Practical analysis for investment professionals
14 October 2014

ESG Issues in Investing: What, Why, and Why Not? (Part 1)

When large companies like British Petroleum (BP), Lonmin (LON:LMI), or GlaxoSmithKline (GSK) make headlines for the wrong reasons, it is often the result of an environmental, social, or governance (ESG) issue. These pertain to a wide range of factors, including climate change, water stress, waste management, human rights, employee relations, corruption, and executive compensation. They are not only about large companies getting things wrong (or right) but also about very long-term economic changes taking place in the world — most notable among them, climate change. Still, there is a widely held perception that many investors seem unable or unwilling to systematically consider these issues in their investment decision-making process.

CFA Institute ESG Discussion Forum

To gain clarity on the debates surrounding ESG issues in investing, CFA Institute hosted an online discussion forum on 27 June 2014, “ESG Issues in Investing: What, Why, and Why Not?” The forum was held under the Future of Finance initiative, which is a global effort to shape a trustworthy, forward-thinking financial industry that better serves society.

We had five distinguished panelists: Amy Domini, founder and CEO of US-based Domini Social Investments; Andrew Canter, CFA, CIO of South Africa’s Futuregrowth; Jeroen Bos, CFA, head of global equity research at ING Investment Management; Raj Thamotheram, a UK-based strategic adviser on long-term wealth creation and CEO of Preventable Surprises; and Roger Urwin, global head of investment content at Towers Watson. Each panelist brought first-hand experience gained over many years of dealing with ESG issues in investing.

In this first of a series of two posts derived from our ESG discussion forum, I will be focusing on reasons for considering ESG issues.

“Value” and/or “Values”

Investors consider ESG issues for different reasons. As Bos said, including ESG analysis along with traditional financial analysis, also known as integrated analysis, results in a more complete analysis and better buy/sell decisions. He sees ESG issues as risks and opportunities, a source of economic “value.” There are others who see ESG issues not just as risks and opportunities, but also as issues for our moral “values.” These investors do not wish to become complicit with actions they find morally objectionable. As Domini put it, “It is wrong to pursue financial goals at the cost of destroying lives.”

Both perspectives can be seen at work in investments. For instance, regardless of the economics of investing in the tobacco industry, an individual or a health-related charity may find investing in tobacco unacceptable because smoking is harmful to human health. But other investors may not share the same sense of morality. They invest in the tobacco industry if they believe it is an economically attractive investment, and they look at ESG issues to simply complement their traditional financial analysis. As Canter noted, some investors have indeed successfully invested in tobacco.

One “Value” but Many “Values”

A fundamental point in the “value versus values” debate is that all investors pursue the same economic “value” (or money), but they inevitably have different moral “values.” Urwin was of the view that he finds it hard “to feel good” about institutional investors who do not see “do no harm” as a line that should not be crossed. Bos added that even an institution’s desire to “do no harm” involves subjective judgements. For instance, should an institutional investor exclude manufacturers of land mines, tobacco, or alcohol? Or all of them? And based on what criteria? The recent debates about exclusions relating to fossil fuels and divestment from Israel show that there is no one set of values held by institutional investors.

Canter also emphasized the challenge of integrating values into the investment process. “It crosses over very quickly into the realm of politics and personal agendas,” he wrote, whereas fiduciary institutions like pension funds invest other people’s money and cannot bring in personal agendas. He suggested that there is a range of legal requirements which companies must follow, and investors can rely on those as a baseline. If they wish, they can vote with their money in favor of companies that exhibit better behavior.

Urwin pointed out that it is also clear that not all investors invest solely for economic reasons. The relatively new and growing field of impact investing is bringing together “value” and “values,” that is, earning an economic return and making a positive difference to society and the environment.

Externalities and Stewardship

Thamotheram explained that institutional investors should be willing to consider ESG issues beyond economic reasons to meet social expectations and to address negative externalities. He raised the question of the price of a bee and where does that fit into the discounted cash flow models used by companies producing chemicals that may contribute to the collapse of bee colonies. Are diversified, long-term investors exposed to agriculture and who would be affected by the collapse of bee colonies being moral or prudent by taking a risk-adjusted view of their investments? Or are those who are overlooking such issues being immoral?

According to Thamotheram, the “moral” versus “immoral” framing keeps us stuck in a rather unproductive discourse. He believes that what we need on this issue and many others is action by means of stewardship. (In simple terms, stewardship refers to institutional investors monitoring and engaging with investee companies for longer term value creation.)

Who Is Responsible for Externalities?

Whose responsibility are externalities such as climate change? More specifically, can the burden of externalities and social expectations be left to governments and regulators to bear?

Urwin believes that investors have a role in addressing externalities. He said that confronting climate change through government policy and cap-and-trade mechanisms has yet to generate the desired results. Should investors knowingly defer to the government on something that the government has yet to effectively deal with and which will inevitably affect the lives of beneficiaries of the investment?

Like Thamotheram, Urwin also looked favorably at “stewardship” along the lines of the UK Stewardship Code. He suggested that the most sensible step forward would be a “comply or explain” requirement for asset owners to take greater responsibility for their externalities footprint and be transparent about their activities.

Summing Up

In the debate on ESG issues, it is relatively simple to understand that investors should consider ESG issues for a complete analysis because these are about risks and opportunities that could be overlooked by confining ourselves to traditional financial analysis. What is not simple are the moral values involved. But the fact that this is a complex issue does not mean it is unimportant or irrelevant. Externalities are a fact of life as is investing for a better quality of life. But investing in a way that could potentially lower the quality of that life does not make sense. Is stewardship the solution or merely a change in vocabulary? Difficult questions have been raised about the UK Stewardship Code since it came into being. But in the absence of other compelling solutions, stewardship by institutional investors merits serious consideration.

Next Up: If there are both economic and non-economic reasons for considering ESG issues in investing, why is it that ESG issues may be overlooked in investments? We will explore this question in the next post. 

If you would like to know more about Environmental, Social, and Governance (ESG) issues in sustainable, responsible, and impact investing, please take this free eLearning course by CFA Institute: ESG-100: A Clear and Simple Introduction to ESG issues in Sustainable, Responsible, and Impact Investing.

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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
Usman Hayat, CFA

Usman Hayat, CFA, writes about sustainable, responsible, and impact investing and Islamic finance. He is the lead author of "Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals;" the literature review, "Islamic Finance: Ethics, Concepts, Practice;" and the research report "Sustainable, Responsible, and Impact Investing and Islamic Finance: Similarities and Differences." He is interested in online learning and has directed three e-courses for CFA Institute: "ESG-100," "Islamic Finance Quiz," and "Residual Income Equity Valuation." The other topics he writes about are macroeconomics and behavioral finance. He has experience working in securities regulation and as an independent consultant. His qualifications include the CFA charter, the FRM designation, an MBA, and an MA in development economics. He has served as a content director at CFA Institute. He is a former executive director at the Securities and Exchange Commission of Pakistan (SECP) and former CEO of the Audit Oversight Board (Pakistan). His personal interests include reading and hiking.

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