Ensuring that “ESG” doesn’t kill ESG
In the wake of Covid-19, nearly every corporate management team, board of directors, and investment committee of major asset allocators has met to discuss its position on how to treat employees and on health and safety more generally. Many of those responses have been reflected in near-term expressions of the need to better protect employees from future health-related crises. Importantly as well, many of these organizations have vowed to take longer-term actions to address the more systemic issues that underlie the health and economic crises of the past few months.
This is good. To effect real change, we will need action from both corporate America and the asset allocators who fund their initiatives. Increasingly for asset allocators, this action is coming in the form of investing in ESG funds, which are a hot topic among institutional investors and the financial press. Interest in ESG funds, which take into account environmental, social and governance issues in making corporate or asset-allocation decisions, has been growing in recent years; in the first quarter of this year, ESG funds took in record levels of capital. And just last week, a top hedge-fund investor left the firm he founded to start a new, ESG-only fund.
No doubt there is growing momentum for more sustainable and equitable investments, and today’s global health and economic crisis only accelerates that trend.
But, how we harness this momentum will ultimately determine long-term success or failure. Critical questions remain about how some of these funds define their investment criteria and measure tangible results. And even for well-defined and managed funds, we risk failing to realize the full potential of the ESG priorities if these goals remain compartmentalized, rather than being mainstreamed into organizational business objectives. To avoid the mistakes of the past, we need to ensure that the how does not become our undoing.
The “Shareholders” vs. “Stakeholders” Debate
The story of ESG goes back to 2004. Then-U.N. Secretary General Kofi Annan asked the heads of 50 global financial institutions to create an investing framework that incorporated ESG. A year later, investment analyst Ivo Knoepfel authored the report outlining this framework — entitled “Who Cares Wins” — arguing that good ESG policies are indeed consonant with good financial outcomes.
And thus ESG as an investment category was born. In the U.S., as of the end of 2019, there were more than 500 funds that had some “ESG consideration” in their investment process, totaling nearly $1 trillion in assets under management.
And in 2018, Larry Fink, CEO of Blackrock, a $7 trillion asset manager, began calling on corporations to consider not just how much profit they can generate, but also how they can contribute to society.
Fink’s letter kicked off a series of discussions around the fundamental role of the corporation, pitting the Milton Friedman “shareholder” acolytes (who advocate that the corporation’s role is to maximize its value for the benefit of shareholders) against the Ian Mitroff and R. Edward Freeman “stakeholder” primacy view (advocating that corporations should balance shareholder interests with those of other groups related to a corporation’s mission or purpose: e.g., employees, unions, and local communities).
More recently, we’ve seen legislative proposals from Senator Elizabeth Warren seeking to codify the stakeholder primacy view. Warren’s Accountable Capitalism Act would create a legal cause of action for shareholders to sue corporations who fail to take into account their broader stakeholders in making business decisions.
I’ve argued elsewhere that the fight between shareholder and stakeholder primacy creates a false dichotomy. Good corporations recognize that the values of their primary constituents (employees, customers, communities) are ultimately reflected in the buying decisions of their customers. It’s why we have a long history in this country of corporations donating to nonprofits; diverting shareholder cash to these efforts would otherwise violate the corporation’s duty to maximize profits, but for the fact that these activities do enhance customer and community loyalty. And that loyalty translates into high longer-term profits.
Ensuring Funds are Doing What They Claim
So, what does all of this have to do with Covid-19?
Well, perhaps not surprisingly, ESG funds soared in the first quarter of this year. Globally, ESG funds raised $45.7 billion, while investors in the broader set of all mutual funds withdrew $384.7 billion. The same was true in the wake of the 2008–09 global financial crisis; there were far fewer ESG funds then, but membership and engagement with the U.N. Principles for Responsible Investment (UN PRI) increased significantly.
On the one hand, this is great — people expressing their preferences via their wallets.
On the other hand, how do we make sure that these preferences translate into sustainable, long-term actions that in fact move the needle on important environmental, health, and other social issues?
First, we need to address the fundamental questions that remain about both the true impact of these funds and how the funds themselves choose their investments. For example, Xylem — which provides technology to make water more accessible and affordable — is among the top 5 holdings in ESG funds, but so too are Microsoft, Apple, Alphabet, and Visa.
What are the objective criteria by which companies are included in ESG funds and what metrics are fund managers tracking to demonstrate compliance with ESG goals? How do we ensure that individual investors and major asset allocators who are motivated to both make money and do good can direct their investments toward companies seeking real change versus being taken advantage of by potentially unscrupulous fund managers seeking to cash in on an investing trend?
While efforts are still nascent, the SEC is reportedly launching investigations into the ESG space to better determine the criteria for investment decisions. And as recently as last month, a subcommittee of the SEC Investor Advisory Committee indicated that they intend to provide a disclosure framework for ESG-related investors in the coming year. More work will be needed here.
Moving From Compartmentalization to Integration
Second, over time we need to help organizations move from the compartmentalization of ESG into promoting ESG priorities to top-level organizational objectives. For example, some asset allocators today engage in ESG investing through side pocket funds to which small dollars are allocated and for which different investment criteria may exist. And of course there are a number of ESG-focused funds (in both the public and private markets) themselves that similarly apply separate investment criteria.
This is understandable in the early days of any new category, but if in the long-term we keep ESG as a separate category, this compartmentalization will limit its ability to become a more generalizable principle that underlies all business decision making. Fundamentally, that’s how any business (or any organization) works: principles are either codified into the objective-setting processes and the metrics tracking processes as first-class citizens or they simply remain as segregated, under-resourced, second-class citizens.
This is true whether we are talking about environmental concerns, governance, or any other social considerations. Creating new and separate initiatives can help overcome the bootstrapping problem and increase the pool of viable investments, but ultimately mainstreaming ESG priorities into the overall decision-making process for any investment will likely prove to be a better way to effect real change.
And therein lies the challenge for all organizations coming out of the post-Covid era.
Will they “label” their efforts and relegate them to isolated departments or investment side pockets, or will they eventually drop the labels and treat these initiatives as core business objectives, with the same accountability attendant to any other corporate objective?
If the latter, we’ll have a real chance to progress from the Covid-19 crisis with measurable and sustainable long-term progress. If the former, “ESG” risks killing ESG.
