ImpactAlpha, Dec. 14 – The recent takedown of MSCI by a team of Bloomberg Businessweek reporters was the latest knock on environmental, social and governance, or ESG, investing.
Investors have poured money into such funds, which have benefited from the assumption they are helping to create a better world. But do they really make a difference? That question has nagged at ESG investing, even before ESG whistleblowers like Tariq Fancy and Desiree Fixler made headlines.
Bloomberg’s expose laid out what impact investors have long known: ESG is a risk mitigation strategy that doesn’t necessarily translate into positive impact. (Or, to put it another way, “If ESG is so great, why is the world still going to hell?” as ImpactAlpha roundtable regulars David Bank, Imogen Rose-Smith and Brian Walsh asked on a 2019 podcast.)
ImpactAlpha has always drawn a clear distinction between largely passive – and mostly public – ESG investing and more active, still primarily private-market impact investing. In recent years, even the public markets have seen a shift from using ESG criteria merely to mitigate risks and towards proactive real-world impact.
To drive such real-world impact, investors are on the hunt for new indicators, metrics and strategies. Shareholder engagement, rebranded as ‘stewardship,’ has become a viable strategy for driving change at major corporations. New indexes and portfolio strategies are identifying companies contributing solutions to major social and environmental challenges.
1. Universal ownership and beta stewardship
Investors are going beyond the identification of risks facing individual companies to push for corporate action on systemic risks that affect the whole market – “beta stewardship.”
Any advantage, or alpha, that ESG stock-picking strategies might deliver is likely to be more than overwhelmed by such system-level risks that affect the entire market, say advocates such as The Shareholder Commons’ Sara Murphy. Now that diversified investors from large institutions to individual 401(k) account holders are effectively “universal owners,” they need to pay more attention to mitigating real-world risks and “negative externalities,” she says, including those generated by companies in which they hold stakes.
“Responsible investment in its current guise is not fit for purpose as a means to address systemic risks,” writes Ellen Quigley, an advisor to the chief financial officer at the University of Cambridge, in her 2020 paper, Universal Ownership in Practice. “Universal owners aim to mitigate systemic risks in the real world, which has the effect of internalizing externalities and protecting the long-term health of the system as a whole.”
- Go deeper: “Chasing alpha is fine, but long-term returns for universal owners require beta stewardship.”
2. Transition investing
ESG presents a snapshot in time. Impact investors reward corporate transitions. A key indicator: Change in the share of revenues driven by products and services that solve major environmental and social challenges.
Simply investing in companies that are not objectionable “is very different from investing in companies that will not only survive in an economy transitioning to a low-carbon footprint, but that also enable that transition,” says Charlotte, N.C.-based Massif Capital.
As the economy is remade around sustainability and inclusion, some investors are pushing legacy companies to spin off their sustainable businesses into what could be called “RenewCo’s.” These spin-offs can reap the rich valuations and easy access to capital enjoyed by clean energy providers and electric vehicle makers at the forefront of the transition to a low-carbon economy.
The OldCos can be milked for profits while they last.
- Go deeper: “Accelerating net-zero transition pushes incumbents to spin off green ‘ReNewCo’s’, and “Asset managers compete on impact as investors move beyond ESG.”
3. Sustainable solutions
Investors are increasingly finding impact alpha in ‘sustainable solutions.’ The strategies go beyond merely selecting public equities that demonstrate strong ESG profiles relative to their peers to making bets on companies providing solutions to major human and ecological challenges.
Carbon Collective offers an index of 169 publicly traded companies working to combat climate change, based on Project Drawdown’s framework of climate solutions. On the list: EV maker Tesla, but also newly public Canoo, Proterra, Nio and The Lion Electric.
“We’re not picking winners and losers in a space,” Carbon Collective’s James Regulinski told ImpactAlpha. “We’re just defining which are the spaces that need to be invested in and who’s working primarily on one of the solutions.”
- Go deeper: “Carbon Collective debuts new index of climate solutions.”
ESG pioneer Amy Domini is finding impact alpha in ‘sustainable solutions.’ Domini built its reputation on finding public equities that demonstrate strong ESG profiles relative to their peers. Domini’s Sustainable Solutions Fund, launched in 2019, goes further by lining up a portfolio of companies delivering accessible and quality healthcare, climate-resilient food, remote work and affordable financial services, including Beyond Meat, Sunrun, Teledoc, Atlassian and Hologic (and, of course, Tesla).
Domini says such an “impact” portfolio couldn’t have been built even a few years ago. Now, more entrepreneurs reaching public markets are taking on bigger human and environmental challenges. Take the growing crop of renewable and clean energy companies, she says. “They want to provide the service beyond petroleum, or beyond meat for that matter.”
4. Better metrics
There’s more to a company’s role in society than “social responsibility.” For five years, researchers at Claremont Graduate University’s Drucker Institute have compiled data on customer satisfaction, employee engagement and development, innovation and financial strength as well.
This year’s rankings, just out, show tech companies in the top tier of corporate management, with the highest overall scores for Microsoft, Amazon, Apple, IBM and Intel.
The late management expert, Peter Drucker, in his 1954 landmark, The Practice of Management, held that to supply the customer is the primary reason “society entrusts wealth-producing resources to the business enterprise.” Mismanaging workers and work is “actually destructive of capital,” Drucker warned. And companies must pursue “the provision of better and more economic goods and services”— aka innovation – to serve their function as society’s “specific organ of growth, expansion and change.”
“It may not all be ESG per se, but it’s all a part of being a responsible company,” the Drucker Institute’s Rick Wartzman told ImpactAlpha.
Dalberg Advisors suggests using metrics that link financial performance and social and environmental performance. Examples of such hybrid indicators include earnings/CO2 intensity for energy or earnings/yield per hectare for agriculture.
The ratings agency Impak Finance emphasizes the impact of the products a company produces, rather than merely how it operates. ImpactAlpha collaborated with the Montreal-based firm in a series of “Impak Battles” to showcase head-to-head assessments of two representative companies.
- Go deeper: Catch up on battles between “Total vs. Neste Oyj,” “Nestlé vs. Danone,” “Engie vs. Enel,” “Novartis vs. Sanofi ,”and “Crédit Agricole vs. BNP Paribas.”
Harvard Business School’s George Serafeim, along with the Global Steering Group for Impact Investment and the Impact Management Project, is developing “Impact-weighted accounts” that aim to quantify a company’s environmental and social performance in monetary terms. Such accounts would provide a sort of impact P&L statement and offer a more holistic assessment of corporate performance. The Value Balancing Alliance, which includes major accounting firms, is pursuing a similar approach.
As many as one in six companies would have their profits erased if they bore the full costs of the environmental damage they cause, the Harvard team has calculated.
5. Impact benchmarks
A group of investors is capturing data on specific sets of impact indicators among their investees. The indicators include reductions in greenhouse gas emissions and portion of staff earning a living wage or higher – and comparing progress to global targets.
The goal: industry-wide impact benchmarks that allow investors to compare the real-world impact of their investments against their peers. While the effort targets private investments, the lessons on impact measurement and management extend to public market investors as well.
To move investment capital at the scale needed for the environmental and social crises, “aspirations and anecdotes alone are not going to be sufficient,” says the Global Impact Investing Network’s Amit Bouri. “We need markets to focus on real-world outcomes for people and planet.”
New impact performance reports from the GIIN developed comparables from an analysis of climate change mitigation and quality jobs reporting among hundreds of investments. The average investment in nature-based solutions, for example, sequestered 3.2 million metric tons of emissions each year between 1998 and 2020.
As for training, companies can measure their own performance against a benchmark. Across the sample, the portion of full-time permanent staff receiving training increased 18% on average annually. Earlier impact performance reports from the GIIN looked at agriculture investments and financial inclusion.
6. Open data
Ratings agencies, researchers and fund managers use different, often proprietary models to assess companies’ ESG performance. That makes it difficult to compare one company to another – and opens the door to greenwashing. It also holds back a full repricing of social and environmental-related risks and opportunities. Climate risk analysis should not be an “investment edge,” but a “public good,” argues Sustainability Arbitrage’s Greg Beier, who is among a growing chorus calling for open ESG data.
- Go deeper: “ESG data is a public good. Let’s open it up.”
A G7-convened task force has recommended ways to improve the integrity, transparency and usefulness of ESG data, building on the efforts of the newly formed International Sustainability Standards Board initiative.
Earlier this year, Kusi Hornberger, Kristina Kelhofer and Christelle Umubyeyi of Dalberg Advisors laid out four ways investors can avoid ESG greenwashing and have real impact. Rather than attempt to replace governments, investors must work alongside them in the common search for solutions.
Legitimate critiques of ESG have grown alongside assets, they wrote in a guest post on ImpactAlpha. “Yet rather than accept the critiques as reasons to divest and return to old ways of investing based solely on financial return, we have the opportunity to use those critiques to improve ESG investing, transforming it into something better.”
Their call to action: Put capital into companies that contribute measurable, effective solutions and recognize that “ESG investing alone will not be enough to effect the needed changes.”
8. Activist investors
The term ‘activist investor’ used to refer to profit-maximizing hedge funds. A new breed of investors is using the activist playbook to push climate laggards to take action. Case in point: ExxonMobil.
This year, the upstart hedge fund Engine No. 1 won a monthslong campaign to shake up the company’s board when three of its slate of four insurgent candidates were elected with the (at least partial) support of major asset managers, along with institutional shareholders like CalPERS, CalSTRS, and the Church of England. Exxon had earlier added another sustainable activist investor to its board, Inclusive Capital Partners’ Jeff Ubben, under an agreement with D.E. Shaw, a large Exxon shareholder.
The Exxon vote represented a tipping point for companies that are unprepared for the global energy transition,” said Liz Gordon of the New York State Common Retirement Fund.
Get ready for an even wilder proxy season in 2022. “People are leaning forward,” says Engine No. 1’s Michael O’Leary. “It’s kind of like the shackles are off and let’s swing for the fences on some of these proposals.”
With contributions from David Bank.