The ESG Standard
ESG investing has gained a lot of traction over the past few years. It’s likely you’ve heard the term on the news or read about it online. But have you ever taken a deep dive into what ESG investing really is? ESG stands for Environment, Social and Corporate Governance. It is essentially a metric used to calculate the intangible assets within a company. It’s all the non-financial stuff that companies desire to include in their overall value. ESG investing refers to a style of investing in which all these intangibles are strongly considered when making investment decisions. It flies in the face of traditional investing where profits, dividends and bottom lines were the primary focus for investment selection.
ESG Scores are calculated a little differently depending on who you look to, which we will talk more about later, but Thomson Reuters has a very clear scoring system, so we will use them. Under each category there are a number of subcategories that are considered and scored. Environmental is comprised of resource use, emissions, and innovation. Social is subclassified into workforce, human rights, community, and product responsibility. And lastly, governance is made up of management, shareholders and CSR strategy. The overall weighting of each of these subcategories is not the same. Management for example is 19% while human rights is 4.5%. There’s an entire white paper available on their scoring system. Here’s the link if you’re interested. (https://www.esade.edu/itemsweb/biblioteca/bbdd/inbbdd/archivos/Thomson_Reuters_ESG_Scores.pdf) Each company is rated in all of the above categories and then given a final ESG score which is then translated into a grade from A+ to D-. Scores in each of the categories will be based on information collected from the media regarding violations or superiority in any of the different areas. Now that we all have a basic understanding of what ESG investing is, let’s talk about the pros and the cons.
Pros
- ESG investing allows investors to use their money to effect change. By choosing to only invest their money in companies and industries that they feel properly align with the environment and social changes they wish to see, investors have the ability to put their money where their mouth is so to say. We call this impact investing. This is very popular amongst young people which is part of why we have seen ESG investing gain traction in recent years. It’s evident when watching shows like Shark Tank. When companies come on the show with some form of social action behind their products, their sales tend to be significantly more impressive than those that do not.
- Value-based investing is the practice of choosing companies and investments that mesh with one’s believes and morals. ESG is a measure of these characteristics. This type of investing isn’t new. Franklin Templeton, a large mutual fund company, was in part created by Sir John Templeton. He stood firmly against tobacco use and refused to own tobacco companies inside his mutual funds. Today, Franklin Templeton has one of the largest selections of tobacco free funds.
- By looking more closely at the non-financial and sometimes intangible assets that a company possesses, it may be possible to draw conclusions about the company’s long-term sustainability and financial standing. This practice may reveal risks in a company that a balance sheet would not.
Cons
- Who gets the be the ultimate moral compass? Thomson, as we previously discussed, has created their system of how they will rate each company. Based on how they elected to unequally weight each category, they decide what is morally more important. The ambiguity of the ESG score leaves room for everyone’s own interpretation of what is important. In Blackrock’s 2021 Investment Stewardship Engagement Priorities, they very clearly line out their expectations for the companies they invest in. (https://www.blackrock.com/corporate/literature/publication/blk-stewardship-priorities-final.pdf) On page 3 they state “boards should consider the full breadth of diversity, including personal factors such as gender, race, ethnicity, and age….” when considering potential board members. That used to be called sexism, racism, bigotry and agism. Now it’s called being ESG friendly.
- The cost of doing business has now gone up. In a recent interview with DoubleLine Capital, economist Jim Reid pointed out the increased costs associated with ESG investing. ESG has repriced the cost of things such as mining which in turn has added heavily to the cost of energy. When we put new costs on the inputs, the price of the final product will go up. We refer to this as ESG inflationary pressure.
- The externalities. Who is it that we aren’t even thinking about who winds up being a loser as a result of ESG investing? Let’s take the human rights category for example. I want to tread very lightly here, but want to get your mind thinking in a way it may not have before. As Americans, we live very privileged lives. That privilege has a way of blinding us to the realities of the outside world. We believe everyone should have the same rights that we enjoy and in a perfect world, they would. There’s an argument to be made that by refusing to financially support a company that sources work in less-than-ideal ways (I am NOT talking about forced/slave labor) we are robbing people of their only means of survival simply because it doesn’t line up with what we think “should” be right. As Americans we believe every child should be given free education and every adult should work in the most ideal conditions to support their family. I believe that too! But that’s not the world we live in and in some areas of this world children work to help put food on the table and adults accept less than optimal pay and working conditions to provide for their families. If those companies go under because we, on the moral high ground, demand better treatment of their workers, have we robbed someone of their livelihood? If a child is no longer allowed to work because we decided it’s unethical, are we responsible for that child starving to death? See the dilemma? ESG investing takes a hard and fast stance on factors that may not be black and white.
Ed and I both come from economics educations. We will be the first to admit that we look at the world a little differently. If the study of economics teaches you one thing, it’s to question everything. What aren’t we thinking about? What variable isn’t being considered here? Who loses? There are never two sides to an argument, there are endless sides and endless externalities, both positive and negative. While we don’t know what the future holds for ESG investing, as with all things, we will continue to comb through it carefully and skeptically until we are confident the pros will outweigh the cons.
Incorporating sustainable investing criteria into the investment selection process may result in investment performance deviating from other investment strategies or broad market benchmarks. Any opinions are those of the Molly VanBinsbergen and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected.
