The ABCs Of ESG Investing Part 1: What ESG Investing Means

A new generation of socially conscious investors is spreading its influence over the corporate world. Today’s investors are often millennials (typically those born between 1981 and 1996) who have grown up on a planet that is obviously getting warmer. They don’t want investment returns that come at the expense of the environment, nor results achieved without the guidance of people who have been historically underrepresented at senior management levels. Millennials won’t invest until they know a corporation’s environmental, social and corporate governance (ESG) practices are fair and reasonable.

Briefly, the E in ESG stands for environmental issues such as pollution, climate change, greenhouse gas emissions and the depletion or preservation of natural resources, while the S represents a company’s social attitudes—how it treats its employees, its customers, and its neighbours. Finally, the G for governance looks at issues such as boardroom diversity, executive compensation, conflicts of interest and shareholder rights. ESG is a broad umbrella term that includes an assortment of attitudes and policies that may help or harm a corporation’s financial performance. Within ESG is a subgroup called socially responsible investing (SRI), in which investors apply their own values to decide whether to invest. For example, a socially responsible investor may refuse to invest in companies that make guns, missiles, cigarettes and so on. Finally, a subset of SRI is impact investing, which involves directing money to businesses, non-profit organizations and charities that are visibly and actively working to improve the world.

Corporations perceived as having an indifferent attitude toward ESG risk alienating investors. Even if they don’t own any shares directly, investors who care about ESG may own units in mutual funds and exchange-traded funds or may be members of pension plans or own policies with insurance companies, all of which are major institutional investors. These funds have a huge influence over corporate decisions and may own so many shares of a corporation that they have seats on the company’s board.

As always, institutional investors must represent the interests of their unitholders and plan members, and today, that means the institutions must follow ESG. Many have clear policies that forbid them from owning shares in companies that have poor ESG records. A corporation seen as a major generator of greenhouse gas or one with a history of toxic spills, for example, would have no chance of appearing on these institutions’ lists of acceptable investments. Similarly, these funds may refuse to hold shares in businesses that turn out products such as tobacco, alcohol or weapons, or companies that have a dual-class share structure, where major decisions are restricted to an inner circle of voting shareholders.

A company that ignores ESG or pays it only lip service risks annoying an institutional investor who may turn activist, casting votes against current board members and nominating replacements. Alternatively, the institution may simply sell its shares and walk away, perhaps reinvesting its millions in a competitor. Either way, ignoring ESG is terrible for business.

With so much at stake, corporations that once focused exclusively on profits now split their time between finding new ways to enrich their shareholders and new ways to make the world a better place. Along with the traditional tables of revenue and earnings, most of today’s financial statements include details on a corporation’s ESG practices. Corporations can reap huge benefits if they can show—or even just convince—investors that they are devotees of ESG principles. Not every corporation is honest. The term “greenwashing” describes the fraudulent practice of trying to trick consumers and investors into believing that the products or services your company turns out are environmentally friendly. Corporations in the energy sector are frequently cited by environmentalists for greenwashing.

Just as corporations try to convince investors of their commitment to ESG, mutual funds, ETFs, pension funds and insurance companies generate mountains of material to reassure their unitholders and plan members that they will only invest in the good guys. As with most corporate ESG literature, the typical institutional investor’s ESG pages are full of vague statements and flowery language. Many say they will invest in concert with guidelines from ESG-focused groups at the United Nations. Among such groups are the UN’s Principles for Responsible Investment (unpri.org), the UN Environmental Programme Finance Initiative (unepfi.org) and the Global Compact (unglobalcompact.org). These UN groups are, not surprisingly, laden with similarly lofty-sounding vague terminology. When the jargon is removed, the simple message is that institutional investors say they will try to invest members’ money in corporations with good ESG policies, particularly “green” companies, and won’t invest in companies or countries that have poor records on ESG. Should a company or country turn out to be less ESG-conscious than originally believed, many institutional investors say their representatives will work with them to improve their ESG performance.

Investors’ new interest in ESG has spawned a wave of sites that collect data on corporations’ ESG performance, analyze the results and rank the corporations. This is expensive information to acquire and as a result most of these sites carry hefty subscription fees that only institutional investors and asset managers can afford. Many only accept inquiries from those with corporate email addresses—a clue they don’t want individual investors as clients.

One of the few exceptions is Morningstar’s Sustainalytics unit, which offers free access to its ESG risk ratings page (sustainalytics.com/esg-ratings) that ranks more than 9,000 companies. Sustainalytics’ ESG risk ratings range from negligible (a score of 0 to 10), through low, medium, high and severe (40+). The data can be filtered by industry and risk rating group. By providing Sustainalytics with their contact information, users can access more detailed reports, a company spokesperson said.

Another source of ESG ratings is Toronto based Corporate Knights, a Canadian quarterly magazine that sells for $22 a year and appears as an insert in The Globe & Mail. The publication features rankings such as the Best 50 Corporate Citizens in Canada and the Global 100 Most Sustainable Corporations.

In the United States, Berkeley, California based As You Sow (asyousow.org), has been advocating for ESG on behalf of shareholders since 1992. This year’s edition of its free Clean200 list of environmentally conscious companies, created in conjunction with Corporate Knights, is made up of 200 giant corporations culled from a pool of 8,480 global firms. The corporations on the list adhere to the goal of net zero carbon emissions, which means the same amount of global carbon is removed from the atmosphere as is added. The group excludes all oil and gas companies, utilities that generate less than 50% of their power from green sources and the top 100 coal companies measured by reserves. The list features companies from 35 countries, with 52 U.S. names and 18 Canadian ones. The 200 companies also meet As You Sow’s social and governance ratings.

Along with its list of 200 giant corporations that conform to ESG principles, As You Sow has a library of downloadable reports that feature pointed and sometimes embarrassing revelations about specific industries and corporations. For example, for the last eight years the group has published The 100 Most Overpaid CEOs, a sortable table likely to make chief executives squirm in their gilded seats. Other reports expose companies with poor records in areas such as plastic pollution, pesticides, tobacco and conflicts of interest.

Resource companies almost never appear on lists of environmentally conscious corporations working toward net zero emissions This is obviously a problem for Canada. One pro-resource group, Canada Action (canadaaction.ca), takes aim at what it feels are the shortcomings of the ESG process. Founded in 2010, Canada Action describes itself as a non-partisan, grassroots organization that advocates for the responsible development of Canadian resource industries, including oil and gas, mining, forestry and renewable resources.

The Canada Action site lists six areas where it feels ESG needs to improve, three of which deal with subjectivity in the ESG ranking process. Ratings agencies don’t yet have standardized rules for measuring environmental and social risks, nor do they have effective methods of verifying data that companies provide. The result is that one company may have a good ESG rating from one agency and a poor rating from another, the group says. Companies without a policy for given ESG criteria may receive a score of zero, the group says, citing the example of some Canadian energy companies operating solely in Alberta and Saskatchewan that were given scores of 0 for their “offshore” safety policies, among others, resulting in what it says was lower (and misleading) scores.

Canadian oil sands companies reduced their greenhouse gas (GHG) emission intensity per barrel by 28% between 2000 and 2017, with a further 16% to 23% reduction expected by 2030, Canada Action’s site says. Mining and forestry companies have also worked to reduce their greenhouse gas emissions by using renewable electricity dramatically, it adds.

Next issue: The second part of this two-part series on ESG investing will examine mutual funds and exchange-traded funds focused on ESG investing and provide a sampling of some publicly traded companies with high ESG ratings.

Richard Morrison, CIM, is a former editor and investment columnist at the Financial Post. richarddmorrison@yahoo.ca