ESG and Responsible Institutional Investing 2/2

CFA Institute

Part 1

The Regulatory Environment

• In many cases ESG/CSR reporting is voluntary, and the lack of standards (looks like this is being addressed now as we speak) makes comparing practices hard due to the different amounts of disclosures.

• The more info is disclosed, the larger the minefield gets for the company, so openness comes with increased litigation risks.

• The “stewardship” codes are used to incorporate ESG agenda into the companies’ decision making and investments. Needless to say, companies have incentives to tick the boxes and use boilerplate language to get around these inconveniences.

• Governments (especially in the EU) are tightening their rules around having companies create their sustainability policies and monitoring benchmarks. In the US the opinions are divided (since ESG policies in many cases go against the fiduciary duty). SEC so far believes that ESG concerns are subordinate to the returns requirements.

Institutional Investors

• G/ESG is not new and gets more important as the separation of management and ownership grows (since managers don’t have as much financial interest in the outcomes as the investors do, hence all the creative compensation schemes and perks).

• In 1990s (at least) the higher level of anti-takeover, voting rights, director/officer protection, etc. (i.e. poorer governance) was correlated with lower returns to investors. This suggests two things: a) good governance is not properly priced into the stock; and b) [MK: this is my personal opinion] poor performance and the need to cover the managers’ asses came first and resulted in anti-takeover provisions, not the other way around.

• In 2000s, however, G/ESG didn’t correlate with increased shareholder returns. The logic is that by then G had been incorporated into share prices, so there was no arbitrage possible.

• In the US governance is about managing the conflict of interest between the shareholders and the management; elsewhere it’s about the majority shareholders vs minority shareholders. So “good governance” means markedly different things in different parts of the world.

• [MK: if I understood the paragraph correctly] There can be too much G, and managers are forced to take unnecessary risks and focus on the short term, leaving to devastating consequences.

• Only the large institutional shareholders can invest money into changing the corporate governance of the firm (benefitting all shareholders). Other approaches include using soft power (trying to persuade the management, i.e. active shareholding) or voting with the feet (i.e. active investing).

• Pension funds investing in certain firms (among others) usually team up with the management of these firms if said firms have their pension plans with these funds. So it’s an implicit conflict of interest.

• Foreign institutional investors are influential in global markets by facilitating cross-border transactions; their presence [quite logically] increases the chance for M&A with international firms. Also, there’s an “export” of good governance practices abroad – board independence, independent audit, terminating poorly performing CEOs, etc. – leading to their adoption internationally.

• The differences in CEO compensation (US vs elsewhere) can partially be explained by the differences in LTIP (long-term incentive plans) approved by US institutional investors. For non-CEO executives salaries often are quite similar for US and non-US firms.

• Higher foreign investment leads to a more long-term view, resulting in firms investing more in R&D, human capital and CAPEX, as well as the internationalization of the firm’s operations and higher valuation. Foreign investors are the ones who make company ownership less concentrated.

• The top 3 index funds (BlackRock, Vanguard and State Street) owned 15-20% of the entire US market in 2017. They are too visible to be ignored, so they don’t have a right to a mistake. But there’s no convincing argument for or against the positive effects concentrated passive ownership has on the firms. Since their stakes are too big, they can’t sell, so they have to care. [MK: what a lovely way to put it!]

What Role Do Institutional Investors Play in ESG/CSR?

• There are two distinct schools of thought: a) CSR is a waste of shareholders’ money – if they wanted to, shareholders could put their gains into any socially beneficial activity they please (noting that a dollar put in by a firm goes a longer way than a dollar invested privately; also, firms can institute wide-ranging policies, while individuals can’t); and b) the Stakeholder Theory states that the firm is accountable to everyone it affects or is affected by (community, employees, customers).

• CSR emerged as a response to the governments’ inability to correct market failures and externalities resulting from state inefficiencies; also, governments are too slow to respond to the societal changes and the new interests of their constituents.

• CSR can affect shareholder value in three ways:

• “Do well by doing good” – think long-term, reduce ESG risks;

• “Delegated philanthropy” – having customers or other “socially responsible” stakeholders pick the bill; and

• “Insider-initiated corporate philanthropy” – managers using corporate funds to promote their own agenda. (They tend to overinvest and can end up destroying shareholder value)

• There are some research papers actively trying to prove that in the long run “green” investments generate more long-term value than the “brown” ones.

• While the proof is not conclusive, it is true that the cost of capital for “green” firms can be lower than for the “brown” ones, hence lowering the expected returns. All other reasons imply that “green” companies will somehow generate higher returns than non-“green” peers – in the short or long run – which sounds quite wishful.

• The major issue of most research papers is that they don’t properly disclose the methodology to explain the cause and effect of particular aspects, they omit listing time horizons and, most importantly, ignore the direction of the causality: does ESG make companies profitable, or profitable companies have more resources to invest in ESG?

• “Sin” stocks (tobacco, alcohol, gambling) exhibit higher returns, lower analyst coverage and less ownership by pension funds. While “moral” investors still hope that sin will eventually be eliminated, returns-focused investors happily put “sin” stocks in their portfolios.

• There is some link between employee satisfaction (S/ESG) and corporate returns; the direction of the correlation is not clear again. Stock markets tend to undervalue employee satisfaction (the level of which is readily available) despite the documented increased productivity. [MK: selling an idea of higher investment into staff wellbeing to the Board is not as easy as it looks on paper.]

• Markets don’t immediately understand what good S/ESG means; they do understand and respond negatively if there’s a PR fiasco that hopefully can be remedied by an active increase in S/ESG scores. By itself the higher investment in S/ESG is not something investors are really happy about. There are material and immaterial CSR scores, and the dividing line is that immaterial scores don’t lead to better firm performance.

• An interesting observation is that firms scoring high on the CSR ratings are likely to perform better in the times of economic downshifts. [MK: say, when COVID hit in 2020, we didn’t let go of any employee and have been able to focus on strategic products while some other companies were struggling.]

• Firms from common-law countries (US, UK) have lower CSR scores than civil-law firms where a stakeholder perspective is more dominant.

• Long-term investors are more likely to request ESG practices as these practices are likely to show outcomes only in the long run (i.e. pricing expectations). As a result, funds with higher ESG portfolio footprints (especially E/ESG) have higher risk-adjusted returns. [MK: due to smaller fines due to non-compliance?]

• E+S/ESG practices are driven by EU (and from other countries with similar social and environmental norms) institutional investors, while G/ESG is driven by the US investors. Higher levels of institutional investment result in higher ESG scores.

not to be continued…