By Andrew Poreda, Vice President & Senior Research Analyst
What it means: Managing ESG risks is critical for the long-term success of a company. In the last few years, companies have aggressively ramped up their sustainability efforts; at the same time, scrutiny from regulatory bodies such as the SEC has also increased. Boards of directors have the difficult task of managing legal, regulatory, and reputational risks, while avoiding “greenwashing.” Many people think boards and executives are legally liable for these risks, but usually companies rely on directors and officers (D&O) insurance to protect leaders by defending, settling, and paying claims. While academic debate exists on whether D&O insurers drive better corporate governance, the author of a recent report, Amelia Miazad of UC Davis, argues that from an ESG perspective (separate from corporate governance), D&O insurers are actively incorporating ESG into the underwriting process; and as a result, they have become active managers of ESG within corporations. Whether they refuse coverage or offer incentives for strong ESG risk management, D&O insurers have to bear the burden of ESG-related lapses, and so they are in a unique situation to monitor boards from an ESG perspective.
Sage’s View: For the insurance industry, ESG is firmly embedded into risk management – whether it be the property and casualty insurer that analyzes the physical risk of climate change when underwriting, the automotive insurer that uses vehicle safety data to insure a fleet of vehicles, or the health insurer that analyzes local air pollution data and its impact on hospitalization and morbidity in assessing premiums for a company’s health care plan. Insurance is an influential facet within corporate America, and as a result companies cannot ignore looking at ESG from a risk management perspective (because they will pay more if they don’t). In the case of D&O insurance, it is possible to self-insure (as Tesla chose to do after D&O premiums became too high due to various controversies), but companies usually try to be smart risk managers and do their best to manage risk. When we talk about the broad need for risk management, many stakeholders are looking at ESG factors in the same manner as insurance companies do, just a different angle. Could a company get away with having a really flimsy cybersecurity strategy and poor data security management? They could, but it would probably have a comparable outcome as giving a 16-year-old the keys to a Ferrari without any collision insurance. ESG has become an essential, embedded part of managing corporations, as evidenced by the number of companies that have published Corporate Social Responsibility reports. Someone needs to tell that to select Republican politicians and asset managers who still think incorporating ESG is optional and are wanting to provide us with “education” on ESG’s woke ways.
What it means: 2021 was a great year for ESG. Product demand was outstanding, and interest in topics like addressing climate change and economic inequality continued to strengthen. Then 2022 hit and ESG became a lightning rod for criticism. Politicians attacked the ESG world for being “woke,” and many ESG funds underperformed their peers due to the rally in fossil fuel commodities. Greenwashing scandals at asset managers like DWS didn’t help instill confidence either. It begs the question: Does ESG need an overhaul? Despite the headwinds, flows into ESG funds have remained resilient. Through the first three quarters of 2022, net inflows to funds in the US were $459 million, while the overall market had outflows of $86 billion. But many see the limitations in funds trying to portray a promised “double bottom line” of both better returns and outcomes for people and planet. In early 2022, we witnessed the Russian-Ukraine war fuel strong performance in the energy and defense sectors (where ESG funds tend to underweight in favor of technology companies), and as a result the average sustainable equity fund lost 19.5% relative to the S&P 500 (total return) losing only 18.1%. Although the debate about whether ESG provides long-term alpha is still ongoing, the current period of underperformance helped fuel the argument of many Republican politicians that ESG investing is not about returns. For historical returns, sustainable funds have not done that bad. According to Morningstar Direct, of the 69 sustainable mutual funds and ETFs that had a 15-year track record, 44 outperformed their fund peers, and 25 underperformed.
Sage’s View: Listening to some critics of ESG, one would believe that you were throwing your money away. But memories are fleeting, and politicians and others are using some of the short-term hiccups to try and assemble a much broader attack on the ESG movement. Is ESG perfect? Of course not, and there are many meaningful discussions that need to take place to help ESG evolve for the better. ESG needs to be seen as more of a dynamic assessment process that captures evolving non-financial risks, not just as a climate-steering tool that boycotts certain industries. Some ESG advocates also need to temper their messaging and not oversell the environmental and social impacts. ESG is primarily a risk management tool, and though there is a correlation to impact outcomes, those that use it here in the United States are mostly looking at it through a financial lens (known as singular materiality). Unfortunately, these welcome discussions have been overshadowed by simplistic political stunts that offer no constructive criticism. Trying to cherry pick one year of slight underperformance (it was a horrible year for all funds) and extrapolate that for the future is dishonest in framing the conversation, as are tactics that frame ESG supporters as default boycotters of fossil fuel industries (the ESG assessments process is especially beneficial for high-risk industries, though the bar may be higher for including companies in a fund). Sage would love to see critics come to the table with constructive dialogue, but to date, all we have seen is political grandstanding.
What it means: Foreign investors have a problem. China’s growth provides equity investors with a lot of upside, but many Chinese companies have very poor ESG profiles (even relative to other emerging markets). In the past, investors have ignored many of the challenges plaguing companies, including censorship, pollution, surveillance, and human rights abuses. However, the growing influence of ESG within investment circles has made decisions more complicated. ESG rating provider Sustainalytics added more complexity to this discussion when they downgraded three Chinese tech rockstars (Tencent, Weibo, and Baidu) to “non-compliant with UN principles” due to internet censorship. The team responsible for evaluation noted that the scope of censorship was increasing, to include surveillance on issues relating to LBGTQ rights and the Russia-Ukraine war. As a result of the downgrade, many ESG-labelled funds had to remove sizeable positions in their strategies.
As President Xi enters his third time in power, many investors now wonder whether China is too risky. Others surmise whether ESG influences are as strong as they once were after Russia invaded Ukraine. Either way, many concerns remain. Hong Kong Watch recently revealed a report that many asset managers and pension funds were passively investing in companies involved in forced labor of the ethnic minority Uyghurs in the Xinjiang province. Foxconn, which makes iPhones for Apple, was just one of the 13 companies listed. Another report from Sheffield Hallam University showcased an investigation that links western automobile manufacturers to the same controversy (primarily through their supply chains).
Sage View: When looking at China’s ESG risks, many usually view the challenges through a moral lens (and to a lesser extent, environmental lens, since Chinese companies have many negative externalities). The Uyghur dilemma is obviously a very important issue, but it is merely representative of an underlying bigger issue: sovereign risk. No shade of rose-tinted glasses will change the fact that China is an authoritarian regime with an adversarial stance towards many western nations as well as its own people. With this glaring challenge comes a plethora of risks. For those investing in Chinese companies, China may try to appear as if they are being less heavy handed in corporate operations, but their “golden shares” in many influential Chinese companies should remind everyone that these companies will always be forced to act in the best interest of the government. And for those who invest in US companies that rely on China, we all should have learned our lesson from Russia. Again, many try to paint this issue as solely a moral imperative, but as Exxon and others found out, authoritarian regimes have no problem seizing and nationalizing assets.
As China reopens and appears to have ditched its “Wolf Warrior” global approach in exchange for a softer tone, we should use this time to have a candid discussion about how as investors we should view China. The Davos crowd warns us that globalization is currently under siege, and we all understand that there are losers when countries focus on nationalism and protectionism. But even though we all yearn to live in a post-conflict world, investors need to not lose sight of the red flags. As a recent BBC article clearly showcased, China continues to actively steal US technology secrets at a wide scale, with the intent to target American ingenuity and topple the US’ status on the world stage. Perhaps we could also look at China’s massive buildup of their military and their creation of man-made islands within the South China Sea, which act as military bases in the backyard of other nations (and violate international law by being within their Economic Exclusion Zones). Or we could look at the story and ones like it that report that the Chinese Communist Party is forcing doctoral students in Sweden to pledge allegiance to the regime prior to commencing their education. Even if China never ultimately invades Taiwan, US politicians have in a bipartisan way concluded that the Chinese-Western World relationship is only growing more complicated. Have investors missed the memo? Sounds like JPMorgan never received it…
What it means: Ever since Elon Musk made the announcement last year that he had acquired a stake in Twitter, it has been a rocky ride for Tesla. Share prices have dropped nearly 70% since then, and many are wondering where is the leadership from their founder and CEO? Tesla’s board of directors has also taken heat from a variety of angles, including some very upset shareholders. Experts anticipated this sentiment to result in a flurry of shareholder resolutions, but many unknowingly missed the opportunity due to Tesla burying annual meeting dates and deadlines in a quarterly filing (vs. the more transparent way of having an 8-K filing or a press release). However, one shareholder did successfully file a resolution, demanding Tesla create a key-person risk report. As Tesla is synonymous with Elon Musk, it makes sense that investors gain an idea of what would happen if Musk were no longer the leader (how it feels ever since he became Twitter’s CEO). Tesla’s board has been scrutinized in the past for its governance issues, as members stood trial in November over whether they created their 2018 CEO compensation package, which could end up being worth $55 billion, in an independent fashion. And although the board may have dodged a bullet this year with many missed opportunities for resolutions, it may be only a matter of time before shareholders come after board members directly.
Sage View: Elon Musk’s antics and the Twitter distraction have been an obvious drag on Tesla stock (though not the sole reason for underperformance). As CEO, a large shareholder, and a board member, Musk should align his interests with other shareholders, but that is clearly not happening. Being that it is such a dynamic time for the automotive industry, one of the world’s most valuable companies needs a leader dedicated solely to its efforts (rather than treating it like a side-hustle). At any other major company, a competent and well-functioning board would have removed Musk as CEO long ago. Tesla’s board continues to be a case study in bad governance with no course changes in the works. Shareholders need to trust that a board will help steer a company, but Tesla’s board has never demonstrated that capability. If we thought 2022 was rough for Tesla, 2023 may shape up to be even more difficult. In addition to massive price cuts across its vehicle lineup, we also learned that Tesla’s 2016 self-driving video was staged (perceived self-driving capabilities are a huge reason for Tesla’s high market value relative to competitors). If that isn’t enough tough news, we also get to watch Musk go to court for his 2018 Tweets where he misled investors about taking Tesla private. But for all this criticism of bad governance, we will probably just be dismissed for being “satanic” instead.
What it means: California has been crushed by atmospheric rainstorms over the past few weeks. Many might surmise that there would be enough water to end the drought, yet most of the state remains in or close to one. The problem is that water storage can be quite complicated. California has a large capacity for storage, but reservoirs often must release water in advance of big storms to prepare for the next storm, and so a lot of fresh water ends up in the ocean. One big solution for more water storage: the ground. Managed recharge has been used for decades to replenish ground water but is gaining attention lately as wells have run dry across the state. Local California agencies have proposed more than 340 projects, in hopes of recharging an additional 500,000 acre-feet of water a year. One example of a strategy is known as flood managed aquifer recharge (Flood-MAR), where water during heavy flows is diverted to parts of the landscape nearby to recharge aquifers. The concept would flood lands in the winter to then be used for farming in the summer. There are some challenges with this concept, such as some areas are poorly equipped to take on water and pests could emerge in a water-rich environment. One other type of potential project encourages landowners to siphon run-off water into basins (where there are coarse soils), use it when needed, and then give rebates on the water fees they pay through a “net-metering” system. The cost-benefit analysis reveals that some of these methods would be competitive with finding alternative suppliers of water, recycling, and desalination.
Sage View: With California having four major drought periods over the past 20 years, planning to ensure water security should have been on the forefront of everyone’s minds for years. From a drought perspective, California may have gotten lucky with a few weeks of heavy rains, but other places in the US may not be so lucky. The Southwestern United States, upstream from California on the Colorado River, is still hopeful for snowfall tallies from the Rockies. Some communities near Scottdale, AZ, had their water cut off on New Year’s Day, and now anticipate paying upwards of triple their current bills to be supplied via water haulers. Throughout our history we have focused on the importance of energy as a national security issue, but these current problems reveal that we have been negligent in our attention to water – whether it be failing to price water via market rates like other commodities or larger-scale planning to deal with droughts (to include mitigating water consumption and spending more on transport, storage, and technologies). We all want to spend billions (or trillions) to address climate change, but what about spending money on issues that plague us now? And it’s not just water quantities that are the problem; water quality is also a critical area of concern. A recent report revealed that all the US’ freshwater lakes and rivers are so polluted with “forever chemicals,” that eating a singular fish sourced from one of them is the equivalent of drinking one month’s worth of forever chemical-contaminated water. As water issues are tied into food security, energy, and geopolitical stability, we need to be doing more in this critical area of concern.
- Miazad, Amelia. D&O Insurers As ESG Monitors. Harvard Law School Forum on Corporate Governance. January 6, 2023.
- Strive Launches ESG Transparency Campaign For Financial Advisors. Business Wire. January 5, 2023.
- Foster, Lauren. Sustainable Funds Face Big Challenges. Only Some Will Be Winners. Barron’s. January 6, 2023.
- White, Edward et. al. China ESG Reckoning Looms For Investors. Financial Times. January 3, 2023.
- Yang, Yingzhi. China Acquires ‘Golden Shares’ In Two Alibaba Units. Reuters. January 13, 2023.
- Tharoor, Ishaan. The Worry in Davos: Globalization Is Under Siege. Washington Post. January 17, 2023.
- Yong, Nicolas. Industrial Espionage: How China Sneaks Out America’s Technology Secrets. BBC News. January 17, 2023.
- Ke, Bryan. Chinese Students Made To sign ‘Loyalty Pledges’ To CCP Before Going To Sweden, Report Reveals. NextShark. January 17, 2023.
- Rubio Sounds Alarm On JPMorgan Partnership With Chinese TikTok Parent Bytedance. Senator Marco Rubio. January 11, 2023.
- Hull, Dana et. al. Life After Elon Musk: Tesla’s Board Takes Heat Over CEO Succession Planning. Los Angeles Times. January 5, 2023.
- Jin, Hyunjoo. Tesla Video Promoting Self-Driving Was Staged, Engineer Testifies. Reuters. January 17, 2023.
- Isidore, Chris. Elon Musk Is Being Sued Over His ‘Funding Secured’ Tweet. Here’s What You Need To Know. CNN. January 17, 2023.
- Wehner, Greg. Musk Rips ‘Satanic’ ESG As World Economic Forum Meets And Discusses Controversial Investment Regime. Fox Business. January 16, 2023.
- Fisher, Andrew. How California Could Save Up Its Rain To Ease Future Droughts. The Conversation. January 6, 2023.
- Fountain, Henry. Will Storms End California’s Drought? That May Be The Wrong Question. New York Times. January 11, 2023.
- Kekatos, Mary. Arizona Town’s Residents Resort To Drastic Measures After Water Supply Is Cut Off.
- BC News. January 17, 2023.
- Boaz, David. The West Needs Water Markets. CATO Institute. January 13, 2023.
- Eating One Fish From U.S. Lakes Or rivers Likened To Drinking Month’s Worth of Contaminated Water. CBS News. January 17, 2023.
This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.
Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high-net-worth individuals. For additional information on Sage and its investment management services, please view our website at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.