by David Robertson, CFA
October 2019
Almost anywhere you look there is commentary on sustainability. What used to be known fairly narrowly as "socially responsible investing" has now grown into a broad effort captured by the acronym "ESG" (environmental, social, governance). These issues range from climate change to sustainable food production to better versions of capitalism.
It is easy to infer from all this coverage that sustainability is something we should be talking about. It is far less clear, however, what we should actually be doing about it. The bad news is that some sustainable efforts are ineffective and even harmful. The good news is that the dialogue on sustainability is maturing in meaningful ways.
In August the Business Roundtable made waves when it released a statement indicating that the purpose of a corporation is to benefit all stakeholders, including customers, employees, suppliers, communities and shareholders. Signed by 181 CEOs, this statement marked a break from the past and made a lot of headlines.
Interestingly, several other organizations have also recently upped the ante on highlighting various sustainability issues. The Economist recently published its "Climate" issue under the pretense that "Climate change touches everything this newspaper reports on." The Financial Times recently heralded a "New Agenda" which explicitly responds to the fact that the "liberal capitalist model" has "come under strain." Advisor Perspectives recently sent out its "most read commentaries on ESG, SRI and impact investing."
As if there weren't already enough dots to connect, Ben Hunt and Rusty Guinn from Epsilon Theory recently identified the top six articles from the past 24 hours [as of September 23, 2019] that were the "most on-narrative (i.e. interconnected and central) stories in financial media. Those articles were:
October 2019
Almost anywhere you look there is commentary on sustainability. What used to be known fairly narrowly as "socially responsible investing" has now grown into a broad effort captured by the acronym "ESG" (environmental, social, governance). These issues range from climate change to sustainable food production to better versions of capitalism.
It is easy to infer from all this coverage that sustainability is something we should be talking about. It is far less clear, however, what we should actually be doing about it. The bad news is that some sustainable efforts are ineffective and even harmful. The good news is that the dialogue on sustainability is maturing in meaningful ways.
In August the Business Roundtable made waves when it released a statement indicating that the purpose of a corporation is to benefit all stakeholders, including customers, employees, suppliers, communities and shareholders. Signed by 181 CEOs, this statement marked a break from the past and made a lot of headlines.
Interestingly, several other organizations have also recently upped the ante on highlighting various sustainability issues. The Economist recently published its "Climate" issue under the pretense that "Climate change touches everything this newspaper reports on." The Financial Times recently heralded a "New Agenda" which explicitly responds to the fact that the "liberal capitalist model" has "come under strain." Advisor Perspectives recently sent out its "most read commentaries on ESG, SRI and impact investing."
As if there weren't already enough dots to connect, Ben Hunt and Rusty Guinn from Epsilon Theory recently identified the top six articles from the past 24 hours [as of September 23, 2019] that were the "most on-narrative (i.e. interconnected and central) stories in financial media. Those articles were:
"Danish pensions to put $50 billion into green investments" [Reuters]
"Gender diversity pays off: A new Stanford study finds equitable hiring boosts companies’ stock prices" [Business Insider]
"Aluminium industry must commit to carbon reductions" [Business Insider]
"Daughter of Ebony founder resigns from spot on magazine’s board" [Chicago Tribune]
"At Amazon, workers push climate policy; Bezos sets net-zero carbon emission goals, but employees want more urgent action." [Vox]
"General Motors Shares Extend Declines As Nationwide UAW Strike Hits Day Five" [The Street]
The narrative is clear: Sustainability issues are front-and-center. Guinn offers a couple of hypotheses as to why this is happening now:
"We have commented before that ESG specifically tends to follow the fortunes of the market. It usually becomes a cohesive, high attention narrative when times are good and investors feel confident. When markets decline and perceived risk rises, ESG issues tend to fade from investors’ attention. Independent of ESG investing as a topic in itself, however, the politics of climate, inequality and identity that we have shown to be dominant in electoral coverage are becoming similarly prominent in financial markets coverage."
Another hypothesis seems to suggest, shall we say, a more sustainable explanation. An FT report on "The limits of the pursuit of profit" notes:
"Prof Ioannou’s latest research, with George Serafeim of Harvard Business School, shows the adoption of common sustainability practices is increasingly a survival issue. 'The ones that fall behind in adopting best practices are the ones whose performance gets hit in the long run,' he says." The article continues, "Chief executives face the threat that if they fail — or if they only apply a veneer of stakeholder concern — they will be accused of 'purpose-washing', leading to further cynicism about their motives."
While this research is encouraging, the reality on the ground is often less straightforward. The very same FT article, which highlighted Danone as a positive example of sustainable approaches, admitted, "It is shareholders, not other stakeholders, who are most in need of convincing with regard to Danone’s good intentions." The FT also noted the challenge of "persuading asset owners to approach investment differently" when it reported, "What is blindingly obvious is that it is very hard for company bosses to take such steps if investors are pulling very strongly in the opposite direction."
What is also blindingly obvious is that many efforts to address sustainability simply do not work. The FT identified Vanguard funds that were designed to "invest in companies with strong environmental, social and governance records" but which also happened to own "A private prison operator, a gun manufacturer and Rupert Murdoch’s media groups." Vanguard claimed, "the companies were included 'erroneously' in an ESG index designed by FTSE Russell", but regardless of the cause, the funds failed to do the one thing they were designed to do.
Nor have quantitative efforts produced much headway. The FT reports on efforts to "find a so-called ESG 'factor' — a systematic, repeatable way of identifying such stocks which rivals would find hard to copy." Despite the potential that "The rewards for the fund managers could be huge", the truth is that "It’s extremely hard to find that factor”.
The silver lining in such failures is that they are leading to more robust and constructive discussions around the relevant issues. "The limits of the pursuit of profit" story in the FT, for example, highlights the fundamental definitional issues of sustainable investing. While a wealthy individual may care relatively more about the "impact" of an investment than the ultimate financial returns, a pension fund has an obligation to produce adequate returns for their beneficiaries. Paul Singer, founder of activist hedge fund Elliott Management, said that earning a rate of return for pension funds and charities “is itself a social good — a very high one”. He's right.
Not only can the "investment" aspect be understated in ESG efforts, but the "sustainable" element can be overstated. The story also reveals the potentially negative consequences of simple ESG ratings which can be "based on incomplete information, public shaming and shunning wrapped in moral rhetoric preached with cold-hearted, self-righteous oblivion". The worst part is that the consequences of such misguided efforts "ultimately fall on real people".
Bill Gates also recently chimed in on the debate by challenging a common practice among sustainability practitioners. He criticized efforts at divestment saying they "won't change anything". Gates explained, “Divestment, to date, probably has reduced about zero tonnes of emissions. It’s not like you’ve capital-starved [the] people making steel and gasoline." As a result, Gates concluded, "Climate activists are wasting their time lobbying investors to ditch fossil fuel stocks."
Helpfully, he offers an alternative approach that he thinks has greater potential to make a difference:
What is also blindingly obvious is that many efforts to address sustainability simply do not work. The FT identified Vanguard funds that were designed to "invest in companies with strong environmental, social and governance records" but which also happened to own "A private prison operator, a gun manufacturer and Rupert Murdoch’s media groups." Vanguard claimed, "the companies were included 'erroneously' in an ESG index designed by FTSE Russell", but regardless of the cause, the funds failed to do the one thing they were designed to do.
Nor have quantitative efforts produced much headway. The FT reports on efforts to "find a so-called ESG 'factor' — a systematic, repeatable way of identifying such stocks which rivals would find hard to copy." Despite the potential that "The rewards for the fund managers could be huge", the truth is that "It’s extremely hard to find that factor”.
The silver lining in such failures is that they are leading to more robust and constructive discussions around the relevant issues. "The limits of the pursuit of profit" story in the FT, for example, highlights the fundamental definitional issues of sustainable investing. While a wealthy individual may care relatively more about the "impact" of an investment than the ultimate financial returns, a pension fund has an obligation to produce adequate returns for their beneficiaries. Paul Singer, founder of activist hedge fund Elliott Management, said that earning a rate of return for pension funds and charities “is itself a social good — a very high one”. He's right.
Not only can the "investment" aspect be understated in ESG efforts, but the "sustainable" element can be overstated. The story also reveals the potentially negative consequences of simple ESG ratings which can be "based on incomplete information, public shaming and shunning wrapped in moral rhetoric preached with cold-hearted, self-righteous oblivion". The worst part is that the consequences of such misguided efforts "ultimately fall on real people".
Bill Gates also recently chimed in on the debate by challenging a common practice among sustainability practitioners. He criticized efforts at divestment saying they "won't change anything". Gates explained, “Divestment, to date, probably has reduced about zero tonnes of emissions. It’s not like you’ve capital-starved [the] people making steel and gasoline." As a result, Gates concluded, "Climate activists are wasting their time lobbying investors to ditch fossil fuel stocks."
Helpfully, he offers an alternative approach that he thinks has greater potential to make a difference:
"Those who want to change the world would do better to put their money and energy behind the disruptive technologies that slow carbon emissions and help people adapt to a warming world".
Indeed, Gates is among a cadre of wealthy businesspeople who are thoughtfully considering what types of actions can really promote sustainability and really make money. The Economist's "Climate" issue describes them as people who are "putting serious money into climate-friendly investments - and expect serious returns". According to the piece, "All want to do good by the planet. Most expect to do well for themselves."
In addition, Sarah Kaplan of Toronto’s Rotman School of Management describes a model by which business leaders can succeed with sustainable investment. "One way to survive," she says, "is for companies that have already pursued the business case for responsible action, to 'innovate around trade-offs'."
In addition, Sarah Kaplan of Toronto’s Rotman School of Management describes a model by which business leaders can succeed with sustainable investment. "One way to survive," she says, "is for companies that have already pursued the business case for responsible action, to 'innovate around trade-offs'."
"One example is how Nike, attacked over its suppliers’ working conditions in the 1990s, not only improved standards but developed an entirely new manufacturing process to take pressure off the old supply chain. The US sportswear company’s Flyknit 'woven' shoe was one result."
This course is a noticeable break from the modus operandi of many global companies. When confronted with such challenges it is frequently the case that the problem is solved by some combination of moving to a jurisdiction with less scrutiny, leveraging the company’s power and authority, and simply paying penalties if they are not excessive. In other words, a lot of people get paid good money to dodge the spirit, if not the letter, of the law.
Looking across the realm of sustainable investing today reveals some striking features. One is that a lot of shortcomings regarding sustainability are related to deficiencies in enforcement. Why would a company spend a lot of money upfront to avoid penalties if the penalties are so small as to be trivial and the chances of being penalized are slim? It is a real business tradeoff.
Further, it is often the case that rules don't even need to be broken if regulations can be cleverly arbitraged. Too often, regulators and enforcement authorities are no match for their corporate counterparts. Sustainability could be greatly improved simply by leveling this playing field. Penalties and enforcement reflect society’s values. If they are substantive enough, they will incentivize compliance.
Another striking aspect of the sustainability movement is just how noncommittal many consumers are. Many people express opinions, and many people take some action, but actual consumer behavior is not matching the sustainability preferences being expressed.
A recent article in The Economist provides a possible explanation, “Many consumers neither read nor understand the contracts they sign", even when it is clearly in their interest to do so. While the research was conducted primarily in regard to the "terms and conditions" of apps and online services, the behavioral phenomenon is broadly applicable. Many consumers simply don't want to exert the effort to ensure better outcomes.
Researchers "concluded that savers doubted the benefits of shopping around and were put off by the perceived inconvenience." The Economist suggested, "'Caveat emptor', it seems, may apply in principle but not in practice."
This results in any number of interesting paradoxes. For example, if a big beverage company packages soda in a can with a liner containing BPA, that company is often targeted for its unfriendly business practices. If, however, a local craft brewer packages its products in the same can, is lauded for its “sustainable” practices and the BPA is conveniently overlooked. Nobody even asks the question even though it is exactly the same practice.
In addition to paradoxes, the incomplete engagement by consumers creates a real hurdle for well-intentioned sustainability efforts to overcome. You may have great ideas and you may be right it the long run, but if consumers don't vote for you by way of their purchase decisions, none of it really matters.
This is a shame because the threats of unsustainable practices are becoming very real. Gillian Tett reports in the FT that an information asymmetry regarding climate change appears to be widening.
Jupiter, a climate advisory group that provides modelling for banks and insurance companies, "forecasts a tripling of losses from flood damage in the next couple of decades." The company arrives at its conclusion by evaluating the type of residential mortgage exposure of a real bank. This is consistent with work done by McKinsey:
Looking across the realm of sustainable investing today reveals some striking features. One is that a lot of shortcomings regarding sustainability are related to deficiencies in enforcement. Why would a company spend a lot of money upfront to avoid penalties if the penalties are so small as to be trivial and the chances of being penalized are slim? It is a real business tradeoff.
Further, it is often the case that rules don't even need to be broken if regulations can be cleverly arbitraged. Too often, regulators and enforcement authorities are no match for their corporate counterparts. Sustainability could be greatly improved simply by leveling this playing field. Penalties and enforcement reflect society’s values. If they are substantive enough, they will incentivize compliance.
Another striking aspect of the sustainability movement is just how noncommittal many consumers are. Many people express opinions, and many people take some action, but actual consumer behavior is not matching the sustainability preferences being expressed.
A recent article in The Economist provides a possible explanation, “Many consumers neither read nor understand the contracts they sign", even when it is clearly in their interest to do so. While the research was conducted primarily in regard to the "terms and conditions" of apps and online services, the behavioral phenomenon is broadly applicable. Many consumers simply don't want to exert the effort to ensure better outcomes.
Researchers "concluded that savers doubted the benefits of shopping around and were put off by the perceived inconvenience." The Economist suggested, "'Caveat emptor', it seems, may apply in principle but not in practice."
This results in any number of interesting paradoxes. For example, if a big beverage company packages soda in a can with a liner containing BPA, that company is often targeted for its unfriendly business practices. If, however, a local craft brewer packages its products in the same can, is lauded for its “sustainable” practices and the BPA is conveniently overlooked. Nobody even asks the question even though it is exactly the same practice.
In addition to paradoxes, the incomplete engagement by consumers creates a real hurdle for well-intentioned sustainability efforts to overcome. You may have great ideas and you may be right it the long run, but if consumers don't vote for you by way of their purchase decisions, none of it really matters.
This is a shame because the threats of unsustainable practices are becoming very real. Gillian Tett reports in the FT that an information asymmetry regarding climate change appears to be widening.
Jupiter, a climate advisory group that provides modelling for banks and insurance companies, "forecasts a tripling of losses from flood damage in the next couple of decades." The company arrives at its conclusion by evaluating the type of residential mortgage exposure of a real bank. This is consistent with work done by McKinsey:
"Coastal regions such as Florida ... could deliver asset price shocks for lenders, insurers and homeowners. So, too, in places such as Spain, southern France, Greece and Italy which are projected to see eye-popping increases in drought."
Further, when the information asymmetry narrows, it could be punishing for many homeowners: "while American households typically use 30-year mortgages to buy properties, the price of insurance is reset annually."
The same information asymmetries exist in the markets for financial assets as well. According to the entity Principles for Responsible Investment (which is supported by the UN), “financial markets today have not adequately priced-in the likely near-term policy response to climate change”. Tett voices her concern about the likely consequences:
The same information asymmetries exist in the markets for financial assets as well. According to the entity Principles for Responsible Investment (which is supported by the UN), “financial markets today have not adequately priced-in the likely near-term policy response to climate change”. Tett voices her concern about the likely consequences:
"History shows that extreme information asymmetries produce market shocks. That’s what happened in the subprime mortgage saga. It is hard to believe it will be any different with climate change."
Given such risks, what can investors, leaders, and consumers do to overcome inertia and narrow the information asymmetries? Dave Stangis, ESG expert and former CSO of Campbell Soup, provides a useful perspective:
“I always sense the macro challenge is trying to find the right language to describe what so many people are talking/writing about. I do believe the expectations of good business have shifted and we see many examples of business done right (not just activities or initiatives) can deliver measurable benefit to shareowners, execs, other employees and customers/consumers. The debate seems centered around what is that called when it works and how do we describe when it misses the mark – or when it is something else (negative screening).”
In other words, don’t get hung up on the language and miss the forest for the trees. Sure, there are frivolous and virtue signaling sustainability efforts, and sure, there are business practices that extract disproportionate benefits from society. But those can all be identified as such and avoided.
On the other hand, there are real efforts to innovate around tradeoffs. Properly considered, these can be characterized as something like continuous improvement in capitalism. It takes ongoing effort, thought, and research to differentiate between “business done right” and business "missing the mark", but expectations are shifting and the benefits can be substantial. Conversely, the costs of failing to do so are rising every day.
On the other hand, there are real efforts to innovate around tradeoffs. Properly considered, these can be characterized as something like continuous improvement in capitalism. It takes ongoing effort, thought, and research to differentiate between “business done right” and business "missing the mark", but expectations are shifting and the benefits can be substantial. Conversely, the costs of failing to do so are rising every day.
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