future. When it comes to ESG, it should not be considered just another financial innovation, but the way capital markets respond to fundamental social and economic transformation.

Investors are increasingly focused on ESG factors. They believe that ESG ultimately stands for opportunity, a positive sum capable of simultaneously benefiting shareholders and other stakeholders. ?

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For additional commentary that focuses on Environmental, Social and Governance read:

US: Global Investment Outlook: Is the E in ESG accelerating?

Global: Global Investment Outlook: Is the E in ESG accelerating?

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What Are the Risks?

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Impact investing and/or Environmental, Social and Governance (ESG) managers may take into consideration factors beyond traditional financial information to select securities, which could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. Further, ESG strategies may rely on certain values-based criteria to eliminate exposures found in similar strategies or broad market benchmarks, which could also result in relative investment performance deviating.

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[1] Bloomberg’s New Energy Finance group (BNEF). October 31, 2021.

[2] Sources: Quarterly Journal of Economics. Corporate Governance and Equity Prices. Vol. 118, No. 1, pp. 107-155, February 2003. “What Matters in Corporate Governance? Review of Financial Studies,” Vol. 22, No. 2, pp. 783-827, February 2009. Harvard Law School John M. Olin Center Discussion Paper No. 491 (2004). Journal of Financial Economics, Learning and the Disappearing Association Between Governance and Returns, Vol. 108, No. 2, pp. 323-348, May 2013. Harvard Law School John M. Olin Center Discussion Paper No. 667.

[3] The economic realities of ESG. James Chalmers, Emma Cox, and Nadja Picard. October 28, 2021.