The market is good at evaluating and pricing systemic risks that are regular and easy to quantify - "known unknowns”, if you will, things like changes in the business cycle or interest rates.
But as the coronavirus pandemic has shown, the market doesn't do as well with risks that are difficult to predict or quantify - the "unknown unknowns”. The environmental, social, and governance risks most firms face fall somewhere in the middle of this spectrum.
There are clear examples in which firms' failure to manage ESG risks has hurt the value of their stocks. Most of these issues have been firm-specific and so tended to have little impact on a well-diversified investment portfolio. But there's a good chance this may change over the long term, as companies face greater scrutiny from consumers, investors, and governments alike over their ESG practices.
Historically, there hasn't been a clear link between firms' ESG characteristics and performance so, enhancing returns shouldn't be the primary motivator for ESG investing.
However, that also means that an ESG mandate doesn't necessarily hurt returns. ESG investing can be an effective way for investors to align their portfolio with their values. But ESG isn't just about values, it's about long-term risk management that affects all investors.
Examining ESG Risks
It may seem odd to group environmental, social, and governance risks together. While they appear to have little in common, they are all issues that affect a firm’s long-term value and are hard to quantify.
There is little dispute that strong corporate governance is in the best interest of long-term shareholders. It promotes accountability and long-term focus by providing transparency and a clear link between long-term value creation and compensation.
Corporate governance failures often arise when firms prioritise quarterly results over the interests of long-term investors and lack appropriate risk oversight. For example, Wells Fargo WFC pressured bank employees to meet aggressive sales quotas, tying compensation to those targets, which led to the creation of millions of fraudulent accounts. When the scandal came to light, it ended up costing the company more than $2 billion in settlements and fines, as well as the trust of many clients.
Environmental and social risks may seem more remote than governance risks, but they are growing for many firms. For example, climate change could directly increase costs for insurers. Warmer oceans increase the risk of more frequent and intense hurricanes, increasing potential property damage. Litigation arising from environmental damage, like the BP oil spill, and damage to brand equity are also direct costs that environmental issues can create.
However, the indirect impact that environmental issues have on business will likely be much greater, as consumer preferences shift toward more environmentally-friendly products (like electric vehicles) and firms. Less environmentally friendly companies may also be subject to greater regulatory risk, including higher taxes and fees imposed on emissions.
Social risks cover a broader range of issues, including data security, product safety, workplace safety, diversity, compensation, and benefits. The opportunity cost of failing to take care of employees is one of the biggest risks here. Companies that offer safer workplaces and better compensation can better attract and retain talent and often get better productivity from their workers.
However, not all firms give these issues the attention they deserve, likely because doing so may conflict with short-term profit maximisation and the long-term benefits are hard to quantify.
Is There a Link Between ESG and Returns?
Historically, there hasn't been a clear link between firms' ESG attributes and performance. That's likely because portfolio-level ESG risks have been low in the past, as many ESG issues that companies have faced have been firm-specific.
Morningstar recently published a study showing firms across the globe with higher ESG Risk Ratings from Sustainalytics did not post significantly better or worse returns than their lower-scoring counterparts over the trailing 10 years through September 2019. In the US and Canada, the study found top-scoring firms slightly underperformed the laggards, though the difference wasn't significant.
Firms' ESG risks are likely growing and could become more correlated over time, if for no other reason than these issues are receiving more attention from consumers, regulators and investors. That shift may have important consequences for performance and create some attractive opportunities over the next several years.
If stocks share common ESG risks and the market does not fully appreciate them yet, firms with lower ESG risks could be undervalued and priced to offer market-beating returns. That mispricing would allow investors to lower their risk and increase expected returns, so it probably wouldn't last. If the market increasingly recognises ESG risks as systemic, it should assign higher prices and lower expected returns to companies with lower ESG risk. The transition to that new equilibrium could push the price of ESG leaders up, helping their short-term performance at the expense of future expected returns.
As more money shifts into funds that incorporate ESG, they will likely have a greater impact on stock prices, voting, and corporate behaviour. That said, the influence ESG index portfolios have is often indirect. As they're already screening for firms with strong ESG practices, they don't do much engagement with the ESG laggards. Those laggards likely care about ESG issues only if they hurt their stock price or business, or cause investors to vote against management.
How Tracker Funds Assess ESG
There is no standard definition of ESG, so it's important to look under the hood of ESG-branded exchange-traded funds (ETFs) to know what you're getting.
For example, Vanguard ESG US Stock ETF (ESGV), which has a Morningstar Analyst Rating of Silver, offers broad exposure to the US stock market and excludes only firms involved in certain lines of business, including fossil fuels, firearms, and vice industries. It doesn't directly consider governance issues or the environmental impact of its holdings.
In contrast, Silver-rated iShares ESG MSCI USA Leaders ETF (SUSL) considers financially relevant ESG risks in each industry and targets firms representing the half of the market with the strongest ESG characteristics relative to sector peers. So, its sector weightings are very similar to those of the market, and it owns some fossil-fuel-related stocks. Even funds that appear to use similar approaches can end up with very different portfolios.
The best approach to ESG for one investor may not be right for another. However, investors concerned about the financial impact of ESG risks should consider funds that use that perspective, like those that track the MSCI Leaders indexes.
