Sustainable investing is at once intuitive and confusing; it seems like the right thing to do, but there are many different ways to do it. It promises a contribution to solving global issues, but perhaps at the expense of investment returns. It represents new risks, opportunities, and ways of doing business in a rapidly changing world of finite resources. At TIFF Investment Management—a not-for-profit outsourced CIO firm managing approximately $9 billion on behalf of roughly 600 not-for-profit member institutions and this author’s employer—environmental, social, and governance (ESG) research is one component of the manager selection process.
Investors need not bear the weight of the world to implement an effective sustainable investment strategy and make a difference through thoughtful capital allocation. Sustainability issues are business issues that affect corporate value, and investment analysis must consider ESG information to be considered complete; for example, energy use is a cost, and different sources of energy present different risks. Poor supply chain management, including the use of child labor, can destroy a brand. Diverse and independent boards are often more effective than homogeneous and intertwined ones.
The sentiment around business practices as they relate to environmental, social, and human capital is changing; business models are adapting to this, and ESG issues are increasingly becoming business issues. But not all ESG factors affect all industries, and decision-useful ESG data is still relatively hard to come by. There is no widely accepted domestic or global standard for corporate reporting of ESG information; therefore, not all companies report, and those that do use disparate approaches. Many investment managers incorporate some form of ESG into their research processes, but not necessarily in very thoughtful ways.
That said, the sustainable investment movement, in its different forms, has tremendous momentum. By the end of 2016, global negative/exclusionary screening assets under management (AUM) had ballooned to approximately $15 trillion, ESG integration AUM had risen to over $10 trillion, and corporate engagement/shareholder activism strategy AUM was over $8 trillion (Global Sustainable Investment Alliance, 2016 Global Sustainable Investment Review,http://bit.ly/2MRLRCu). The United Nations’ (UN) Principles for Responsible Investment (PRI) signatories, of which there are over 2,000, manage $81 trillion in aggregate AUM (UN PRI). The EU Nonfinancial Reporting Directive represents a critical step in the history of capital markets. UN Sustainable Development Goals (SDG) and the UN Framework Convention on Climate Change Paris Agreement are but two examples of international cooperation aimed at solving ESG problems.
Still, while institutional investors may believe in these initiatives, the concerns of investment execution and performance remain. TIFF’s members, for example, have annual spending rates typically between 3% and 5%; their portfolios need to achieve real rates of return in line with those targets in order to support their missions while maintaining their purchasing power. Furthermore, investors may accept that ESG factors affect corporate value and are thus relevant to achieving performance goals, but there is still no standard framework for measurement or comparison across industries and companies. The Sustainability Accounting Standards Board (SASB) offers an excellent ESG reporting framework, but no one is required to use it. The EU Nonfinancial Reporting Directive is mandatory for approximately 6,000 large companies in Europe but provides a great deal of flexibility to corporations in terms of what they disclose: “relevant information in the way they consider most useful” (Robert G. Eccles and Mirtha D. Kastrapeli, The Investing Enlightenment: How Principle and Pragmatism Can Create Sustainable Value through ESG, State Street Corporation, 2017, http://bit.ly/2tJYkQi).
The current lack of ESG reporting standardization presents both investment risk and opportunity. The risk is in not fully understanding investment vulnerabilities associated with ESG factors; the opportunity results from information asymmetry. For example, the total share of global greenhouse gas (GHG) emissions that fall under a carbon pricing regime (e.g., carbon taxes, cap and trade) increased from less than 5% in 2005 to roughly 13% in 2016. The number of laws and executive acts related to climate increased from just over 200 in 2005 to 1,200 in 2016 across 124 countries (Generation Investment Management, 2017 Sustainability Trends Report,http://bit.ly/2KnMoxK), and these numbers are likely to rise. An analysis of companies with material exposure to carbon and climate-sensitive regions would be incomplete without an understanding of the costs of emissions and regulatory compliance, which is not standardized. Those investment managers who do the work to cover this information gap will have an edge.