By Kent McClanahan, CFA; Emir Beganovic; Peter Kolar, CFA
Investors who care about the environment have an expanding suite of tools empowering them to allocate capital towards companies that align with both their values and financial objectives. Considering a company’s environmental, social and governance (ESG) factors is not only good for the environment, but can be good for business and shareholders alike.
To commemorate Earth Day 2016, we’re highlighting ways the business sector and investors can benefit from incorporating and tracking ESG policies and standards. First founded in 1970, Earth day was set up as a way to address environmental issues through the public sector and it is credited with the creation of the Environmental Protection Agency. While the public’s awareness and support of environmental issues has grown, we still have a long way to go in our evolution.
A 2010 study from the United Nations Principals for Responsible Investment (UN PRI) and United Nations Environmental Programme (UNEP) Finance Initiative quantified damage to the environment caused by human activity at $6.6 trillion, one third of which, or $2.2 trillion, is attributed to the operations of the top 3,000 public companies. It is estimated that if these companies were forced to pay for the damage caused it could reduce their profits by as much as 30 percent.
The “E”, the environmental factor of ESG, is one way to acknowledge the business sector’s role in the creation of and solution to environmental issues. The UN PRI defines environmental issues as “… relating to the quality and functioning of the natural environment and natural systems.” A CFA Institute Guide on ESG Issues in Investing provides the following as examples of environmental issues in investing: “climate change and carbon emissions, air and water pollution, biodiversity, deforestation, energy efficiency, waste management, and water scarcity.”
Not considering the environment in business practices can expose firms to undue and outsized risk. Building out an infrastructure that benefits the environment, whether focused on reducing inputs, increasing efficiency, or limiting waste, can reduce risk and generate value in both the short and long term. In a 2006 research report, Food and Beverages: Corporate Responsibility UBS Limited looked at the key environmental factors in the food and beverage industry identified significant environmental issues and opportunities. First, the report recognized firms maintaining sustainable practices integrated into business plans performed better than their peers. This was achieved because climate change is a systemic issue and all competitors face the same challenges. Because water and energy are such important inputs to food and beverage production it only stands to reason that companies that integrate climate change management into their business model could achieve lower costs of production.
Additionally, firms experiencing below-average profitability improved earnings after implementing sustainable business practices, which could be seen as a signal to investors. Implementing green practices limited a firm’s consumption of water and energy, lowered CO2 emissions, and decreased solid waste generation, which again lead to increased profitability. Because of these indicators, the report integrated environmental data as a routine company performance metric affecting their view of a company’s prospects.
To use a real life example of a company monetizing environmental programs, we can turn to a 2016 study published by the U.S. Chamber of Commerce Foundation, Trash to Treasure: Changing Waste Streams to Profit Streams. Without accurately estimating, measuring and managing their waste streams, American companies are throwing away significant opportunities for profit, increased efficiency, and improved brands.
IBM, which has had a waste reduction program in place since 1991, is one company held up as an example. IBM has become incredibly efficient at processing waste and keeping certain products from entering landfills. In 2014, IBM processed 32,000 metric tons of end-of-life products. They were able to recycle, refurbish, resell, or reuse these products so that only a fraction of one percent of the 32,000 metric tons of waste ended up in a landfill. Through their environmental, product stewardship, and waste reduction programs, IBM has seen significant monetary savings. Between 1998 and 2007, the firm estimated that their programs had saved them more than $100 million.
So where do investors begin?
Investors can align their values with their investments by first reflecting on and defining what those values are. Once these are determined, then the exercise becomes an extension of the already-familiar “know what you own” process. Individuals will vary in what they deem acceptable in terms of their values. For example, some people who care about damage to the environment caused by fossil fuels may choose not to invest in oil companies at all, while others may choose to invest only in companies with strong, environmental, governance and social scores. Others may choose to focus on companies that are coming up with solutions to an oil-free economy understanding the wide-spread use of oil in a variety of consumer products. There is no right or wrong approach – only the right approach for you.
How to source the information you’ll need
ESG data can be difficult to find but its availability is increasing. Investors can learn more about the environmental, social, and governance information on individual companies by reading regulatory filings or through third-party data providers like Bloomberg, Sustainalytics and MSCI.
Investors in diversified funds can learn more about their investments by reading fund documents including the prospectus, annual report, fact sheets, or through third-party data providers like Morningstar. Morningstar has teamed up with Sustainalytics to provide sustainability scores on the mutual funds in their database. Some mutual funds may have a sustainability-focused mandate, which means that they may integrate ESG research into their investment process and Morningstar also discloses if the manager is integrating ESG evaluation into their process. Companies and funds are dynamic and complex, which means that investors should be careful not to take ratings at face-value.
Focusing on ESG issues as an investor does not mean that one has to trade off returns for values. A 2015 report by MSCI demonstrated that portfolios with an ESG bias can outperform the benchmark. The report utilized the MSCI World Index, which is made up of over 1500 larger equities in developed markets across the globe, as a benchmark. Two ESG portfolios were created from this index – one that was overweight securities with high ESG scores and another that was underweight securities with low ESG scores. Both portfolios outperformed the index, suggesting that investors in equities can improve their performance by investing in securities with high ESG scores.
A 2014 paper from RBC Global Asset Management, A Framework for Responsible Investing, highlights the benefits of companies with higher ESG scores. Those benefits include higher and more durable returns, which translate to stronger earnings and performance. The paper further provides reasons why ESG considerations will be more important in a world of expanding population and finite resources.
When considering ESG ratings and investable solutions, it is important to understand how they are defined and whether or not they address your concerns. A financial advisor can be an invaluable resource to help you sort through the expanding suite of tools.