Investment products that make consideration of environmental, social and governance (ESG) issues a central part of investment decision-making are on the rise. Why? It’s not because of the conventional wisdom that the share market places undue emphasis on quarterly earnings (which is inconsistent with the evidence), and it’s only in part a marketing angle. The biggest issues facing corporations – climate change and labor relations – are challenging because executives have to make decisions today using their best guess as to community expectations in the future. Executives who consider material ESG issues are more likely to make investment and operational decisions that buttress the business against underlying risks that have not yet shown up in earnings or balance sheets. ESG analysis helps investment managers work out which companies and business models are likely to succeed as community expectations shift.
According to Morningstar, in 2020 there were an estimated 392 exchange-traded and open-end funds in the United States (U.S.) which made consideration of ESG issues a central part of the investment process. [i] This is almost triple the 139 funds of 2015. Sustainable fund assets under management have increased five-fold, from around $50 billion in 2015 to $250 billion in 2020. $51 billion in net flows to sustainable funds comprised a quarter of overall net flows to stock and bond funds in the U.S.
Does this represent a fundamentally different investment philosophy? Or does ESG-focused investing mean consideration of more proxies to identify companies that are likely to be future industry leaders – and which therefore make worthwhile investments today? Those who contend that ESG investing represents a seismic shift in investment philosophy often rely upon the straw person argument that “traditional” financial analysis is too short-term in nature. The CFA Institute has decried “the excessive focus of some corporate leaders, investors and analysts on quarterly earnings and a lack of attention to long-term value creation”[ii] and Morningstar contrasts the “short-term shareholder-centric approach [with] a longer-term perspective that focuses on creating value for all stakeholders.”[iii]
Survey evidence supports this view. Researchers from Duke University and University of Washington found that 80 per cent of CFOs would decrease discretionary spending (R&D, advertisiting, maintenance) in order to achieve a desired earnings target, and 55 per cent of CFOs would be willing to bear a small loss in value by delaying a new project.[iv] The limitation of this argument is that the share market doesn’t actually overweight short-term earnings performance. Researchers from Utah State, Michigan and Stanford provided persuasive evidence that share prices take a long time to account for the new information in earnings above or below expectations.[v] There are instances in which executives make accounting, investment or operational decisions to achieve a particular quarterly earnings per share number (the cluster of earnings surprises are just slightly positive isn’t an accident). But the price investors actually pay for shares acounts for all prospective earnings: short-, medium- and long-term.
There are two motivations for investment managers’ desire to brand themselves as ESG-centric. There is a prominent marketing angle. But informed investment managers know that funds, and therefore manager compensation, will flow to the top-performing managers on a return versus risk basis. So they use ESG metrics to try to identify firms with disciplined processes for allocating capital, and firms with inherent underlying risks, that have not yet shown up in earnings or balance sheets.
Five years ago every CEO claimed to be “laser-focused” on creating shareholder value. Now every CEO claims that the pathway towards creating shareholder value is to align the interests of shareholders with other stakeholders – employees, suppliers, customers, and community.[vi] Investment managers are trying to distinguish companies with the willingness and ability to create long-term sustainable returns to shareholders from the companies that take a narrow, legalistic view on shareholder value, which is to take any actions legally permissible to increase the share price.
Externalities – Community Expectations
Why do investment managers prefer a more expansive view on shareholder value, namely the alignment of interests of shareholders and other stakeholders? Externalities. Some corporate conduct imposes negative externalities on other constituents. Consider carbon emissions from energy companies, disinformation spread by social media companies, and adverse health consequences associated with food sold by fast food companies. That doesn’t mean these corporations are necessarily doing anything wrong – we need reliable, low cost energy sources, social media companies provide platforms for debate on social issues, and Domino’s and Little Caesars delivered so many pizzas during the pandemic they could be classed as an essential service. But as community expectations change, investment managers are trying to guess which externalities will end up on the liability side of corporate balance sheets, or even put an end to currently profitable business models. In short, ESG metrics are being used as a proxy for whether a company is giving due consideration to potential changes in community expectations.
Data providers are doing their best to identify material ESG strengths and risks using similar language based around exernalities and changing expecations. For example, MSCI asks, “Of the negative externalities that companies in an industry generate, which issues may turn into unanticipated costs for companies in the medium to long term?”[vii]
Externalities – Climate Change
Consider the impact of climate change on the business models of Ford and GM. Transportation accounts for 29 per cent of U.S. greenhouse gas emissions, according to the EPA.[viii] This means that lower vehicle emissions will necessarily comprise a large portion of emissions reduction if the U.S. is to meet its commitments under the Paris Agreement.[ix] The ongoing challenge for Ford and GM is to determine the level and pace of investment in electric vehicle technology and manufacturing that meets today’s consumer preferences (consumers have range anxiety) versus tomorrow’s consumer preferences for low emissions, and uncertain regulatory standards.
Is the share market overly-focused on short-term earnings? On May 26 Ford announced it plans to spend $30 billion over 2021-2025 on development of electric vehicles and that 40 per cent per cent of global sales volume will be all-electric by 2030.[x] The share price rose 7 per cent. On November 9, 2020, GM announced a $27 billion 2020-2025 spending program on development of electric vehicles and autonomous vehicles, up from a prior commitment of $20 billion.[xi] The GM share price increased by 10 per cent over the two trading days surrouding this announcement.
On the same day as the Ford announcement, courts and shareholders exerted their influence on three energy giants. A court in the Netherlands ruled that Royal Dutch Shell must cut carbon dioxide emissions from its own operations and its products by 45 per cent from 2019 levels by 2030.[xii] At ExxonMobil, at least two directors were ousted by shareholders, replaced by Gregory Goff (former CEO of Andeavor, a refining company) and Kaisa Hietala (former EVP of Renewable Products at Neste, also a refining company).[xiii] At Chevron, shareholders passed a proposal that requires the company to “substantially reduce the greenhouse gas emissions of their upstream and downstream energy products.”[xiv] The Chevron vote does not mean a great deal in isolation because there is no definitive emissions target. But it sends a message that shareholders want the company to work with suppliers and customers to lower emissions throughout the value chain.
Externalities – Labor
The classification of drivers as employees or contractors is a crucial issue facing ride-sharing firms Uber and Lyft. The business model relies on efficient utilisation of spare productive capacity (drivers’ vehicles and time). In California, the ride-share companies provided $107 million in support of Proposition 22,[xv] which allowed the continued classification of drivers as contractors, but which also mandated three driver conditions – a minimum level of pay per hour while accepting and completing a request, health insurance subsidies for regular drivers (15 hours per week or more), and accident insurance subsidies.[xvi] Other companies contributed $97 million in support. Voters supported Proposition 22 by a 59/41 margin and, in the two days surrounding the November 3, 2020 election, the share prices of Uber and Lyft rose by 18 per cent and 19 per cent, respectively.
ESG-focused investors are just a subset of investors who give particular emphasis to ESG metrics as a means of identifying companies that try to run ahead of community expectations, rather than make decisions upon existing legislative and regulatory constraints. The hard part for corporate executives is determining what future legislative and regulatory constraints are likely to be. For corporations making investment decisions, it’s best not to be distracted by the loose and empirically false statement that the share market has a short-term focus. Investors in Ford, GM, ExxonMobil and Chevron have demonstrated that they care about long-term outcomes, using their wallets and their votes.
Investors considering ESG-centric funds also face a difficult task – working out what ESG markers are reliable indicators of valuable, long-term, strategic decision-making. The materiality map of the Sustainability Accounting Standards Board (SASB) is likely to help.[xvii] For example, material ESG issues for auto companies are product safety, labor, fuel economy and materials sourcing risks; oil and gas companies are primarily concerned with greenhouse gas emissions and critical risk incidents. Researchers at Harvard University and University of Minnesota found that portfolios formed on the basis of material ESG indicators earned positive risk-adjusted returns, but there is no returns premium associated with consideration of immaterial ESG issues.[xviii]
Jason Hall is a lecturer in finance at the Stephen M. Ross School of Business, University of Michigan. He is co-founder of Hamilton12, which provides rules-based investment strategies, and is the owner of Cardinal Economics & Finance, a corporate advisory firm. Jason is a PhD graduate of The University of Queensland, a CFA Charterholder, and a board member of the CFA Society Detroit.
[i] Morningstar, 2021. Sustainable funds U.S. landscape report, 10 February.
[ii] CFA Institute, 2015. Environmental, social and governance issues in investing: A guide for investment professionals, October, p. 6.
[iii] Morningstar, 2021, p. 33.
[iv] Graham J.R., C.R. Harvey, and S. Rajgopal, 2005. The economic implications of corporate financial reporting, Journal of Accounting and Economics 40: 3-73. Graham J.R., C.R. Harvey, and S. Rajgopal, 2006. Value destruction and financial reporting decisions, Financial Analysts Journal 62: 27-39.
[v] Doyle, J.T., R.J. Lundholm RJ, and M.T. Soliman, 2006. The extreme future stock returns following I/B/E/S earnings surprises, Journal of Accounting Research 44: 849-887.
[vi] Business Roundtable, 2019. Statement on the purpose of a corporation, August 19.
[vii] MSCI, 2020. MSCI ESG ratings methodology: Executive summary, p. 3.
[viii] https://www.epa.gov/ghgemissions/sources-greenhouse-gas-emissions accessed on May 26, 2021.
[ix] https://unfccc.int/process-and-meetings/the-paris-agreement/the-paris-agreement accessed on May 26, 2021.
[x] Ford, 2021. Superior value from EVs, Commercial Business, Connected Services is strategic focus of today’s ‘Delivering Ford+’ Capital Markets Day, Media release, May 26.
[xi] GM, 2020. GM boosts investment, grows electric portfolio to lead in EV race, Media release, November 9.
[xii] The Guardian, 26 May 2021. Court orders Royal Dutch Shell to cut carbon emissions by 45% by 2030, https://www.theguardian.com/business/2021/may/26/court-orders-royal-dutch-shell-to-cut-carbon-emissions-by-45-by-2030.
[xiii] Barron’s, 26 May 2021. Exxon board will seat at least two activist candidates. Why the world’s oil companies can’t fight change, https://www.barrons.com/articles/exxon-mobil-board-vote-oil-companies-51622037099.
[xiv] https://chevroncorp.gcs-web.com/node/31241/html#toc74377_61 accessed on May 26, 2021.
[xv] Los Angeles Times, 26 May 2021. Billions have been spent on California’s ballot measure battles. But this year is unlike any other, https://www.latimes.com/projects/props-california-2020-election-money.
[xvi] https://ballotpedia.org/California_Proposition_22,_App-Based_Drivers_as_Contractors_and_Labor_Policies_Initiative_(2020) accessed on May 26, 2021.
[xvii] https://materiality.sasb.org/ accessed on May 26, 2021.
[xviii] Khan, M., G. Serafeim, and A. Yoon, 2016. Corporate sustainability: First evidence on materiality. The Accounting Review 91: 1697-1724.