Types of ESG Investing
Can companies profitably produce and sell the goods and services that consumers want to buy while concurrently contributing positively to society?
ESG (Environmental, Social, Governance)[1] investments by a firm should be guided by a business case that takes into account both the firm’s values and the impact on profit and shareholder value.[2] One of the positive financial impacts of a good ESG track record is access to potential additional capital from ESG-oriented investors. In this article series, we discuss the ESG investment phenomenon with a focus on the factors most relevant to supply chain practitioners. We first discuss what is meant by ESG investing and the processes through which ESG activities affect a firm’s resilience, the market, and society. We note issues related to greenwashing and the traceability of data to ensure the validity of ESG activities. In part two of the series, we explore the observed impact of ESG investment so far and the pros and cons of firms pursuing ESG-aligned efforts to both reduce risk and solicit shareholder investment.
Approaches to the provision of social goods: the case for ESG
Financial markets have not historically accounted for the ways in which the exchange of goods and services impacts the public, shared resources like clean water, and a stable climate. Similarly, it seldom elicits high returns on investment when a firm focuses on the social impact of its leadership or practices to the exclusion of the bottom line. Companies’ production activities impose costs on stakeholders.
Various approaches attempt to encourage better corporate behavior to alleviate these unintended consequences and/or provide social goods that benefit society. Regulation, government policies, market forces (i.e., buyers’ preferences), and financial markets (investors’ preferences) all provide paths to drive improvements to the social consequences of firm activities. In efforts to reduce industry’s contribution to climate changes, the Biden Administration has ordered federal agencies to include the ‘social value of carbon’ in budgeting, procurement, and other agency decisions.[3] Similarly, the EU Sustainability Finance Disclosure Regulation requires additional transparency in disclosing sustainability data. ChainLink has previously discussed[4] how market policy mechanisms are an approach to better account for social and environmental value. Socially responsible or ESG-driven investment decisions can be another, possibly complementary, approach to encouraging activities that provide broader positive social and environmental value.
Types of Impact Investment
Socially responsible, impact, ethical, conscious, and ESG are all types of investment that are often conflated, and all taken to mean morally-driven investing in which funds or stocks are screened based on how aligned the assumed social goods provided (or bads avoided) are to the investor’s values. The idea is to direct investment capital towards firms that provide positive social and environmental benefits. For example, investors concerned with the climate may avoid investing in companies that promote the expansion of fossil fuels. Employee safety, wage equity, and DEI factors fall within the realm of social issues, and promoting gender equity among corporate leadership is an example of equitable governance behavior. Investors may select funds that promote positive social outcomes, or avoid those with which they disagree or view as harmful.
Amount of ESG Investments/Assets Under Management
How large is the ethical investment sector compared to conventional investment? Because defining and measuring what is meant by “socially responsible”, “sustainable”, and “ethical” is so unclear, the amount of assets under management thought to be invested in value-oriented funds varies greatly among sources. The U.S. Sustainable Investment Forum found that 1 in 3 dollars (or $17.1 trillion) of US-domiciled assets under management employed a sustainable investment strategy in 2020 and was only growing.[5] Another source, CNBC, found global ESG investing to be more than $30 trillion in 2018[6] while a third, Bloomberg, reported that ESG assets exceeded $35 trillion as early as 2021.[7] Consistently across sources, conscious investment funds are reported to be substantial and increasing rapidly. While ethical motivations and the opportunity for financial returns both drive ESG investment, one of the primary rationales[8] for firms’ environmental, social, and governance activities is the business case for risk reduction[9] and may additionally support and fund the proliferation of corporate practices and activities that provide social goods.
ESG business performance and financial returns
Among the types of investment oriented towards positive social impacts, ESG performance is closely linked with business performance,[10] including risk reduction and financial returns.[11] Corporate behavior that creates positive environmental, social, and governance impacts benefits firms and is therefore linked to competitive market returns.[12] Companies along the supply chain reduce risk by developing a strong ESG proposition and investors purchase shares of ESG funds with the expectation that environmental, social, and governance benefits will lead to financial gains for the company and increase fund value.
Source: ChainLink Research
Figure 1 – Companies’ activities impact environmental, social, and governance risk opportunities,
which in turn impacts investment returns and company value.
Measuring ESG Effectiveness to Inform Investment Choices
How can the effectiveness of ESG investing be consistently measured and transparently tracked so that investors can make informed investment choices?
Two important considerations in assessing ESG investment effectiveness are reporting capabilities and transparency. ESG factors carry material physical, financial, and social impacts on firms. It is challenging to derive appropriate performance indicators across environmental, social, and governance issues and across disparate industries that can accurately assess the actual impact the firm’s actions are having. Seemingly straightforward metrics can be collected and measured in so many different ways. Understanding the path by which a firm’s ESG behavior may bolster resilience and risk reduction is the challenge of ESG measurement and reporting. There are continually evolving industry reporting standards that attempt to provide the framework and methodologies for firms to measure many aspects of ESG.
Understanding how ESG creates value
In order for ESG investment to have positive broader impacts and to reduce risk, value links must be identified between corporate ESG behavior, and the value generated by that behavior. Five identified links include the value of top-line growth, cost reductions, regulatory and legal interventions, productivity uplift, and investment and asset optimization.[13] A 2019 study published by McKinsey provides examples of these five dimensions:
For example, firms can provide their employees competitive wages which is known to increase employee productivity or ‘productivity uplift’, as well as reducing turnover, the expense of retraining, and loss of expertise. If productivity gains and the advantages of lower turnover outweigh the increased cost of higher wages, then this is a good business decision as well as supporting a firm’s fair wage goals. Firms can establish and enforce transparent and ethical compliance policies to reduce regulatory fines or legal fees. Similarly, firms that increase energy efficiency create a value link to risk reduction impacts and market value as cost reductions in energy spend.
Source: ChainLink Research
Table 2 – Example ESG Activities’ Risk and Social Impacts.
ESG Measurement is Key
Establishing, tracking, and accurately measuring these linkages is essential and challenging. Numerous indices have been developed to evaluate investment performance within these categories related to risk and resilience. The most often cited index denoting US ESG securities is the MSCI KLD.[14] MSCI’s client, BlackRock, is the world’s largest asset management company, managing $10 trillion. Among others, BlackRock uses the KLD Index to determine funds they consider under the ESG umbrella – those that promise risk reduction and bottom-line benefits to firms and shareholders. The validity of MSCI’s index has been slammed by Bloomberg[15] as having a very tenuous, if any, connection to how socially responsible a firm actually is. Rather it is primarily a measure of how exposed those companies are to environmental and social risks. Bloomberg states that this is true of many of the other indices and ratings used by investment funds as well.[16]
There are a myriad of other indices and categorizations of ESG investment funds. Some of these, such as EcoVadis, are aimed at rating suppliers for companies that want to ensure good behavior by the suppliers in their supply chain. Ratings such as those are (presumably) a bit more rigorous than some of the investor-oriented indices.
A number of recent regulations mandate more transparent and consistent ESG reporting by firms, to help investors make better-informed ESG investing decisions. Some of these regulations are described in Goals of ESG and Supply Chain Risk Legislation, in the subsection titled Socially Responsible Investing.
Part One of this article series has highlighted the differences among various kinds of impact-oriented investment and how critical it is to uncover the mediating processes between firm behavior and ESG performance. In Part Two of this series, we delve further into the role of data and measurement in determining ESG investment options that provide its touted company risk reduction, shareholder returns, and social impact. We explore how data is critical to demonstrate proof of activities in relation to ESG goals and the potential for greenwashing. Most critically, we discuss the impact of ESG investment on supply chain firms and how well ESG funds perform relative to conventional stocks and funds. The ability to understand how ESG investment drives firm activities and impacts risk reduction, shareholder returns, and social impact, requires accurate traceability, outcome measurement, and transparent reporting. Informed investors can then determine its value in benefits to society and in providing benefits to companies throughout the supply chain as a risk management strategy.
[1] According to Wikipedia, “Environmental, social, and corporate governance (ESG), also known as environmental, social, and governance, is a set of aspects considered when investing in companies, that recommends taking environmental issues, social issues and corporate governance issues into account.” — Return to article text above
[2] Does it pay to deliver superior ESG performance? Evidence from US S&P 500 companies. Journal of Global Responsibility, 2022. — Return to article text above
[3] FACT SHEET: Biden-Harris Administration Announces New Actions to Reduce Greenhouse Gas Emissions and Combat the Climate Crisis. The White House. www.whitehouse.gov — Return to article text above
[4] Environmental Markets – Part One: Are Market Mechanisms a Solution for Addressing Collective Action Problems? ChainLink Research. www.clresearch.com — Return to article text above
[5] The US SIF Foundation’s Biennial “Trends Report” Finds That Sustainable Investing Assets Reach $17.1 Trillion. US Sustainable Investment Forum. uusif.org — Return to article text above
[6] Your complete guide to investing with a conscience, a $30 trillion market just getting started. CNBC Investing. cnbc.com — Return to article text above
[7] ESG by the Numbers: Sustainable Investing Set Records in 2021. Bloomberg Green Finance. bloomberg.com — Return to article text above
[8] For some firms, their values and mission are also key drivers of their efforts and investments to improve ESG behavior and outcomes. — Return to article text above
[9] ESG, SRI, and Impact Investing: What’s the Difference? Investopedia. investopedia.com — Return to article text above
[10] Understanding the Business Relevance of ESG Issues. Serafeim, G. and Yoon, A. Journal of Financial Reporting, 2022. — Return to article text above
[11] ESG is just business seen through a new lens of competitive risk analysis & opportunity. Thomas Reuters. thomasreuters.com — Return to article text above
[12] ESG and financial performance: aggregated evidence from more than 2000 empirical studies. Friede, G. Busch, T., and Bassen, A. Journal of Sustainable Finance & Investment, 2015. — Return to article text above
[13] Five ways that ESG creates value. McKinsey Quarterly. November 2019. http://dln.jaipuria.ac.in:8080/jspui/bitstream/123456789/2319/1/Five-ways-that-ESG-creates-value.pdf — Return to article text above
[14] MSCI KLD 400 Social Index (USD). msci.com — Return to article text above
[15] MSCI, the largest ESG rating company, doesn’t even try to measure the impact of a corporation on the world. It’s all about whether the world might mess with the bottom line. Bloomberg. bloomberg.com — Return to article text above
[16] In The ESG Mirage, Bloomberg says, “Different credit rating agencies almost always give the same ratings, because their assessments are based on identical financial data and they’re all measuring exactly the same thing: the risk that a company will default on its debts. The U.S. Securities and Exchange Commission regulates credit raters. MSCI and its competitors in ESG rating, by contrast, often disagree with one another, sometimes wildly. That’s because each ESG rating provider uses its own proprietary system, algorithms, metrics, definitions, and sources of nonfinancial information, most of which aren’t transparent and rely heavily on self-reporting by the companies they rate. No regulator examines the methodology or the results.” — Return to article text above