Part I: The Basics of ESG
Why do we need ESG Investing?: There are at least three reasons why we need ESG. First, companies may be better placed than individuals to provide a social good, and an ESG mindset may help persuade companies to act on this. Second, there are certain issues that governments cannot regulate (like corporate culture), or which extend beyond the boundaries of any one country (like air pollution). In these situations, ESG awareness may induce better behaviour. Third, ESG can create shareholder value by recognising and exploiting opportunities that are difficult to quantify with traditional methods, like a net present value analysis.
Why is ESG relevant now?: Investors are increasingly conscious about maximising total welfare for all stakeholders, not just shareholder value. Additionally, more evidence (some robust, some dubious) is now available on the positive impact of incorporating ESG information into investment strategies. As larger asset managers and pension funds become more concerned with the broader impact of their portfolios, ESG investing is set to have a greater effect on markets and asset prices.
Academic evidence and estimation issues: While numerous academic studies have been conducted to determine the efficacy of ESG investing, the most convincing evidence is in the G category – all things being equal, better corporate governance correlates to better returns. The evidence is not as strong for the E and S. Studies linking better ESG metrics to better operating performance face well-known estimation problems, such as omitted variable bias and reverse causality.
Part II: Does ESG work?
Exclusion lists and engagement: Exclusions lists are a basic method to incorporate ESG. However, taking the easier, and certainly less controversial, route of exclusions should not be the answer. A method supported by better evidence is that of engagement, where investors influence companies to make changes, whether on specific problems (often used by activist funds) or on more general issues (usually preferred by large passive investors).
The impact on returns: There is evidence that some G metrics have a real impact on returns. The picture is more mixed for the E and S. It is also important to look at ESG using a broad perspective, as value added to society. If some investors exclude companies because of a superficial analysis based on narrow definitions of ESG, that might create an opportunity for investors who don’t. An issue in evaluating the return potential of ESG metrics is that the history is short, and companies did not care about these metrics historically like they do now.
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