ESG Investing: Theory, Evidence, And Fiduciary Principles
Harvard Law School
What is ESG Investing
An umbrella term encompassing the firm’s governance structure, or the environmental or social impacts of the firm’s products or practices.
Many investors think that companies focusing on ESG deliver superior returns [MK: supposedly have a positive alpha]. There’s also a trend of investors into funds, pension funds, trusts, etc. to make use of ESG strategies. This paper puts forward an argument that ESG is positively correlated with positive risk and return benefits.
The original motives were moral or ethical, based on third-party returns (i.e. for non-financial stakeholders) rather than investment returns. The SRI (Socially Responsible Investing) used to be all the rage 30 years ago.
This concept evolved into the ESG concept by adding governance to the mix. Ecological concerns started having a litigation / compliance price tag associated with them, thus reducing the potential economic benefits to shareholders and/or increasing their risks. [MK: most of the literature I read on ESG is using similar approaches of emphasizing probable major losses.]
ESG can mean two different motives that are usually incorrectly mixed together (these terms will be used throughout the post, so please remember what they mean):
o Investing for collateral [i.e. non-financial] benefits (SRI), and
o Investing to improve risk-adjusted [i.e. financial] returns from ESG.
ESG strategies are considered active in one of the two ways:
o Working with the management and shareholder vote to bring about change into the firm’s activities (active shareholding), or
o Actively picking and choosing securities (active investing).
Legally speaking, for trustees with fiduciary duty the choice of collateral benefits above the risk-adjusted return may be considered a breach of said fiduciary duty of loyalty. This is not true about risk-adjusted returns as they can be considered an investment strategy exploiting market mispricing of certain securities or applying shareholder control mechanisms to deliver superior returns.
Active investing and active shareholding both require subjective judgements about the relevant factors and their weights. Defining ESG in the context of a given firm adds to the subjectivity.
The weights given to each E vs S vs G are very discretionary: indeed, polluting (E) is bad; treating employees well (S) is good; good governance (G) is definitely good for the firm. But what if any of these variables are not at 100%? An environmentally conscious company with poor governance or excellent governance with constantly unhappy employees?
This poses a bigger problem of the emergence of snake-oil ESG practitioners using cookie-cutter approaches to evaluating firms’ “ESG scores” (often in incompatible ways). Ambiguity is good for them but is expensive for the firms.
Most people think of the environment when talking about ESG. But even some kinds of coal (universally regarded as “bad”) can be cleaner than others. Nuclear is the cleanest of them all – but a few catastrophes have scared politicians off it. Social norms come into play at unexpected times.
Another contextual example is a staggered board (i.e. when directors are rotates in chunks every 2-3 years instead of all at once once a year): indeed, the poor decisions can take longer to reverse, but on the other hand the management will have an opportunity for a longer-term view when choosing new initiatives. [MK: in my beloved Australia the leading party is elected once every 3 years; guess how hard it is to push for any major policy change knowing that it can be reversed before any results will be evident without a magnifying glass?]
Is the Risk-Return ESG Even a Thing?
It’s important to distinguish between:
o whether ESG factors relate to firm value, and
o whether such a relationship can be exploited by an investor for profit via active investment or active shareholding.
Both must be true for a successful risk-return ESG strategy.
ESG Factors and Firm Value
Governance has been found to have theoretic relationships to firm performance. There’s mixed evidence (i.e. don’t bet on it) that there’s a relationship between governance and firm value. Governance is very contextual, so the differences in firms may require differences in governance.
Environment and Social factors can be less confidently linked to the firm’s value via:
o The identification of specific risks and the costs of non- or poor compliance (political, regulatory, litigation, public perception);
o The quality of the management: good managers recognize the importance of strong internal controls and compliance, as well as there can be self-selection of good managers at play.
There is some evidence demonstrating that firms with higher environmental and social scores perform enjoy higher earnings with lower risk than the ones with lower scores. This can also lead to PR successes and counter any potential reputational harm.
At the same time, there’s a risk that ESG policy implementation will come at the expense of shareholders (i.e. via spending the firm’s money on the ESG activities that are not uniformly considered productive). Heavy reliance on the government’s policies leads to high ESG scores with increased risks arising from said policies.
Exploiting ESG Factors for Profit
Active investing (i.e. stock picking): benefitting from investing into companies with strong ESG factors requires the market to consistently misprice these factors. There could be two reasons why this actually may occur:
o Investors don’t believe the markets are efficient (i.e. correctly price securities based on all the available information). [MK: I am a firm believer that the markets are inefficient.]
o Investors believe that consistent market inefficiencies arise from misunderstanding of ESG factors. We can put the “black swan” (low probability, no data points, high impact) events here, too.
The two categories of active investment strategies are:
o Screening: avoid companies with low ESG scores or even avoid certain industries. It’s a no-brainer, and more investors over time may choose similar screening strategies thus vastly reducing the returns to screening, especially when companies are under severe pressure to dedicate half of their annual reports to the ESG activities.
o Stock picking: applying ESG factors in constructing portfolios of individual securities. It’s a qualitative method of choosing the firms to invest in, using their ESG scores are part of the overall returns model (similar to the multifactor Fama-French model), and there’s some evidence showing that the predictions become more accurate.
To put some water on the fire, the evidence that ESG factors can be used to profit from active investment is weaker than the evidence that said factors are related to firm performance. There is also evidence for contrarian, anti-ESG strategies. It’s too hard to obtain consistent data on the risk-adjusted returns net of fees, the internal cost of diversification and also the fact that successful strategies, like any arbitrage, are short-lived.
Active shareholding targets improving or protecting firm value. It doesn’t have the active investing costs; and in the ideal world the cost of increased governance can easily be offset by increased efficiencies resulting in higher investment returns. Active shareholding in many cases is not bad (a “friendly” kind) and firm managers don’t fight tooth and nail to resist them. There’s a free-rider problem, sure, but sometimes the value of involvement for the activist is higher than the cost.
In many cases active shareholding is not good for the firm, though: by definition is undermines the separation of ownership and control, and the management’s time often is spent on implementing shareholder proposals or contesting election instead of being involved in value-adding activities. It’s important to recognize that in many cases activist investors have less useful information than the incumbent management does; in this case their involvement can’t be anything but harmful.
ESG Investment by a Trustee or Other Investment Fiduciary
The trustee must at all times act in the sole / exclusive interest of the beneficiary, i.e. pay no regard to the interests of any third parties. A mixed motive is a direct breach of the duty of loyalty. Thus, collateral benefits ESG investing is expressly prohibited.
Risk-return ESG can be consistent with the duty of loyalty. The key here is prudence, i.e. putting the best efforts in to maximize the financial outcomes for the beneficiary employing a risk management strategy, not avoiding risk as used to be the case in the past.
An ESG investment strategy may be prudent depending on the circumstances. It must be well documented, and the assessment of the financial benefits less applicable fees should be spelled out. The same applies for ongoing monitoring, which may result in rebalancing the portfolio according to the returns and fees.