The Evolution of SRI (Part 2/3)
Craig Swistun - Aug 12, 2021
Socially conscious investors have a choice to make. Do they invest passively in companies that have high ESG scores or do they invest and actively work to change a company with a poor ESG score?
In the last post, we tried to explain “SRI” (socially responsible investing), and show how the industry is constantly evolving. While it may be easy to state emphatically what to avoid -- not this, none of that -- tools haven’t been readily available to help determine which companies deserve additional investment. That’s changing, as more and more companies are embracing SRI criteria in their public reporting. Now investors can be passively engaged in responsible investing or take a more active approach.
ESG is Environmental, Social and Governance. I like to think of it as the evolution of socially responsible investing. It’s a framework for evaluating how companies are performing against a non-financial metric. Companies can be rated against a specific set of criteria: social criteria examines how they manage relationships with employees, customers, communities and their commitment to Diversity, Equity and Inclusion (DEI); governance deals with leadership, executive compensation, and shareholder rights; while environmental criteria judges their stewardship of environmental issues.
If you research any public company today, you’ll likely find some mention of their ESG score. Once again, the industry has responded. There is a large market of ESG data providers calculating scores for publicly-traded companies. In certain circles, these scores are contentious because each provider uses its own proprietary and often subjective methodology. That said, they are simply a tool to provide insight and should be used with caution.
Want to see how your favourite insurance company compares based on ESG criteria? No problem. But, ESG is just another data point when making investment decisions. One company may score higher than another, but that is no guarantee it will outperform financially.
There is some evidence that ESG investing may be good for portfolios. Some studies suggest that companies that follow ESG principles have outperformed their peer group, but understanding why is always a bit more nuanced. Dale Jackson, writing for BNN Bloomberg in May 2021, puts it this way: “A likely explanation for the success of ESG investments lies in wider global trends towards transparency and sustainability. Governments around the globe have been pouring money into financial incentives for alternative energy sources to replace tradition fossil fuel producers. Costs to produce alternative energy are normally higher but as efficiency increases, those costs come down and profits increase.”
Whatever the reason, socially conscious investors have a choice to make. Do they invest passively in companies that have high ESG scores or do they invest and actively work to change a company with a poor ESG score?
Imagine two companies in the same industry, making the same product. One scores high on its ESG measurements -- they provide employees with generous benefits, focus on reducing waste and pollution, and have a diverse board of directors. The other company has poor relationships with their employees, often is fined for polluting, and never invests in new equipment or training. Armed with that knowledge, which company would you choose to invest in? Which one has the best opportunity to outperform over the long-term? Financially, you might choose the one with the high ESG score. However, to increase social change, you might choose to become more active in helping steer the low-scoring company towards improving employee relationships, reducing pollution, and changing management.
The answer depends on your goals, objectives, and level of passive versus active engagement.
Scores, ratings and metrics provide portfolio managers with a window into the inner workings of a company. Another data point, another tool. It doesn’t tell anybody how they should invest or why. When constructing socially-conscious portfolios for clients, portfolio managers now have access to data that helps them evaluate what clients could be investing in instead of simply avoiding.
If you do choose to factor ESG criteria into your investment decision-making process, it is important that you document it properly in a well-written Investment Policy Statement. That way you and your portfolio manager can work in concert with one another to accomplish the objective.