Resolving ESG Conflicts: Important, But Not Material?
Institutional investors take note: “Doing Well by Doing Good” is not just a sales pitch private wealth advisers use to court millennial clients. The global economy’s interconnected nature has turned every business decision, even the nonfinancial ones, into forces that can have far-reaching and unexpected effects on investment returns.
Pension plans and other large, long-term investors are acting accordingly.
One such institution is the California State Teachers Retirement System (CalSTRS), which oversees a portfolio of about $208 billion. At the 62nd Annual Financial Analysts Seminar, CalSTRS CIO Christopher J. Ailman discussed the importance of integrating environmental, social, and governance (ESG) considerations into the investment decision-making process.
Ailman began by sharing his frustration with the various terms applied to concerns classified under the ESG heading. “The one that drives me nuts the most is ‘responsible investing’,” he said.
The challenge with these labels, as Ailman sees it, is the way they can divide ESG considerations from normal investment decisions. What do these divisions imply about the normal decision-making process? When companies have groups designated for “responsible investment” activity, Ailman wanted to know, “Who the heck are all these [other] people? Irresponsible investment officers?”
“The words get in the way,” Ailman said. “The words create a problem.”
In fact, Ailman has seen many of the relevant issues already being monitored by investors. “I describe ESG risk as actually long-term operational business risk,” he said, “material operational business risk.” And private equity firms, fixed-income investors, and value analysts are noting those risks. “People won’t use the phrase ‘E,S, and G.’” he said. “But almost always I find I can label those things back into an environmental risk, a social risk, or a governance risk.”
“These risks are business risks that are very long term in nature,” Ailman said. The relevant question is what “long term” means to each investor. “Our typical holding period is 10 years to 30 years,” he said, and in many cases “we’re going to own these companies for so long that we actually have a longer timeframe than their CEOs.” This perspective makes ESG considerations impossible for him to ignore.
“I believe in fiduciary duty,” Ailman declared. But managing ESG implementation in the context of fiduciary duty can get complicated. “It’s nice to try and do other things,” he said, “but the minute you have two goals, you’re serving two masters, and I don’t think you can achieve both as effectively.”
From Ailman’s perspective, focusing on fiduciary duty means that some issues must be set aside if they are not material to the investment decision. “Materiality is still going to be our big struggle when it comes to ESG,” he said, especially with factors that are important but not material to the investment decision. As an example, he shared his experience with a product under development for application on strawberry fields.
“Strawberry fields are actually a big deal in Central California, and particularly along the coast in California, and a lot of the strawberry fields are right up against schools,” he said. Plan participants had contacted Ailman’s office to discuss their concerns about the increased cancer risks associated with the product. But the chemical the new product was to replace burns a hole in the ozone layer.
Not only was CalSTRS being asked to weigh the local risk of chemical exposure against the global risk of ozone depletion, but the company developing the product was based in Japan and owned by a private equity firm headquartered in London. At that point, CalSTRS had to decide whether this single product, out of an entire line of about 100, was truly material to that company and whether that company was material to the private equity firm.
Later in the presentation, a member of the audience asked about palm oil, which has been a source of controversy in Malaysia. “This stuff is not black and white,” Ailman said, noting that decisions around palm oil need to consider possible trade-offs among concerns that include air pollution, water pollution, and increased unemployment. “This is not simple, it is all really hard,” he added. When trying to untangle which issues should affect investment decisions, “you’ve got to start at the level that’s material.”
Separating the important from the material is difficult, but Ailman praised the work of the Sustainability Accounting Standards Board (SASB) in this area. “They’ve identified by industry sector what’s actually material and what’s immaterial.” He noted that in addition to identifying obvious ESG considerations, for any given area, “they’ve already figured out: here are the extra risks you need to be paying attention to.”
When using ESG criteria to analyze investment decisions, Ailman has found that the order of execution does not matter. “We don’t care if a manager does fundamental analysis first, and then factors in ESG, or does ESG first, and then looks at fundamentals. To us, it’s got to be part of the process.”
He also cited the CFA Institute guide to “Environmental, Social, and Governance Issues in Investing,” which finds that “systematically considering ESG issues will likely lead to more complete investment analyses and better-informed investment decisions.” In Ailman’s opinion, a review of ESG issues provides a deeper, more penetrating risk analysis.
Ailman sees ESG analysis as a worthwhile undertaking. Although he has not yet seen attribution analysis that links positive investment returns with ESG screening — he cited Enron and the BP Deepwater Horizon disaster as negative returns that could have been avoided through screening — he said, “I firmly believe it adds to the bottom line.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.