The Environmental, Social, and Governance (ESG) investing journey has not followed a freshly paved path, rather it has been a trek through the woods for trailblazers on an unpaved, and oftentimes, nonexistent road most of the way.
If we reflect on the evolution of ESG investing in the US, as recently as five or six years ago, few people could define what the initials ESG stood for.
- Then the trailblazers started to create a narrow trail: as awareness of ESG investing began to increase, so did the assets, with a record of $19bn in net flows in 2019 (Morningstar as of 12/31/2019).
- That trail turned into a more defined dirt road once the pandemic hit in 2020, and social issues bubbled up and energy prices fell in the stay-at-home world. With the pandemic, came the first significant market pull back in many years, alleviating many investors concerns around underperformance of ESG investing and the thinking that it was just a nice to have in strong bull markets. This was reflected in record 2020 flows, (Morningstar as of 12/31/2020)1 more than double the prior year, which continued on in 2021. (Morningstar as of 12/31/2021)
- ESG then once again hit a rocky patch, as the Russia/Ukraine crisis hit and energy prices soared in early 2022. Flows sharply fell, ending 2022 significantly below 2021 levels. (Morningstar as of 12/31/2022) 2022 was also the year ESG became a political topic, as each party ran on different conflicting trails, benefiting from the broad nature of the term.
- That brings us to where we are today: on an unpaved, unclear path where some believe investors are not doing enough, and others believe ESG investors—including advisors, governments, institutional investors, non-profit organizations, foundations, etc. are violating their fiduciary duty.
Let’s take a step back and take a look at where ESG first began. Did you know the acronym was coined in 2004 when Kofi Annan, the Secretary-General of the United Nations at the time, started an initiative to integrate environmental, social and governance issues into capital markets? It was called Who Cares Wins (WCW) and was backed by 23 financial institutions, representing over $6tn in assets. The idea of WCW was that companies with stronger ESG practices would materially increase in shareholder value over the long term. While many think about ESG evolving out of socially responsible investing, focused on values or morals alone, the original concept of ESG investing was actually quite different, focused on enhancing shareholder value. It is about finding companies who are more likely to succeed in the future due to strong operational quality, limited reputational risks and innovative businesses, positioning themselves to benefit from structural trends.
This is where the dialogue should get back to: about using environmental, social and governance information to identify companies who are mitigating today’s risks and capitalizing on tomorrow’s opportunities.
Investors may wonder how ESG data can really add to shareholder value. Here are a few thoughts:
- The rapidly changing world is creating a risk landscape very different from the one 10-20 years ago. For example, according to the World Economic Forum, eight of ten of the top global risks are environmental and social in nature, whereas 10 years ago the risk landscape looked very different and was dominated by economic risks.2 ( World Economic Forum, Global Risks Report 2022) This creates trillions in environmental and social risks which have significant economic implications, as well as the potential for new opportunities for innovative companies offering solutions.
- Furthermore, due to the rapid pace of the news cycle, growing prominence of social media and instant nature of communication, information is far reaching and can have an immediate impact. This has made reputational risks much more significant and costly than in the past. Many years ago, poor practices or scandals were easily covered up, where today companies have no secrets.
- This changing investment backdrop has caused the value drivers to shift and in order to understand where companies are heading, investors must incorporate material E, S and G information into the analysis. There is evidence of this in the data, with tangible assets only accounting for a small portion of total value. For example, in 1975, 83% of the S&P 500’s value could be accounted for by tangible assets, whereas in 2020 just 10% of the value is tied to tangibles (Ocean Tomo LLC, Intangible Asset Market Value Study, 2020). E, S and G information can help investors understand the intangible piece making the case that traditional analysis may no longer be enough to understand where our investments are headed.
The confusion about ESG and ultimately the ability to politicize the concept, comes down to the fact that we are labeling apples, oranges and bananas all with the ESG acronym, ignoring fundamental differences in investment approaches and objectives. While all may leverage ESG data, different approaches use the data very differently to achieve varying financial and non-financial objectives. Some investment strategies may be using ESG data to invest alongside certain values, limiting the investment universe, whereas others may be leveraging the information to invest in one particular theme. Investors may also use the information to exclude companies in certain industries, whereas others are using the data to conduct a more forward-looking analysis of potential investee companies. The latter is really what ESG is about at its core: doing good diligence and using material information to mitigate risks and capitalize on opportunities. This is something all investors have the potential to benefit from, regardless of political orientation. Of course, this information can be used to invest alongside certain values, but it doesn’t have to be all or nothing, this data can have various uses.
In the end, ESG data allows for more informed investors, and just like any other industry, we must evolve to remain competitive and relevant in a changing global landscape.