Doing well by doing good

Doing well by doing good

Environmental, social and governance (ESG) factors are increasingly important benchmarks used by investors in their decision-making. The idea is simple: companies which account for environment factors are in tune with the society in which they operate and promote models of good governance most likely to ensure their survival and consequently deliver the best long-term returns. Although there is a presumption that investing in companies adhering to such principles means accepting lower short-term returns, the empirical evidence suggests this is not necessarily the case. Unlike SRI strategies, ESG does not apply negative filters and can be thought of as a way to maximise returns subject to certain constraints rather than imposing outright limits on investment choices.

What is ESG?

Back in 2004, former United Nations Secretary-General Kofi Annan wrote to the CEOs of 20 leading financial institutions inviting them to participate in the ‘Who Cares Wins’ initiative. The report which stemmed from their participation, together with the support of the International Financial Corporation and the Swiss government, sought to integrate environmental, social and governance (ESG) factors into mainstream investing decisions.

Although ESG is sometimes used interchangeably with socially responsible investment (SRI), which has a long-established track record, the two concepts differ in some key respects. SRI is based on ethical and moral considerations and primarily applies negative filters, such as not investing in areas connected with armaments or carbon fuels. ESG investment operates on the principle that the factors underpinning it guide investors towards companies with higher growth potential. In other words, SRI investors take a moral stance on particular forms of investment and are prepared to accept lower returns as a consequence, whereas ESG investors focus on maximising returns subject to certain constraints on investment activity.

As implied by the name, there are three main components of ESG investment (Chart 1):

Chart 1: Key areas involved in ESG investing
  • The environmental element focuses on a company’s influence on the environment and its ability/willingness to reduce risks that threaten harm. Companies that score well in this category account for environmental factors in their decision-making process and focus on factors such as energy use and its impact on the climate, waste generation and sustainability. In addition to any ethical issues reflecting investors’ desire to reduce their environmental impact, the financial rationale is that increasingly onerous regulations impose a significant cost on businesses for those that are unprepared, and companies that adhere to them can be expected to generate higher earnings.
  • Social factors assess a company’s relationships with the wider community and look at progress in areas such as diversity, human rights, consumer protection and animal welfare. Not only are the legal requirements with regard to these areas significantly tougher than was the case a few years ago, but they are also deemed to be important in attracting and retaining high-quality employees and customers, which again can be expected to impact on the bottom line.
  • Governance is primarily concerned with internal company affairs and the nature of relationships between the various stakeholders, including employees and shareholders. Getting corporate governance right is increasingly important to avoid conflicts of interest which is important in avoiding major litigation costs and has a secondary benefit in attracting and retaining high-quality employees.

It is estimated that 93% of the world’s 250 largest corporations apply the standards set by the Global Reporting Initiative (GRI) which is an independent body that helps companies to understand and communicate their impact on issues such as climate change, human rights, governance and social well-being. Getting a precise handle on how much is invested in ESG funds is difficult, partly because many of the estimates also include SRI activities, but according to a report published by Morningstar last year, ESG funds now account for over USD 1 trillion of assets under management (AuM), up from USD 655 billion in 2012. According to Morningstar’s estimates, the sector has expanded most rapidly in Europe with around USD 630 billion in assets versus USD 300 billion in the US. But these numbers are based on a relatively narrow definition of the sector. According to the Forum for Sustainable and Responsible Investment in the US, around USD 5.6 trillion of AUM were in some way related to ESG investing in 2018 (Chart 2).

Chart 2: Total ESG incorporated assets in the US
Chart 2: Total ESG incorporated assets in the US
Source: US SUF
Explaining 'E'

ESG funds are increasingly popular with female and millennial investors, and interest can probably be most easily explained by the fact that climate-related issues have risen up the corporate agenda. The evidence clearly suggests that millennial investors have a different attitude towards sustainability compared to their parents’ generation, taking more account of such factors in their general decision-making and particularly with regard to investment decisions. Whilst such demographic changes are a driving force behind the switch to more environmentally aware investing, they are being reinforced by regulatory changes which raise the cost of failing to comply with environmental legislation. Innovation is acting as a further disruptor driving investors to look at environmental investments, particularly since new technology which meets society’s demands for improved sustainability is increasingly an area of investor focus.

All these areas combine together in the auto industry where regulation has favoured vehicles with lower emissions which in turn results from changes in social attitudes towards the impact of carbon emissions on the environment. This is being facilitated by developments in battery technology, which offer interesting investment opportunities in themselves but also enhance investment opportunities in other areas – after all, it would be impossible to advance the agenda of electric vehicles without them. Increased interest in autonomous vehicles in response to technical advances could take the auto industry in yet another direction, particularly if they match up to their hype by producing improvements in road safety – an obvious social good. Whilst autos would not appear to be an obvious choice for a sector which might benefit from increased interest in ESG, it is evident that many of the forces for change in this area are being driven by environmental factors.

The 'S' and 'G' of ESG

At the heart of the debate on ESG factors is whether companies have a wider duty beyond their shareholders. The neoclassical view, best expressed by Milton Friedman in 1970, is that a business executive who exercises social responsibility in the course of their work ‘must mean that he is to act in some way that is not in the interest of his employers’. Businesses which do anything other than maximise profits were ‘unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades’ and were guilty of ‘analytical looseness and lack of rigor’.

The Friedman view was influential in stimulating the shareholder value revolution by arguing that managers should ‘conduct the business in accordance with [shareholders’] desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom’. In order to motivate managers to maximise profits, this model supports the idea they should be paid in proportion to the profit they generate, usually in the form of stock options on the basis that the share price reflects the company’s profit performance.

We have pointed out previously1 that this model is flawed because it fails to differentiate between short-term and long-term profit maximisation. Companies that ruthlessly pursue short-term profits are likely to lose sight of longer-term goals, perhaps because this makes them reluctant to invest in technology whose pay-off only becomes evident in the longer-term. As a consequence, the business model may become obsolete over time, and the company may eventually fail or be absorbed by rivals.

Moreover, the practice of outsourcing management to professionals concerned only to maximise profits is a good illustration of the principal-agent dilemma (a situation where the interests of those running the business differ from those who own it). There are three different aspects to the problem. On the one hand, it gives managers an incentive to pursue short-term gains to maximise their own pay packets but, as noted above, this may not be in the company’s long-term interests.

A second factor is that the owners of the company, i.e. the shareholders, may not simply want to maximise their monetary returns. To the extent that shareholders are ordinary citizens they may well be concerned with a range of other issues such as the environment or the way in which companies treat their employees. Friedman argues that individuals can best express their individual preferences by donating the returns from equity investment to the cause of their choice. But in a paper entitled ‘Companies should maximize shareholder welfare not market value’ the economists Oliver Hart and Luigi Zingales argue ‘if consumers and owners of private companies take social factors into account and internalize externalities in their own behavior, why would they not want the public companies they invest in to do the same?’ In other words, Friedman’s view holds in a world where social activity is independent of profit-making activity but precisely because they are not independent, the Friedmanite view no longer holds (thus putting the ‘S’ into ESG).

A third issue is that in the pursuit of short-term goals, companies might overstep the boundaries of what is morally or legally permissible. Banks were placed in the line of fire in the wake of the 2008 financial crisis when it became clear they were guilty of sanctioning activities that breached both the letter and spirit of the law. In a different vein, Volkswagen was found guilty in 2015 of cheating on emissions tests to sell more diesel-powered vehicles in the US. What these cases have in common is that they attracted the attention of regulators, which imposed significant fines, and prompted the companies concerned to rethink their internal cultures (the ‘G’ element of ESG).

The investment case for ESG

There has traditionally been a presumption in finance that money is morally neutral and that investors should not always poke too closely into how their returns are generated. Today that is increasingly less true. But there remains a lingering perception that applying moral and ethical considerations to investment decisions leads to suboptimal returns. The evidence suggests otherwise. A major study conducted by academics at the University of Hamburg2 in 2015 looked at more than 2,000 empirical studies and concluded that ‘the business case for ESG investing is empirically very well-founded’. Indeed, trends in the MSCI World ESG Index almost perfectly match the MSCI Global Index (Chart 3), although since the MSCI Global Index is dominated by large cap firms which tend to be the most passionate advocates of ESG principles this is hardly a surprise.

Chart 3: MSCI ESG Index perfectly matches global stock trends

Indices, 1/1/2015 = 100

Source: Bloomberg

Perhaps a more interesting question is which of E, S or G contributes most to the performance of overall corporate performance. According to the analysis of Friede et al., which assesses those studies with identifiable ESG categories, the correlation between each of the individual categories and overall corporate performance is broadly similar although there is a slightly higher correlation from those studies focusing on G (Chart 4). This makes intuitive sense: well-run companies which focus on governance aspects tend to perform well (and similarly, bad governance results in poor performance). There again, the highest degree of negative correlation can also be attributed to G (governance issues have no impact on performance). Netting out the positive and negatives, the best net performance derives from environmental factors (E). It is also notable that studies which look at ESG factors together tend to have a low degree of correlation with overall corporate performance. This may be due to sampling problems – studies that identify each of the factors separately may be more focused and thus more relevant.

Chart 4: ESG categories and their relationship to corporate financial performance
Chart 4: ESG categories and their relationship to corporate financial performance
Source: Friede et al. (2015)

On a regional basis, Friede et al. find that the degree of correlation between corporate financial performance and ESG criteria is fairly low in Europe (26%) versus North America (43%). But in emerging markets the degree of correlation is much higher (65%). It is difficult to draw any strong conclusions from this. But one possibility might be that the institutional framework in the developed world is already sufficiently strong that the gains from applying ESG criteria are relatively low, whereas in many emerging markets the framework is somewhat less developed and firms benefit from setting their own benchmarks (e.g. better corporate governance structures).

It is also worth noting that the results for Europe are significantly improved if we strip out portfolios (those focused on mutual funds, indices and long-short portfolios). This underperformance of portfolio studies can be attributed to various idiosyncratic factors. For example, many ESG funds are based on a mixture of positive and negative screening factors which could cancel each other out. Moreover, portfolio performance is generally calculated net of management fees and transaction costs which distort the underlying performance. This does not mean that investors should steer clear of ESG portfolios – it simply suggests that the results are less unambiguous than for the single name or single asset case. As Friede et al. suggest, ‘portfolio-study findings have to be treated as a specific outcome of a subgroup within the entire ESG–CFP discussion’


There are still many who dismiss ESG as just another in the long line of investment fads. Like the more widespread SRI approach it can be seen to some extent as a strategy of enlightened self-interest. Arguably it goes further. Companies which adhere to many of these precepts are the ones most likely to be best prepared for future challenges posed by environmental issues, regulatory changes and new technology. In that sense, they act as a yardstick as to which companies to overweight in investment portfolios and which to avoid. It also gives more scope to investors to act in accordance with their individual preferences. Like it or not, ESG is here to stay.

1 Thinking Ahead, February 2015.

2 G. Friede, T. Busch and A. Bassen (2015), ‘ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies’, Journal of Sustainable Finance & Investment, 5:4, 210–233.