News & Blog - Capital Markets

Rethinking ESG

By Jeff Tryka, CFA, Senior Director

I have to admit – like many others – my thinking on ESG (Environmental, Social and Governance) investing has evolved recently.  I have long been a vocal advocate for the “G”, as good corporate governance is essential to the functioning of companies and the capital markets.  The “E” has always been important, not only because we should be good stewards of the environment but also for the more pragmatic avoidance of cleanup and litigation cost associated with polluting the environment.  I had been more circumspect regarding the “S”, aligning with the perspective of Thor Industries, Inc. co-founder Wade Thompson that personal contributions are warranted but companies did not have the right to spend the shareholders’ funds on any charitable endeavor, whether a community group or little league team.

Having recently listened to a webinar on ESG investing, hosted by Robert W. Baird, there are a number of interesting insights that have pushed my thinking on ESG and its importance to investors more broadly.  For companies that are contemplating initial or enhanced ESG efforts, below are a few key points that might inform strategy and potential long-term benefits to stakeholders.

Companies with a greater focus on ESG initiatives are generally viewed by the market as having a lower risk profile, resulting in a lower cost of capital.  This seems rather obvious, since companies that place greater emphasis on good corporate governance and environmental concerns should naturally have lower risk profiles.  But what may be less obvious is the impact of social factors on risk.  Often, as companies place greater effort on social factors in their business, the corporate culture begins to evolve and staff begin shifting their focus toward becoming valued team members.  This may result in more loyalty, greater productivity and enhanced ethical behavior, which further lowers risk.  Many ESG investors are focused on company culture and they want to learn about it from front-line team members, rather than simply hearing the CEO’s view of culture.  They want to know what motivates people to jump out of bed and get to work each day, from team members across the organization.

ESG-focused investors tend to be truly long-term shareholders.  It may be somewhat cliché, but most management teams would define long-term shareholders as those willing to invest for five years or more; but, ask a portfolio manager, and long-term could mean anything from six months for an aggressive hedge fund to 2-3 years for a typical mutual fund.  ESG investors tend to align more closely with management’s five-year horizon, as many take a much longer-term view that understands the ESG efforts companies pursue could take that long, or longer, to accomplish.  This results in very different conversations, as these investors are much more concerned with the sustainability and long-term impact of a company’s business model.  So rather than focusing on earnings a quarter out, these investors will ask about the resiliency of the business model in the face of a shift toward renewable power or constrained resources, such as water use.  These types of concerns are ideally addressed by long-term strategic imperatives, outlined by the senior management team.

Finally, the Baird investor panel was asked to offer advice for corporate issuers, which provided some interesting and actionable insights.  The first piece of advice was to take ESG seriously.  There are a number of ways to show that a company takes ESG seriously, but the best is to ensure that responsibility for ESG initiatives lies with the CEO and CFO.  Having a dedicated sustainability officer may be a reasonable approach, but when the CEO and CFO take ownership, it becomes obvious that the company takes ESG seriously.  In that same vein, companies should integrate ESG criteria into their executive compensation programs, highlighting the importance of these issues as well as aligning management with long-term ESG goals.  The panel also suggested companies think about ESG more broadly, as stakeholders will become more important than shareholders over time.  Managers should also consider the impact of their strategy on more than just shareholder value, critically dissecting how it impacts employees, customers, suppliers and the communities where the company operates.

Although the origins of ESG investing can be traced back decades, as the global economy and society evolve, implementation of a solid ESG strategy will become increasingly important.  Many investors view such a strategy as an eventual basic investment threshold for consideration – the basics that every company will be expected to pursue.  Others view ESG as something that will evolve into a standard part of the investor evaluation process, similar to the way investors view earnings, cash flow or EBITDA in their screening of potential investments.  Regardless of how it evolves, ESG investing is here to stay, and management teams need to be prepared to address it proactively.