Making (Some) Sense of ESG Investing and Opportunities for Private Sector Engagement? (Part 1)
This is the third post in a four-part series exploring impact investment and finance for development authored by Autumn Gorman of USAID's Private Sector Engagement Hub. Access the series' first, second, and fourth installments.
The worlds of impact investing and commercial investing have typically been quite distinct (as previously discussed). ‘Fiduciary duty,’ the principle detailing that those who manage money on behalf of others must act in their clients’ interests, has been a key driver of this separation. The main responsibility of profit-driven corporations is therefore to provide the greatest financial benefit to their shareholders, by providing a return on their investments through higher profits. This is as true for sole-proprietorships, with the owner being the only shareholder, as it is for publicly-listed companies with thousands of shareholders, either directly or through mutual funds. But how a company or investor thinks about its fiduciary duty is evolving. Let’s consider how different investors may look at it.
To varying degrees, impact investors’ duty to society (a social good) may reduce the primacy of fiduciary duty in how they invest, that may or may not apply to their portfolio holdings.
Investors that refer to themselves as Environmental, Social, and Governance (ESG) investors are primarily commercially-oriented in that they seek market-based — or higher — returns, and they invest according to their fiduciary duty into companies that are also driven by that principle. What is changing are the factors included in how one might calculate the greatest financial benefit to shareholders over the longer-term to meet that duty. Corporations and financial institutions are increasingly incorporating ESG considerations to improve their bottom line — that is, unlike impact investors, fiduciary duty remains the driver of ESG actions and investments. It isn’t about the ESG, but rather a recognition that some ESG factors directly affect the potential for higher profits and returns. And this starts by looking at risks, per the categories of ‘responsible’ and ‘sustainable’ investing as noted in this series' kickoff post titled, "What is (and isn’t yet) Impact Investing?"
Just as an investor in Blockbuster in the early 2000s may have seen the rise of Netflix as a risk to the long-term sustainability of its business model, an investor in ExxonMobil may see risks around the company’s focus on fossil fuels to its ability to sustain profits over the long term.
Last year, ExxonMobil investor hedge fund Engine No. 1 managed to convince enough investors to see this fossil fuel risk as core to longer-term shareholder value. As a result, they were able to change the structure of ExxonMobil’s board of directors, getting their preferred (i.e., climate-aware) members elected to oversee the company. They didn’t do this because they wanted to reduce greenhouse gasses per se; they did it because as investors, they thought they would make more money for their clients if ExxonMobil was to start making more substantial shifts to lower-carbon projects over time. The principle of fiduciary duty remained at the heart of the move. The difference was in how they thought the company could best fulfill it. From Engine No. 1’s website: “Our Total Value Framework is a data-driven approach to investing that allows the firm to put a dollar value on the environmental, social and governance actions a company takes and then tie those impacts to long-term financial value creation” (emphasis added).
In other words, climate change is now material to how some investors assess risks and potential long-term returns of an oil and gas company. That is the important shift here.
This ESG “play” signifies how profound this change is becoming. Commercial investors en masse are calculating their fiduciary duty differently by incorporating ESG factors into how to assess risk and return. Why? It PAYS! Early evidence suggests ESG investing could be better investing. S&P found that 19 of 26 ESG funds they studied outperformed the S&P 500 during the first year of the pandemic. This resulted in a rapid increase in capital flowing into sustainably-focused mutual funds and exchange-traded funds (ETFs).
There is so much happening in this space that it will take two blogs to cover it all and how it is relevant to development. The ESG investing field is rapidly changing; there could very well be new developments between when this was drafted and when it is read, but let’s start by looking at why ESG investments might be outperforming non-ESG investments.
Why might ESG make financial sense?
ESG literature, news articles, and thought leaders often refer to stakeholder capitalism, which, as the name suggests, indicates a form of capitalism where corporations serve the interests of all their stakeholders (customers, suppliers, distributors, employees, shareholders, and local communities) and not just shareholders. However, in practice, this can mean different things to different people. A few voices have outsized influence in the discussion of what stakeholder capitalism is.
One that tends to get a lot of attention is Larry Fink and his Annual Letter to CEOs. Fink is the CEO of BlackRock, the world’s largest asset manager with $9.52 trillion in assets under management (AUM). And no, that is not a typo, BlackRock manages more money than the economies of Japan and Germany combined! In his latest letter, Fink spoke about stakeholder capitalism, but framed it within its fiduciary duty to shareholders. “I write these letters as a fiduciary for our clients who entrust us to manage their assets — to highlight the themes that I believe are vital to driving durable long-term returns and to helping them reach their goals…. In today’s globally interconnected world, a company must create value for and be valued by its full range of stakeholders in order to deliver long-term value for its shareholders” (emphasis added).
Even on an intuitive level, this stakeholder-fiduciary connection makes sense. Companies that treat their employees better will have less turnover, more enthusiastic sales people, fewer harassment lawsuits, and draw more highly skilled people that are more productive. All of these areas are fundamental to achieving higher profits — by lowering costs and/or increasing revenues. Similar arguments can be made for companies that have better policies for suppliers, distributors, etc. For example, consumers and governments do not typically respond well to companies that have child labor or harmful ingredients in their supply chains. Thus, ignoring exposure to such risks is bad for businesses and their fiduciary duty to their shareholders — even if it is a sole proprietorship with only one shareholder. But that is also true for BlackRock.
There is a lot of information available to potential investors, employees, and suppliers. With the rise of big data, social media, and communications technologies, any ESG issue can be raised and shared more widely and quickly than ever before (e.g., #MeToo). There are also more avenues, including digital platforms (e.g., not through a broker), through which individuals can make direct investments into companies. What started with younger generations being more interested in socially responsible investments and wanting to work for companies that employ ESG principles, has expanded across the generations. What this means is that 1) supply has been created to meet the growing demand in capital markets, and 2) companies are taking action at significant scale.
How do we know what companies are doing?
In the above example, ExxonMobil tried to fight Engine No. 1, and lost. However, other oil and gas companies have started exploring lower-carbon options without causing a shareholder fight. In fact, many companies in all sectors have been voluntarily disclosing ESG elements in annual reports for many years under various names: sustainability, corporate social responsibility, or environmental. It is in these areas in which development agencies and partners have historically worked with companies.
However, such reporting has been voluntary, inconsistent, unverified, and unstandardized. For example, in one of these reports a company might highlight steps taken to reduce greenhouse gas emissions in its factories, without mentioning how it has shifted its supply chains to more distant places where the increase of emissions from transporting those goods more than offset those reductions. Or it may say nothing about its water use, pollution, or whether it has done anything about issues the company might have around workforce safety or harassment. Thus, when reviewing a company’s sustainability reporting, it can be more important to look at what is NOT there instead of what is — especially in conjunction with what might be in the news or on social media about the company. Financial statements are typically audited by a reputable third party. Sustainability reports have no equivalent.
For this reason, various parties have stepped up to provide much-needed guidance and take steps towards common frameworks and standards. These include the Principles for Responsible Investment, The Global Reporting Initiative, the UN Global Compact, the Sustainability Accounting Standards Board (SASB) Standards, the Nature-related Financial Disclosures framework and the Climate-related Financial Disclosures framework. There are so many it can be confusing. Which is why 1) the International Sustainability Standards Board (ISSB) was announced in November 2021 at COP26 with the mission to develop a comprehensive global baseline of sustainability disclosures for capital markets; and 2) USAID’s Private Sector Engagement Hub has supported efforts to harmonize development indicators with such frameworks.
There has also been a significant increase in the support available to companies in the ESG space. Credit rating agencies like Fitch, Moody’s, and S&P are now offering ESG ratings, as are many others. Investment banks and consulting firms are there to help any company with its sustainability reporting and incorporating ESG in its operations. These factors are likely to drive both the demand for private sector engagement, but also expand its scope to new areas. The key message here is that it isn’t just about corporate social responsibility (CSR) anymore. The ESG elements of greatest interest to a sector, company, or investor (e.g., climate, inclusion, transparency) provide the best entry point to stronger engagement with the private sector — and to more and larger opportunities to engage at the core of business and investment!
This provides an opening to pull more of the left side of the impact investing spectrum towards the right, although 1) it won’t happen overnight, and 2) it will likely happen in smaller steps given the gap in between remains large. It will be particularly interesting to watch these developments and to what extent they align with the impact investing world and its tools, such as the Global Impact Investing Network’s IRIS+ system, as well as development metrics and frameworks, such as the Sustainable Development Goals (SDGs) and the U.S. International Development Finance Corporation’s Impact Quotient. Wherever the alignment is strongest will deliver the best opportunities!