By Andrew Poreda, Vice President, ESG Senior Research Analyst
Environmental, Social, Governance (ESG) has taken hits from all angles as of late. Whether it be former sustainability leaders going on record to strongly criticize ESG investing for not doing enough to tackle issues like climate change, or those who would accuse the movement of fervently pushing environmental and social agendas as an excuse to collect higher management fees; it almost seems like everyone is hating on ESG. The real problem is not ESG itself, but that ESG as an investing discipline is simply not well understood. And rightly so; there are multiple ways to incorporate ESG factors into the investment process – just look at all the various fund options. This has made it difficult for many investors to grasp what is really at the heart of ESG: risk management.
The corporate landscape has changed drastically over the last 50 years. If you had told a student of finance in the 1970s that in 2021 a company’s greatest assets would be considered “intangible”, they probably would have laughed. Yet, this is true. In the 1950s, manufacturing made up a sizeable percent of the United States’ gross domestic product (27%), and now it comprises a mere 11%. Ours has become a highly technical, service-based economy where the most valuable assets are intellectual property, brand recognition, and human capital (all intangible assets), not factories and buildings (tangible assets). To highlight this point, in 1975 intangible assets of the S&P 500 represented 17% of market value. Last year, intangible assets of the S&P 500 were 90%.
As the way companies are valued by the market and financial analysts changes, so too should the methods by which we analyze them. But herein lies a challenge that is pivotal to the widespread adoption of ESG integration: the need for measuring and reporting on financially material issues. Peter Drucker’s famous quote, “what gets measured, gets managed,” is a mantra of ESG investing, because it gets to the heart of effective ESG risk mitigation. First, companies must measure the ESG risks that are most financially material to their company and their industry (because it varies widely), and then they must report on those risks to allow for evaluation of positive or negative change over time.
In the United States, the Security and Exchange Commission requires companies to report on all issues that may be financially material, yet there are certain topics (mainly ESG ones) that have historically gone unreported. As a way to ameliorate investors’ need for additional information on emerging material ESG issues, public companies (and increasingly, private ones as well) began publishing Corporate Sustainability Reports (CSRs). CSRs address issues that pose risk to a company’s well-being, e.g., crafting a new workplace model in a post-Covid world, developing an enhanced strategy to ensure better data privacy for customers, or managing water scarcity in drought conditions.
Companies have recognized that assessing these ESG risks and opportunities is highly valuable to protecting their bottom lines. It also helps companies look beyond the short-term mindset that accompanies being publicly held and focus on creating a long-term sustainable business model. As a result, CSRs have rapidly risen in popularity with large companies, and 90% of S&P 500 companies published one in 2019 (vs. only 20% in 2011). Smaller capitalization companies, however, have not jumped on the disclosure bandwagon at the same level, as only 39% of the smallest half of the Russell 1000 index produces a CSR. The easiest explanation is a lack of resources.
Another challenge with CSRs is that they can often be a data dump of everything a company is doing from an ESG perspective. Generic “boilerplate” disclosures on a wide array of topics had historically lined the pages of many CSRs, providing little use to investors and companies alike. However, through the work of groups like the Global Reporting Initiative (GRI) and the Sustainable Accounting Standards Board (SASB, now the Value Reporting Foundation), we now witness companies providing decision-useful information in the form of metrics and company tailored qualitative disclosures, which are unique to their specific business model and industry. By concentrating the reporting on these material issues, it provides clarity on what should be considered important from an ESG perspective. An investment bank, for example, faces very different financially material ESG risks than an auto manufacturer.
The number of companies reporting to SASB standards has grown rapidly, and since the standards were released in 2018, over 1,200 companies have reported to them (and over half of the S&P Global 1200 now does so). Reporting to SASB standards (or another framework) is not the only way to showcase disclosure of key ESG issues, but it is an indication of the efforts that many companies are undertaking to provide sustainability information to stakeholders.
The use of ESG analysis as a risk mitigation tool has already made a great deal of positive progress. But if you need further proof that ESG is here to stay, just look at those that evaluate and manage risk for a living. Credit rating agencies such as Moody’s, Fitch, and S&P have all spent vast resources on integrating ESG into their rating methodologies, and we now see insurance companies that have fully incorporated ESG into both their underwriting and investment activities. ESG continues to become more interwoven into the investment ecosystem, and those that don’t adapt will be left behind. When we as ESG investors criticize ESG (alas, it’s true), our skepticism encompasses the potential greenwashing of ESG-labeled funds (a discussion for another post) and the need for mandatory ESG disclosures, because to us, the value of ESG is clear – it’s all about risk management.
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