ESG Investing

Executive Summary

Part I: The Basics of ESG

Why do we need ESG Investing?: There are at least three reasons why we need ESG. First, companies may be better placed than individuals to provide a social good, and an ESG mindset may help persuade companies to act on this. Second, there are certain issues that governments cannot regulate (like corporate culture), or which extend beyond the boundaries of any one country (like air pollution). In these situations, ESG awareness may induce better behaviour. Third, ESG can create shareholder value by recognising and exploiting opportunities that are difficult to quantify with traditional methods, like a net present value analysis.

Why is ESG relevant now?: Investors are increasingly conscious about maximising total welfare for all stakeholders, not just shareholder value. Additionally, more evidence (some robust, some dubious) is now available on the positive impact of incorporating ESG information into investment strategies. As larger asset managers and pension funds become more concerned with the broader impact of their portfolios, ESG investing is set to have a greater effect on markets and asset prices.

Academic evidence and estimation issues: While numerous academic studies have been conducted to determine the efficacy of ESG investing, the most convincing evidence is in the G category – all things being equal, better corporate governance correlates to better returns. The evidence is not as strong for the E and S. Studies linking better ESG metrics to better operating performance face well-known estimation problems, such as omitted variable bias and reverse causality.

Part II: Does ESG work?

Exclusion lists and engagement: Exclusions lists are a basic method to incorporate ESG. However, taking the easier, and certainly less controversial, route of exclusions should not be the answer. A method supported by better evidence is that of engagement, where investors influence companies to make changes, whether on specific problems (often used by activist funds) or on more general issues (usually preferred by large passive investors).

The impact on returns: There is evidence that some G metrics have a real impact on returns. The picture is more mixed for the E and S. It is also important to look at ESG using a broad perspective, as value added to society. If some investors exclude companies because of a superficial analysis based on narrow definitions of ESG, that might create an opportunity for investors who don’t. An issue in evaluating the return potential of ESG metrics is that the history is short, and companies did not care about these metrics historically like they do now.

Part III: ESG in Practice

Is the push for ESG coming more from clients or asset managers?: The answer is both, as asset owners see ESG as material for their financial returns, while asset managers work to generate business and product differentiation in a sector which is otherwise increasingly commoditised. In fact, client-driven demand and asset managers-driven push might feed off each other. There may be some clients who initially care about ESG and asset management firms follow by creating products based on it. Once those products become more visible, other investors might realise that they also care about ESG issues.

The role of asset managers: Asset managers need to show some flexibility, especially as investors are moving away from restriction lists and towards engagement. ESG is a much more developed concept in cash equities than in futures, where challenges exist in offering ESG products.

ESG data: ESG data usually requires substantial pre-processing. Moreover, history is short and the way in which corporations think about ESG issues has changed over time. These issues make it very difficult to look at historical relationships as a guide for the future.

Do academics have a role in setting the standard on data?: Accessing ESG data is expensive and academics do not face the right economic incentives to be pushed towards setting the standard on data. However, they might help in areas such as understanding how ESG affects business variables or understanding how to validate ESG datasets.

1. The Basics of ESG

1.1. What Is ESG Investing and Why Do We Need It?

Alex Edmans (AE): There are at least three reasons why we need ESG. First, there are certain situations where companies have a comparative advantage in providing a social good. For example, it is presumably better for companies to reduce plastic packaging directly rather than relying on shareholders to use the higher profits that plastic packaging might generate to address the problems after the fact (for example, by donating to environmental charities). Second, there are certain issues that governments cannot regulate (e.g., government can regulate minimum wages, but they can’t really regulate corporate culture). Third, ESG can lead to a firm undertaking intangible investments that ultimately improve shareholder value but would have been difficult to justify with traditional methods (e.g., net present value).

Campbell Harvey (CH): One of the problems is that ESG is very hard to define in a consistent way that everyone agrees on. This is particularly true for the S and the G. I think this leads to most research efforts and client demands to be focused on the factors that are easier to define and measure, such as carbon emissions. For the other areas in ESG, the difficulty in defining the boundaries of the problem can make it difficult to make much progress.

Neil Shephard (NS): Another issue is that ESG variables are difficult to categorise. For example, gender and diversity usually fall under the S. However, they also impact governance, as paying attention to diversity is important to tap the best talent and because diverse groups of people have been shown to make better decisions. This lack of clear definitions can create measurement issues and complicate the research process.

Antoine Forterre (AF): For publicly listed companies, there is yet another battle between the willingness to do good and the need to maximise returns, which are not always aligned. Ethical and financial views may differ.

Virginia Nordback (VN): Having good performance on ESG metrics can be a prerequisite for having a competitive leadership position in the future. Therefore, from a stock-picking point of view, it can make sense to use ESG variables to identify which companies have better chances of being dominant. There are also several reasons why a strong business would intrinsically follow ESG principles, and the experience of the pandemic has offered several examples of this. We have successful players in the retail space that are continuing to pay their employees despite most of their shops being closed. This not only ensures that those companies will be ready to serve the demand when it comes back, but also encourages loyalty among their employees. This is something that is difficult to replicate, and we see it as a competitive edge.

Shamez Alibhai (SA): ESG does not need to be related to pure financial performance. It can just be a measure of the kind of values an investor wants the investments to reflect. I would add that one has to be careful when comparing the performance of an ESG portfolio with that of an unconstrained portfolio, as the latter does not consider the cost of externalities imposed on society by the companies it holds.

AE: An important issue is that of measurement. There are three main factors that make measurement difficult. First, different investors might have different preferences in what should get prioritised beyond long-term shareholder value. Second, even for measurable variables, it is not clear whether good is better. For example, the evidence on the link between diversity and long-term returns is really nuanced. Finally, some factors are intrinsically unmeasurable. For example, semiconductor companies often have poor environmental scores because of the emissions released in the manufacturing process. However, this does not consider the fact that these companies can power some of the solutions to environmental issues such as global warming.

1.2. Why Is ESG Relevant Now?

Jason Mitchell (JM): One explanation could be the leadership of large investors. Large pension funds and sovereign wealth funds in Canada, Australia and Europe were the first to show a strong preference towards responsible investing. This behaviour seems to have then trickled down to other investors and geographical areas. In other regions, like the US, this leadership effect did not materialise and, even to this day, there are fewer investors with a preference for responsible investing. This could be because funds in Canada, Australia and Europe tend to have higher funding ratios than their US counterparts. Funding pressure might have pushed US-based funds into a shorter-term mindset, where near-term returns are more important than long-term issues, therefore discouraging responsible investing.

AE: There are three other possible explanations: First, that investors are placing increased importance on maximising stakeholder welfare, not just shareholder value. Secondly, we now have reasonable evidence that certain forms of ESG are positively correlated to shareholder value. The third reason is false data, in the form of published studies and reports biased towards the support of specific views. These can lead investors to believe that certain factors lead to long-term shareholder returns when they actually don’t.

Matthew Sargaison (MS): Like so many other areas, part of the explanation might lie with the changing nature of communication. The increase in globally available information and communication around ethical and social issues could lead general investors, pension fund managers, etc, to adjust their behaviour.

1.3. Academic Evidence and Estimation Issues

AE: The most convincing academic research is in the G category. The evidence is not as strong for the E and S. A first important result is that from Gompers et al. (2003)¹, who found that stocks of companies with better governance outperformed significantly in the 1990s. Bebchuk et al. (2013)² found that the outperformance disappeared in the following period. Governance still mattered for operating performance, but investors had started to price it in. Giroud and Mueller (2011)³ found that even in more recent times, better governance was linked to higher stock returns in sectors with low external product competition, suggesting that governance might be more valuable in the absence of competitive pressure.

Nicholas Barberis (NB): Studies linking better ESG metrics to better operating performance face well-known estimation problems. The first one is omitted variable bias: a variable not considered by the study could be causing both progress on ESG metrics and performance improvements. Another problem is reverse causality: firms with better operating performance could be the only ones that can afford to worry about ESG.

AE: One way to correct for these problems is to focus on future earnings compared to analysts’ expectations. If ESG factors are indeed mispriced, then we should find that better ESG scores lead to profits that are not just higher, but also higher than what equity analysts expected. However, analysts might not consider all the relevant variables. Hence, to get more precise results, more sophisticated methods might be needed, such as the regression discontinuity approach of Flammer (2015)⁴.

Rob Furdak (RF): Many studies look at earnings or profitability metrics before extraordinary items. However, extraordinary items such as data breaches, stranded assets or large lawsuits should have an impact on the value of the company even though they are often excluded from historical studies.

NB: In general, there are many studies about whether ESG investing does – or indeed, does not – result in higher stock returns. For example, Hong and Kacperczyk (2009)⁵ is a well-known study showing that sin stocks have higher average returns.

CH: ESG research results need to be approached with caution, as some researchers might have an agenda. There are ways to strategically approach the data to get the desired result. For social and governance issues, results tend to be mixed and hard to interpret. For environmental factors, the narrative is much more consistent. The environmental research is published in hard science journals and, at least in the case of climate change, the evidence is overwhelming.

2. Does ESG work?

2.1. Exclusion Lists Versus Engagement

JM: Exclusions can be grouped into three categories. The first one is universal exclusions, which are the ones supported by international agreements such as UN conventions, WHO conventions, or the Paris agreement. Examples of exclusions in this category are weapons, coal and tobacco. The second category is that of conduct-related violations. This relates to corporate behaviours that are not necessarily a sign of bad business, but more of bad business practices. The third category is what we call idiosyncratic, including, for example, faith-based investing, bans on whale hunting, etc. There is a strong consensus around avoiding companies in the category of universal exclusions. When moving to the conduct-related category, a case can be made that some companies are not bad businesses, but they are just hamstrung by bad business practices. This strengthens the case for engagement or stewardship.

NB: There is an argument that exclusions could be counter-productive: if investors who care about ESG do not invest in certain firms, then they are leaving them in the hands of people with no interest in ESG. Therefore, those firms are unlikely to change. Is there evidence that divesting or excluding firms impacts their cost of capital in a way that forces them to change their business practices for the better?

JM: There are cases on both sides of the argument. We had an example of a mining company divesting certain assets on environmental grounds and those assets being acquired by companies with no transparency on their environmental impact, therefore defeating the initial purpose of the initiative. There are also some positive stories, for example in Europe, where the European Investment Bank (‘EIB’) and the European Bank of Reconstruction and Development (‘EBRD’) stopped future financing for coal plants, making some projects for future plants not economically viable and leading to their cancellation.

Sandy Rattray (SR): It might be true that if people don't invest in your company, the cost of capital might increase. However, this would require a very large number of investors to shun the company before any actual pressure materialises. Moreover, even if restrictions managed to increase the cost of capital, the targeted companies would need to know who shunned their stock and why. If that information is not public, then it is difficult for restrictions to really have an impact. Therefore, I find it unlikely that restrictions could have a material impact on the cost of capital and, consequently, corporate behaviour. I think that a better way to have an impact on a company would be via engagement.

VN: I also think engagement can be a very powerful tool. We’ve had experience with companies that, when engaged on their performance on ESG issues, started paying attention to and measuring these variables. And when things start getting measured then they can also be changed.

Luke Ellis (LE): In some cases, engaging will just not be effective. Some companies have, at their core, lines of business which are incompatible with ESG criteria, irrespective of the amount of effort they can put into trying to change their approach. One example is that of companies whose revenue comes predominantly from tobacco products: there is no way to reduce the health impact of tobacco consumption to a point that would make it acceptable from an ESG point of view.

RF: This is true, and indeed most asset owners put companies into two categories. The first category is that of firms whose business is unacceptable, no matter how they change. Examples include tobacco companies, cluster munitions producers, etc. The other category is that of companies for which engagement can make a difference. This includes companies with issues related to climate change, racial inequality, transparency in their remuneration policies, etc. For these companies, engagement will make a difference, and asset owners are changing their approach to them from exclusion to engagement.

AE: Some very interesting research exists on shareholder activism in a series of studies by Alon Brav, Wei Jiang, and co-authors. Brav et al. (2008)⁶ found that the changes proposed by activist investors lead to price appreciation. Brav et al. (2015)⁷ showed that this continued in the long-term and was caused by an increase in the productivity of the company. Finally, Brav et al. (2018)⁸ looked at innovation, showing that these companies spend less in R&D but generate more patents. This suggests that when shareholders become active there is an improvement not just in long term shareholder value, but also social value. The approach by activist funds, which can be defined as specialised engagement, usually involves engaging with a company on a very specific issue, and with a lot of skin in the game. If such actions add value to society (for example creating more patents with fewer resources) then we should still consider them good from an ESG perspective. Another approach to be considered is that of generalised engagement. This refers to engagement with the aim of achieving broad objectives, using general principles that do not need to be tailored to a specific company. There is evidence suggesting that this method is also able to produce benefits for investors and society. For example, Appel et al. (2016)⁹ show that higher institutional ownership leads to better governance and operating performance.

2.2. The Impact on Returns

NB: There are two main mechanisms through which ESG can affect returns. The first one is a discount rate mechanism: if investors get excited about ESG, they might push up prices of stocks with good ESG scores. This can make returns lower going forward. The second one is a cash flow mechanism: if a firm makes some progress on ESG, investors may not immediately realise how valuable that is. The asset will therefore earn higher returns in the future as investors eventually recognise the value. The issue is that we do not know which mechanism will prevail. And I think that is why the empirical literature often reaches conflicting conclusions.

JM: I think we have enough data to make reasonable conclusions in particular cases. We have done some work on exclusions of tobacco companies, estimating a potential exclusions-related outflow of between USD35-60 billion from the sector. This is quite meaningful given that the world tobacco index trades at approximately USD350-400 billion. It would be reasonable to expect tobacco to be structurally under-priced relative to the market because of this.

AE: There is evidence that some G metrics are related to higher returns. The picture is more mixed for the E and S. A lot of research has been conducted into ESG, but not all of that is getting into the real world perhaps due to confirmation or publication bias. It is also important to look at ESG using a broad perspective, as value added to society. If some investors exclude companies because of a superficial analysis based on narrow definitions of ESG, that might create an opportunity for investors who don’t.

RF: An issue in evaluating the return potential of ESG metrics is that the history is short, and companies did not care about these metrics historically like they do now. Another important factor is the time-mismatch in evaluation: some ESG factors might play out in the next over the next decades so it is inconsistent to evaluate them with a time horizon focused on the next few quarters. Finally, we should consider ESG not just in the context of generating returns, but also as a tool to mitigate the impact of idiosyncratic risks, such as stranded assets, lawsuits, breaches in governance, etc.

3. ESG in Practice

3.1. Is the Push for ESG Coming More From Clients or Asset Managers?

AE: The answer is a bit of both. Many asset owners see ESG as material for their financial returns, as they think these factors are going to influence long-term financial returns. Moreover, some investors might have objectives other than financial terms. However, there is also a push from asset managers. This could partly be linked to the desire to generate business and product differentiation in a sector which is otherwise increasingly commoditised.

NB: Demand for ESG from clients and asset managers may feed off each other. As human beings we have limited attention. Often, we do not realise that we care about something until it is right in front of us. Hence it might be that there are some clients who initially care about ESG and asset management firms respond by creating products based on it. Once those products become more visible, other investors might realise that they also care about ESG issues. I think these processes are mutually reinforcing.

Otto Van Hemert (OVH): There might also be a natural end to this: the process might be self-reinforcing for a while, until interest tapers off and then a reversal occurs, with fewer and fewer people caring about the topic.

NB: This is possible and has happened already in the past for other investment trends. However, problems like climate change are not going to be solved for years and decades to come, hence I believe environmental factors will be relevant for a long time.

Greg Bond (GB): I still think we must worry about the short-term returns. Investors tend to judge asset managers based on their 3- to 5-year performance. There is some fear that in three to five years’ time, if ESG products underperform, investors might abandon them. We might end up with the long-term implications of climate change because of the short-termism of shareholders and investors.

OVH: We could also end up with something that is in between; that is, responsible investing is here to stay, but within a much narrower scope, maybe more focused around climate change.

NB: I think the S might also have a good chance of being relevant for the long run. We talked about diversity and racial equality, which these days are very salient topics in the US. These topics are likely to become salient for many other countries around the world going forward.

3.2. The Role of Asset Managers

RF: No two investors have the same set of values, so asset managers need to show some flexibility. Historically, specific requirements have been handled through restriction lists. Today, investors are realising that this is a blunt tool and that engagement may be more effective at changing corporate behaviour. The largest and most sophisticated investors are now starting to transition towards representing their values through engagement, either directly or indirectly, through the managers that they select.

SA: Asset managers could add value by trying to figure out what are the right metrics to focus on to achieve different environmental, social or governance outcomes, rather than financial outcomes. The private markets business is relatively lucky from this point of view, as there is intentionality and attribution in every investment. I think that asset managers wanting to achieve something similar in public markets really need to focus on attribution and making sure that there's a very clear line between the actions of the manager and the target social outcome.

AF: ESG is a much more developed concept for asset managers who deal in cash equities rather than, say, in futures or other derivatives. In equities, it is not just about applying the exclusion lists that we mentioned earlier, i.e., avoiding trading certain companies, which is usually a product design choice to accommodate client preferences. It is more generally about incorporating ESG as ‘alpha’ factors to improve predictive power. This is an area where we will see more work being done going forward. I think outside of the corporate equity or credit space the notions of ESG are much weaker and it is much less clear how to operate. A good summary of the problems encountered in the futures space can be found in Forterre (2019)¹⁰.

CH: Would it be possible for asset managers to create products that are carbon neutral just by excluding commodities like oil, gas and coal?

AF: The issue is not just contained to commodity futures. For example, equity index futures might own polluting companies on a look-through basis. I think the exclusion approach is important but not enough. It is also difficult to justify from the performance point of view, unless one has a very strong view that the instruments excluded might detract from performance.

OVH: Some people have approached this question differently, for example by avoiding exclusions but then offsetting the carbon exposure of the portfolio by taking positions in carbon emissions futures. So, there might be more nuanced approaches than strict exclusions list.

MS: The issue is that some investors might not accept having to invest in an index future to then short polluting stocks – even if, from an economic point of view, this would be similar to never have invested in the polluting stocks in the first place. In the same way, investors might not accept a method that relies on investing in an index future and then hedging out the carbon exposure with emissions futures.

NS: Is there a way to decarbonise futures-based strategies such as trend following or risk parity?

AF: Trend following relies heavily on diversification. So, using an exclusions approach would decrease some of that benefit. Another factor to consider is that these strategies can be both long and short the instruments. The implications of this in terms of ESG are unclear. One criticism is that we provide liquidity to some carbon-intensive industries, but a counterargument is that we provide the same liquidity to industries that are looking for technological replacements.

MS: One possibility is to use ESG compliant versions of index futures. There is a move to establish such products, but they do not have enough liquidity yet.

3.3. ESG Data

RF: ESG data presents several issues. First, datasets do not have a long history. This makes it more difficult to estimate significant statistical relationships. Moreover, the way in which corporations think about issues such as diversity and data breaches has changed over time. This compounds the problem, so that any past statistical relationship might not hold going forward. This makes it very difficult to look at historical relationships as a guide for the future.

Jeremy Wee (JW): Processing ESG data is a very resource-intensive task. First, we have the already mentioned problem of defining what constitutes ESG. The same ESG factors might be defined in different ways by different people. Secondly, because the data is new, it usually requires substantial cleaning and pre-processing. It is also important to understand the underlying definition of ESG used by the data provider, and whether there is any bias in the way the data is constructed. Before using the data, it is also important to understand the client’s objective: is the aim to use ESG as a risk-mitigation tool? Are absolute or relative ESG scores more important for the problem at hand? After answering these questions, it is then possible to find the data provider that aligns with the final objective. Finally, it is always useful to incorporate several points of view by using multiple providers. In some cases, investors with specific ESG requirements might have a view on what dataset should be used and on how to measure the specific ESG factor. A popular example is carbon emissions. Some investors might want to measure carbon exposures not just as current emissions, but also in the context of 2-degree alignment. Answering this type of questions often requires looking at specific datasets.

3.4. Do Academics Have a Role in Setting the Standard on Data?

CH: ESG datasets are expensive, and it is rare for a research institution to have access to all of them. Multilateral agencies that academics consult for could provide some leadership in terms of putting together comprehensive datasets, but it is unlikely that the academics will take the lead on this problem.

NB: I agree with this. There are at least six leading databases on ESG, all of them quite expensive. Very few researchers are going to be able to get hold of these databases and hire the research assistants to dig through them. Secondly, academics generally focus on different kinds of questions, more related to establishing causality, determining the underlying economic forces of a phenomenon, etc. They would not be rewarded for creating good ESG databases. The career incentive is not there.

GB: I think academics could potentially help on the study of environmental factors such as emissions. The real impact of this data could be in understanding how climate change will affect specific businesses. There is an interesting literature from the past 5-10 years of the impact of rising temperatures on a country’s GDP growth. Academics could help by mapping this type of climate data to financial data like revenues and productive capabilities of companies.

NB: Academics might be able to help by finding a way to validate one ESG database versus another. This is similar to work already done in the past, for example in the definition of sectors based on earnings correlations, returns correlations or even textual analysis of annual reports.

3.5. Final Words From the Academic Advisors

NB: Milton Friedman claimed that we should leave ethical and social issues to individuals and to governments. But it is increasingly clear that there are many issues that individuals and governments cannot solve on their own. An important conclusion from this discussion is that firms, corporations and asset management firms really do have an important role to play in this context.

NS: I find ESG a challenging area because it combines topics that are intellectually very different, such as the management of negative externalities, the design of good governance, the appropriate use of talent and having a motivated workforce. I think the area would be easier to understand, quantify and study if one was to aggressively split apart these different issues.

CH: This area is also challenging because it is difficult to make inference on such limited data and history. I believe that of the three components of ESG the one that will get more attention in the near future is the E, followed by the S. We already have plenty of products under the quality style that incorporate the G component. The low correlations among the different data sources and the different preferences means there is a lot of quantitative work to do. To be clear, I believe that ESG is a quantitative problem and, importantly, there is an opportunity for quantitative asset managers to take the lead to develop products that best achieve both the goals of the investor and society in general.

AE: When approaching ESG, I think the first question to be asked is why we are doing it: is it to further a social cause or to improve long-term risk adjusted returns? This has important implications for the optimal ESG approach as not all strategies that achieve the former also achieve the latter. The second question is what does the evidence say? There is evidence that some types of ESG data do lead to outperformance. We also have some evidence showing that engagement (whether generalised or specialised) is effective at bringing about change. There isn’t much evidence instead supporting divestments. The final question is how to do it. A key priority should be to rely on the most rigorous evidence of where ESG works. There will be a lot of noise in the market from groups thinking certain factors work when they don't. This could lead to some mispricing, which a data-driven, evidence-based investor will be able to exploit.

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