Quality Companies Inherently Focus on ESG Factors

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Quality Companies Inherently Focus on ESG Factors

ESG investing is all the rage. And why wouldn't it be? Making money while doing good is the holy grail for many. But is ESG investing all hype and no action?

Published by Motley Fool Wealth ManagementWed, Dec 8, 2021

read time 5 min read

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Environmental, Social, and Governance (ESG) investing is all the rage. And why wouldn't it be? Making money while your money is also doing good is the holy grail for many investors. But is ESG investing all hype and no action?

ESG investing—The latest trend or a sustainable movement?

Before we delve into the debate on ESG investing, let's first discuss what it is. Funds that fall in the ESG category attempt to invest in companies that operate with an environmental, social, and governance lens.

  • The environmental component focuses on a company's impact on its surroundings and how climate change may affect its business and industry. An example is how much pollution it may generate.
  • The social component looks at a company’s relationship with people and society. Typical examples are the level of diversity and inclusion within a company, the health and safety of its employees and surrounding community, and paying an appropriate level of taxes.
  • The governance component assesses a company's operations. Examples include the strength and independence of the Board of Directors, protecting shareholder rights, and appropriately compensating management.

If asked, almost every investor probably would want to invest in companies that intend to be good corporate citizens. But the problem is not intent. Instead, it's how it's measured. Consider this example that highlights the complexity of assessing whether a business can be considered beneficial or harmful.

ESG investing is not straightforward

51 billion tons of CO₂ equivalent is pumped into the atmosphere each year, significantly more than what is absorbed. Even with the economic shutdown caused by the COVID-19 pandemic, emissions were only reduced by 6%. This highlights the truly challenging nature of reaching net-zero emissions by 2050.1 One proposed solution is to replace gas-powered or internal combustion engine (ICE) vehicles with electric vehicles(EV).

A typical ICE passenger vehicle emits about 4.6 metric tons of carbon dioxide per year2—far more than an electric car. So, where's the controversy?

email-chart-emissions

Source: U.S. Department of Energy

EVs also affect the environment, first by generating the electricity they need to charge the battery. Depending on how this electricity is produced (say by a coal-burning or gas-powered power plant), an EV may not reduce the amount of CO2 released as much as one might think.

Second is the battery itself.

EV cars run on lithium batteries. The process of mining lithium requires a lot of water—approximately 500,000 gallons per metric ton of lithium.3 It is similar to fracking, where it uses copious amounts of precious water and has the potential to leak toxic chemicals into the local drinking supply. And then there’s the issue of disposing of the old batteries.

So, on the one hand, reducing carbon emissions is a massive benefit of EVs over ICE cars. But on the other hand, it's not without deleterious environmental impacts. So the question remains: How do investors measure the trade-off? That question is the crux of the debate around ESG investing.

The holy grail?

ESG funds have grown by leaps and bounds recently, with global assets in ESG funds surpassing $35 trillion in 2020.4  And over the last decade, there’s been a nearly quadrupling of the number of sustainable funds.5 The reason for the upsurge?

email-chart-sustainable_funds

Source: Morningstar Direct. Data as of Dec. 31, 2020. Note: Includes funds that have been liquidated during this period.

Many people want to make the world better—by helping others or the environment.

But the debate around ESG investing is not questioning the desire to do good. Instead, it's gauging if it’s actually bettering the world.

Measuring impact is complex—it’s muddled and unclear because of a lack of industry standards. In other words, there often is not enough data to separate good from bad companies. So how do you know if your money is making a difference?

Is ESG little more than a marketing ploy?

Unfortunately, the answer is not straightforward. Because for some fund managers who jumped on the bandwagon and promoted their strategies as ESG, it can potentially appear to be more of a marketing ploy than an actual values alignment.

Even the former chief investment officer for sustainable investing at BlackRock, Tariq Fancy, agrees. “There’s this promise of doing well by doing good…Wall Street is growing this entire area because it's great for marketing and PR, and also, more importantly, because they can sell products at higher fees—on the promise that they're achieving some kind of green goals and doing good. There's no way to quantify that this does anything that would not have otherwise happened.”6

Luckily, the Securities and Exchange Commission (SEC) has recognized the need to help investors wade through the marketing malarkey! In February 2021, the acting Chair of the SEC, Allison Herren Lee, enhanced the agency’s focus on climate-related disclosures in public company filings. In addition, in June 2021,  the House of Representatives passed the ESG Disclosure Simplification Act of 2021. If passed by the Senate, the Act would require the SEC to define ESG metrics and obligate publicly traded companies to disclose how ESG affects their business strategy annually.

These actions should go a long way to clear out ESG "greenwashing"—the practice of making unsubstantiated, misleading, or exaggerated claims—when in reality, many firms have done little to integrate ESG into their decision-making.

ESG factors should be part of an investment process

But even as industry standards get worked out, we believe fund managers should still take into account ESG factors. The reason is simple: Sustainable businesses need to reduce their long-term operational risks through awareness of how they engage with the environment and society and whether they have strong governance.

These aren’t new risks. Nor should they be novel investment considerations. Think about it like this:

A recent study found that over half of Americans buy from companies that are conscious of protecting the environment.7 In other words, many consumers are using their wallets to back sustainably aware companies. So, in the long run, these companies' sales should grow faster than companies that fail to think sustainably—which means that investing in a company that is not weighing its environmental impact could present a long-term risk.

Integral to our investment decisions

Our Four Pillars investment framework has always incorporated these factors. For example, in our Management, Culture, and Incentives (MC&I) pillar, we rate a company's board for its relevant knowledge of the industry and whether we believe they have appropriate checks and balances and a stakeholder focus. We also look at the incentive structure of executives and accountability procedures. Translation? We put a heavy weighting on the strength of the governance structure of our companies.

email-chart-4_pillars

The “C” in our MC&I pillar focuses on company culture.

In a world of accelerating technological change, long-term winners will likely have to constantly upgrade their products and offerings if they want to remain relevant. For this reason, we often ask ourselves, “Does the company have innovation built into its DNA?”

Similarly, research shows that diverse teams tend to be more innovative, so one could reasonably make the argument that a company that places an emphasis on employee diversity and inclusion may have better odds of long-term success in today’s competitive environment than a company that does not.8

Another pillar is Trajectory. Here we break out our crystal balls and attempt to understand where the economy may be in 10 years. In that context, we try to assess how a company’s strategy and business model could impact it a decade down the road.

Could it run into anti-monopoly friction? Could its technology give it a leg up in a more environmentally focused world? Does its current competitive advantage come from a potentially temporary government policy?

Obviously, we cannot foretell the future. But this thought exercise helps us become more comfortable with our investment theses and intention of holding companies for the long term.

Importantly, these considerations are not new—they’ve been a foundational part of our process since day one. And while we use different terminology for our approach, our goals aren’t that different from the professed goals of the ESG framework; we strive to own high-quality companies that have the ability to sustain their competitive advantages for years, if not decades, to come. So, whether you frame it under ESG or our Four Pillars, for us, it’s not a ploy or a fade. It’s just what we do.

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Footnotes

1iea.org, Mar. 2, 2021

2EPA.gov, Mar. 2018

3instituteforenergyresearch.org, Nov. 12, 2020

4Bloomberg, L.P., Jul 21, 2021

5Morningstar, Feb. 25, 2021

6Financialpost.com, May 7, 2021

7PwC Global consumer insights pulse survey conducted in March 2021,  Jun. 2021.

8Kentscientific.com, Apr. 23, 2021; hbr.org, Feb. 11, 2019; Columbia.edu, Sept. 2012

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