ESG boasts an influential support base that consists of the multinational investment management corporation BlackRock, as well as the World Economic Forum (WEF), the international lobbying organization. Although ESG has powerful and serious backers, investors and company leaders interested in ESG often share the following confusions: 1) How to measure ESG, 2) How to implement ESG.
There are many ways to measure financial returns. It is far more complicated to measure ESG and social returns. This complication makes ESG difficult to explain and invites confusions and misunderstandings.
ESG is not a straightforward investment concept. This difficulty is based on opposing traits about ESG regarding its overall investment performance: 1) ESG (investing) always outperforms non-ESG investing, and 2) ESG (investing) always underperforms non-ESG investing.
Many investors want to do good while doing well. In 2020, one-third of the invested assets in the USA were in socially responsible investments (SRI). A snapshot at the US stock market on the critical first six months of 2020 shows that portfolios which incorporated ESG earned the same or even better returns than non-ESG portfolios.
The overall Q1 and Q2 2020 ESG stock performance show that investing in ESG is a valid and successful investment strategy. However, this perspective should be balanced. A typical ESG mutual fund has at least 20 percent of its assets in technology stocks. ESG portfolios were fueled by the strong performance of technology stocks during that unusual period, which in turn was fueled by a demand in work from home (WFH). Hence, the difficulty remains: it is not easy to measure ESG investments.
Popular ESG goals are to limit climate change, promote diversity, and make corporations act more responsibly. As ESG goals are not always clear, a company interested in adopting ESG may start to understand what ESG is not: ESG companies no longer just focus on maximizing profit to the benefit of shareholders and managers. ESG incorporates a broader set of stakeholder interests, such as: Employees, Suppliers, Customers, Communities, Government Actors, Civil society, Natural environments.
Let’s say there is a company that receives criticism for sourcing raw materials from questionable suppliers. On the other hand, that same company takes its responsibility to its community very seriously. For example, that company shares a large amount of its profit with its local community. The following is a valid question to ask: is this company a non-ESG company or is this company an ESG company?
As there is no straightforward ‘yes or no ‘answer, let’s rephrase what is known about that company: The company sources raw material from questionable suppliers while the company also invests in and cares about its community.
That company may choose to counter critics by saying that changing suppliers or changing how their suppliers operate will require time. While that company should honestly communicate that it understands that it may not yet follow all possible ESG principles, it should also communicate that it holds a strong track record of giving back to the local community.
Companies interested in adopting ESG need to know their strengths and weaknesses. This means that companies should honestly reevaluate themselves and seek to understand where they do well and where they need to improve.
Citing various reasons Tesla was recently removed from the Standard & Poor 500 ESG index. This caused some ESG critical tweets accentuating strong ESG criticism. These different ESG opinions and ESG philosophies should not be blindly dismissed, nor should they be blindly adopted. The lesson learned is that a company which decides to adopt ESG needs to be aware that business circumstances change quickly – the ESG heroes of today may turn into tomorrow’s ESG villains.
Particularly factors like climate change, may be used to influence companies and, if left unchecked, companies may be directed to adopt approaches that reduce competitiveness. Environmental factors are often seen as a key part of ESG, but they are not the only ones.
BlackRock recently indicated that it will not stray from its commitment to ESG, but it will abstain from micro-managing companies. BlackRock favors measures which improve a company’s disclosure of information that help investors understand how well a company is positioned to adapt to climate-related changes.
If a company decides to openly subscribe to ESG, it should make sure that each employee makes a wage that enables that employee to live a decent life. Companies embracing ESG should not create a class of ‘working poor’ workers – employees who work fulltime but barely make ends meet.
In many affluent countries, there is a considerable number of employees who are working hard but are only barley able to make ends meet. A company that follows ESG principles understands the social responsibilities of a fair wage and the positive societal impact a decent salary creates. A fair wage allows employees to feel more relaxed, respected, and dignified.Research shows that employees who are paid a fair wage are more likely to act like ambassadors of their employer. Happy employees profoundly help to enhance their employer’s brand image.
Another area where strong ESG-related contributions are possible is in governance. A company’s board of directors should consist of different nationalities, age groups, educational backgrounds, genders, and a solid ratio of independent directors. ESG-oriented investors will study a company’s board of directors and might find a too homogeneous company board less attractive and even riskier. Research shows that tunnel vision in business, the situation of only seeing one single possible way out of a crisis and not multiple solutions, is often an unintended outcome of a homogenous group.
Tunnel vision is far less likely to occur if a company has a diverse board. The world of business is not static and what is the status quo today may not be the status quo tomorrow. When a crisis strikes, a more diverse board will likely find diverse solutions. This ESG factor ensures a company’s longevity and enhances investor confidence.
Recent statements of some of the biggest ESG drivers, the WEF and BlackRock, indicate that ESG is continuously evolving. A company which embraces ESG ought to understand that adopting ESG is a long journey as ESG ought to become a genuine part of a company’s long-term vision and mission.■