ESG and Responsible Institutional Investing 1/2

CFA Institute

0/ Introduction

• ESG investing == incorporation on ESG considerations into investors’ portfolio decisions. It’s mainly non-financial.

• It’s important to understand the difference between the size of the funds publicly “buying” into the agenda (AUM) and the actual ESG investment. The difference is somewhat 1:100 (i.e., the actuals are 100x smaller).

• ESG principles are often not disclosed publicly by firms or their investment managers, and companies have an incentive to engage in greenwashing to look attractive.

• The driving force is the generational shift: Boomers are gradually thinking of making the world a better place for their heirs and are increasingly investing in the E+S companies.

• Is “doing well by doing good” a viable financial strategy?

The Driving Forces

• It’s important to understand that the value corporations create is a sum of the values (to and from, can be negative) for all stakeholders, including indirect effects (i.e., externalities). The ways to address the externalities are through government policies, rules/regulations and subsidies. Globally this is an unmanageable task.

• Hence the idea of ESG investment – trying to use capital markets to do governments’ bidding.

• The reason behind the global climate change investment response is not because climate change is 100% real (as of today, 17.02.2021, Texas is freezing, Europe is freezing, Russia is comfortable, and Gazprom is rolling in money from natural gas sales), it’s because IF it is, the damage is enormous, and it’s better to do some reallocation of capital now to diversify this uncertainty. [MK: I did read a coursebook on climate change 10 years ago when I did my MBA, but the best way is to look at it from a utilitarian / pragmatic perspective.]

• [MK: from a different source] While there’s weak evidence that good corporate governance is a driver for superior returns, sharp declines in share prices in many cases have been caused by poor corporate governance. Yes, it’s risk management again.

• Many companies are trying to please shareholders with their “sustainability” reports emphasizing the “stakeholder” value vs the “shareholder” value [MK: I’m not clear on which legal basis they’re doing so]. Public statements and pledges are fine, but again, this has quite weak legal ground (assuming the courts are not woke). Yes, indeed, there is a big temptation that poor management can be disguised as ESG-friendly business practices.

Some basic stuff

MK: Sorry, I need to have this somewhere other than my head to reference later.

• E: Climate change and carbon emissions

• E: Natural resource use and energy and water consumption

• E: Pollution and waste

• E: Eco-design and innovation

• S: Workforce H&S, diversity and training. [MK: It’s funny that the Board’s diversity is usually listed under the G.]

• S: Customer and product responsibility.

• S: Community relations and charitable activities.

• G: Shareholder rights

• G: Composition of BoD (independence and diversity, see above)

• G: Management compensation policy

• G: Fraud and bribery.

MK: The curious thing is that G is thought to address the long-term shareholder interests (in the light of the provokingly obscure term “corporate sustainability”), while in fact the market doesn’t really care.

Climate Change

• MK: Again, I’m not going to doubt the concept, while the evidence is not as strong as the mass hysterical media forces us to believe.

• The concern is that the current average temperature levels exceed the pre-industrial levels by at least 1c, supposedly because of the population growth and the industrial emissions (which is very plausible). The 1.5c increase is expected by 2030-2055, hence the Paris Agreement and the net-zero emissions, otherwise the climate change becomes irreversible.

• One can very much disagree (for instance, quoting the previous lack of access to information vs the current 24/7 flow of bad news), but one can’t argue against the facts that the extreme weather is a fact of life now (which includes stronger hurricanes, tsunamis and snowfalls in, among many places, Texas). This has a direct influence on many companies’ operations and valuations.

• MK: the reasonable person’s concerns are as follows: trying to replace the traditional sources of energy (disregarding the gradually reduced use of energy, which is a topic in itself) with the “renewable” ones can reduce certain risks, including, of many others, the risk of “stranded” assets, i.e., the ones which carrying values are going to be substantially written off as a result of the change of energy use (think oil/gas production).

• MK: sustainable energy is as much of a liability as it’s an asset, if not more. Germany, the country lauded for its renewable energy targets, has to resort to very much non-renewable energy sources not just to power the grid, but also to clean the wind turbines. The point here is that theory can be very politicized.

• But in fact, the carbon risk is already priced into the markets. However, climate risks end up being reputational risks for investors, i.e. it’s suicide to doubt this narrative because of the “what if” factor (meaning the possible complete destruction of value).

• The levels of disclosures are country-specific, i.e. the stronger the environmental norms are in the country – the more likely its firms are to go an extra mile in disclosing their environmental impact.

Part 2.