Editor’s note: This is the third and final article in a three-part series about the corporate sustainability movement. The first part focused on the many different sustainability frameworks that have arisen, with an emphasis on four major ones. The second part focused on the unusual incentives built into some sustainability frameworks, which can lead to unexpected results

Environmental, social and governance (ESG) factors related to corporate social responsibility are increasingly moving beyond specialized sustainability portfolios and into more general investment strategies, leading to growing investor action on issues that had once been considered ancillary to their interests, such as climate change and gender diversity.

This is reflected in a recent survey of about 800 investment professionals conducted by RBC Global Asset Management and BlueBay Asset Management LLP. They found that 70 percent of respondents said that ESG principles are either somewhat or significantly part of their investment approach and decision making, compared to 30 percent who don’t consider them at all. As for why, the most commonly cited reason was “lower risk, increase[d] return” at 53 percent. This could be because 53 percent of respondents thought that an ESG-integrated portfolio would perform “as well” as a nonintegrated investment, and 29 percent said it would perform “better.”

Rationales like these have led to asset managers such as BlackRock, Inc., incorporating sustainability into their voting policies, pension funds pressing firms on gender diversity, and traders reading carbon data on Bloomberg terminals.

Anthony J. Artabane—a consultant serving primarily investment managers and private funds, who also serves as chair of the NYSSCPA’s Investment Management Committee—said that ESG considerations have become widespread among asset managers, and those who haven’t yet developed their own ESG strategies are eager to start.

“It is on the minds of virtually every traditional asset manager—retail or institutional—to build or somehow buy access to managing strategies that are called ‘ESG,’” he said.

This is because these investors have started to understand that sustainability is a value that affects not only one’s conscience, but also the company’s entire bottom line. Poor labor policies might mean that a company has higher turnover and less access to talent; poor environmental practices could damage its long-term operations; and poor governance and business ethics could expose it to lawsuits.

This paradigm is connected to what’s been called the “Five Capitals” model. Its proponents have argued that, for too long, companies have had a narrow view of wealth, restricted to financial capital and manufacturing capital. Viewing these two forms of wealth as the only ones that make an entity wealthy means severely undervaluing the three other capitals that the model points to: environmental capital (such as scarce natural resources), human capital (such as the knowledge and skills of the workers), and social capital (including partnerships and networks, as well as norms, values and public trust). Any organization uses these to deliver products and services, and a sustainable one maintains these resources rather than depletes or degrades them, thus creating long-term value.

It was under this thinking that New York City Comptroller Scott M. Stringer recently called on 56 S&P 500 companies to increase the number of women board members and C-suite executives. In the letter he sent to each of them, he cited research saying that firms with greater gender and ethnic diversity tend to have stronger financial performance, and that diverse boards have fewer instances of bribery, corruption and fraud.

This was also why BlackRock and Vanguard, two of ExxonMobil’s largest shareholders, chose in 2017 to support a proposal to pressure the company to undergo a stress test of how environmental regulations and new energy technologies could affect its oil assets. David H. Webber, a Boston University law professor who specializes in shareholder activism, said that those two asset managers taking this proposal seriously indicates how “pervasive” ESG thinking has spread into the wider investment world.

“These environmental issues, for years, would get on the ballot and lose, but that has started to change in the last couple of years, and one of the reasons is the big players, the big mutual funds, that used to be totally opposed to this stuff have started to back it for a variety of different reasons,” he said.

He said the ExxonMobil vote was one of the first times that “these traditional centrist players” saw environmental issues as, what he called, “bread-and-butter investment stuff,” rather than a political distraction, as they had traditionally been viewed. This is further reflected in these firms’ voting policies, which, along with State Street Global Advisors’, stand in opposition to corporate boards that do not have any women on them. He said that BlackRock, in fact, now demands two women on each board that it invests in, and will vote against incumbent directors on boards that have not followed that policy.

Companies have observed this shift as well, and many have taken action to respond. Suzanne Fallender, Intel Corporation’s director of corporate responsibility, said that her firm has been a longtime promoter of the link between corporate sustainability and profits, having issued its own sustainability reports to investors since 1994. She noted that a long-term energy conservation effort at the firm, from 2012 to 2018, was able to save 4 billion kilowatt hours and $500 million in energy costs.

“These projects have a positive [return on investment,] so that has driven the discussions in multiple parts of the company,” she said, adding that profit and environmental stewardship “are not mutually exclusive. If you take an integrated approach, a lot of things with an environmental benefit also have a business benefit.”

Intel, she said, has long worked directly with investors on ESG issues, noting that it began going on formal road shows 20 years ago, specifically to meet with such investors. She added that, over the years, she has witnessed more mainstream investors start to integrate ESG factors into their overall approach toward her company, which has meant that “the number and types of investors we regularly have conversations with have changed and expanded significantly, which has also impacted the kind of feedback we get and how we integrate that [feedback] into our disclosures.”

As the accompanying table indicates, companies have increasingly signed on to at least one of the “big four” sustainability frameworks: the General Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), the United Nations Sustainable Development Goals (U.N. SDG) and the International Integrated Reporting Council (IIRC.) Michael L. Kraten, a member of the Sustainability Investment Leadership Council, has observed that  these frameworks produce complementary standards, and thus, work well together.

The role of institutional investors

So far, most shareholder action on sustainability has been on the part of institutional investors, such as large, diversified pension funds. Such players tend to be bound by fiduciary duty to seek the best returns for their beneficiaries. As the finance world has grown more aware of the link between sustainable business practices and long-term profits, these fiduciaries have taken it upon themselves to leverage their capital in the service of encouraging responsible corporate behavior. The aforementioned RBC/BlueBay survey reflects this approach, as 50 percent of respondents said they incorporate ESG into their investment approaches because of their fiduciary duty.

But that same fiduciary duty can sometimes restrain sustainability choices too—last year the U.S. Department of Labor (DOL) issued guidance, Field Assistance Bulletin 2018-01, warning plan fiduciaries operating under the Employee Retirement Income Security Act of 1974 (ERISA) that they “are not permitted to sacrifice investment return or take on additional investment risk as a means of using plan investments to promote collateral social policy goals.” 

“Fiduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision. It does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors,” said the DOL guidance.

So while something can be both profitable and sustainable, the DOL guidance said that a fiduciary cannot prioritize the latter over the former.

Webber said the extent to which a fiduciary can or should consider ESG factors while still fulfilling its duties as a fiduciary is currently a “hot topic” in legal circles. Given the rapidly changing discourse around corporate sustainability, he believes there might come a day when there’s significantly more flexibility for fiduciaries to make choices. Today, however, he said that current law means it’s easiest for fiduciaries to remain within the long-term profit frame.

“There’s a certain debate over how much flexibility [they can have], but traditionally fiduciaries have been on safest legal ground when they say they’re focusing on ESG as a source of returns,” he said.

Artabane said there’s a little more flexibility when it comes to non-ERISA fiduciaries, although the extent depends on what’s being given up, and what is expected in return. Different clients will have different tolerances for long-term, sustainable growth versus shorter-term profit maximization.

“If you’re giving up 50 basis points in performance over time, that’s a huge amount if you’ve got a 20-year time horizon. If it’s just five, it’s not inconsequential, it’s something, but you could maybe make a decision to live with that as an investment,” he said.

Inherent tensions

Kraten noted, however, that, fiduciary duty or not, there has always been tension between optimizing profits and acting responsibly. He pointed to the film Miracle on 34th Street, in which Macy’s hires a Santa Claus who steers people to rival stores, if it’s a better deal for the customers. He conceded that it’s a challenge to navigate these tensions, not helped by the “murkiness” of the laws surrounding corporate social responsibility.

“On the one hand, it’s true that if you give something to a competitor, your shareholders can sue you,” he said.  “But if you don’t give something away and you damage the external stakeholder, they can sue you. So either way, you have benefits and risks of either acting on a socially responsible manner in accordance with principles of sustainability, or simply focusing on immediate profit maximization.”

Muddying this issue, however, is a lack of clarity on what these disclosures mean to investors, and how useful they actually are in making a decision on ESG factors. NYSSCPA Past President J. Michael Kirkland, who serves on the Sustainability Committee, said that investment bankers and advisers today very much want to invest in sustainable companies, but many struggle to determine which ones are actually walking the walk. While over 90 percent of S&P 500 companies currently issue sustainability or corporate social responsibility reports, there is little uniformity or comparability between them, which can limit their usefulness to the investing community. Kirkland noted, too, that there’s also the concern, due to a lack of attestation requirements, over whether the information itself can even be trusted.

“How much of that information is useful that they put in their reports? How much of it is factual?” he said.

He noted, for example, that a soda company could use large amounts of water, and its sustainability report might say that it’s doing a “really great job” to protect the environment, “but you’ve got to dig deeper to find where they source that water” and other raw materials, as well as who produces those raw materials and under which labor policies. “You have to kick the tires a bit to make sure the information the company gives you is truthful.”

Kraten knows this from experience. He said that while he does consider the data in the sustainability report, he does not completely rely upon it. When evaluating a firm, he considers a host of other factors besides that, such as its compliance with industry standards, its performance relative to similar firms, what other firms disclose that it does not, media reports about the firm (particularly from trade journals), and third-party data compiled by outside evaluators. In this respect, he said, it’s quite similar to the due diligence someone would do for any company, sustainability-minded or not.

“That’s no different than the task that falls before traditional financial analysts when looking at annual financial statements and Form 10-Ks, but also every other bit of information they can glean about the company, the industry it operates in, and the general economy and economic trends,” he said.

However, Leon M. Metzger, an NYU adjunct finance professor and a member of the Society’s Investment Management Committee, said that many of these investment decisions, regardless of the data backing them, run into the confounding factor that there’s little agreement over what exactly counts as an ESG-compliant company. This means, according to Metzger, that many of these choices are being made on what are effectively subjective value judgments, often outsourced to so-called experts, who rely on their own value judgments.

Imagine, he said, a business that manu-factures ethically sourced paper using environmentally sound techniques, but 100 percent of its customers are cigarette companies. Would a green-preaching non-smoker invest in the manufacturer? In Metzger’s eyes, it is impossible to objectively determine whether such a company is ESG compliant, as the answer depends on one’s individual viewpoint. While the market might coalesce around one answer or another, he noted that the market has not always been the best judge of what is and isn’t socially responsible, as it too depends on subjective value judgments.

While he likes the idea behind ESG reporting, these sorts of issues make him highly skeptical of the value of ESG investing and sustainability reporting in general.

“The idea sounds nice, it sounds great that we can invest in ESG-compliant companies, and I really like the theory behind the idea,” he said. “I just think implementing it is next to impossible. What you think is ESG compliant, I might not, and vice versa.”

As an investor, Kraten has also considered this issue, but was less troubled. He previously noted that, in stock investing, people disagree all the time about whether a firm is doing well, and often both sides have at least some point. With this in mind, he said that he was untroubled about disagreements over what is and is not sustainable. More productive is to think of how ESG factors play into being a well-run business that people want to invest in. He noted that the Five Capitals model “is simply a model that describes how a well-run company should be organized.”

“You’re always thinking through these potential alternative scenarios of the future where outcomes will be good versus poor. These sustainability-related negative events should be treated in any valuation activity or any risk management activity the way you’d treat a cybersecurity concern or an economic tariff concern: They’re risks that face the company and need to be managed by the company,” he said.