ESG (Environmental, Social, and Governance)
ESG is becoming a huge issue in the corporate world and in this article, Justin Lukacs delves into the high-level aspects of this new methodology.
Socially responsible investing is on the rise, with that, so is the importance of adhering to the Environmental, Social, and (Corporate) Governance system. This is basically three broad categories of practices, procedures, and programs that companies are expected to follow to increase the sustainability of their business, while also increasing the profitability of their stock. There are also larger goals of the ESG program such as building a resilient and valuable economy, that incentivize further the implementation of these practices in the workplace. ESG follows criteria to ensure these metrics can be measured and defined and is becoming a large trend as more companies are transparent with their efforts in this area and investors are more willing to support this behavior.
The three broad categories are Environmental, Social, and (Corporate) Governance and all have their own criteria to clearly define what needs to be done to promote a responsible and tenable business.
Environmental considers how a company acts as a steward of nature. This means looking at a company’s use of renewable resources, waste management, potential pollution problems, and raw material sourcing, to name a few. It also considers the organization’s attitude and actions towards climate change issues.
The Social side covers a wide range of potential problems. Social considers how the company manages relationships with employees, suppliers, customers, and even the local community. Out of these sub-categories, how a company treats its employees has become one of the more relevant in recent years. To show how in-depth these metrics can be, let us dive into some of the points of interest when looking at just this section. Social will take into consideration how the company pays its employees; is it fair pay? More than that is it even generous compared to other competitors in the industry? In tandem, this will also consider benefits provided to employees, outside the typical benefits given to workers, generally. Are there paid lunches? On-site fitness center? An additional trending topic for concern is diversity and inclusion programs that tie in the prevention of sexual harassment. Other notables include employee training programs, turnover rates, and engagement with management. There are plenty of other points that make up just this section of social responsibility, this should show just how dense this whole system is.
Corporate Governance essentially considers how the company is run by those in the executive offices. How well does the board of directors address the interests of their shareholders, employees, and customers? Investors are looking for transparency from the company, especially in terms of accounting. This means full and honest financial reporting is key to success in this area so stockholders can feel confident they know where their money has gone and how much they can expect to see in return. Another key aspect is executive compensation. ESG investors do not look favorably at million-dollar executive bonuses while posturing a salary freeze for all other employees. Compensation at the top level should be for the purpose of increasing the long-term value and viability of the business. A good way to gauge responsible corporate governance is to look at a company’s policies to see if they have many or any that align with these criteria.
Those are the criteria laid out by ESG that are of importance to socially responsible investors, but who are socially responsible investors? These are investors who consider their own values and beliefs strongly when considering stock options, over profitability alone. Therefore, ESG is important as it provides the metrics for investors to understand these qualities in a company. As mentioned at the beginning of the article, this type of investing is certainly on the rise. In fact, from 2016 to 2018, the increase of holds in stocks with ESG criteria grew from $8.1 trillion to $11.6 trillion (most recent report from US SIF Foundation). The growth of this kind of investing can largely be attributed to millennials. It is projected that nearly 90% of millennial investors follow the mentality of pursuing investments that align with their values. This is anticipated to rise as millennials continue to increase their hold on the stock pool. However, the increase in popularity of this trend does beg the question; is socially responsible investing profitable?
Traditionally investing has largely been about profitability, and with the distraction from this by other metrics, is it still a viable tactic to make money? There is a fair share of critics to this model, such as the late Milton Friedman, who argued that socially responsible expenditures are non-essential and lead to the erosion of corporate and shareholder profits. In years past, socially responsible trading had a reputation of being a trade-off on the part of the investor as it would limit the number of companies available for investing and potentially reduce their profits. The tides have seemed to change more recently, though. Socially responsible investors believe that sticking to these procedures will help companies avoid large-scale risks (such as the BP oil spill of 2010) and will increase the strength and long-term viability of the business. This will in turn make the company more profitable in the long run. By increasing the durability of businesses, especially in the energy industry, these types of investors also believe it will lead to a more resilient economy overall.
This trend is more evident by the number of companies (including large corporations) that are jumping on the ESG bandwagon. For example, the Energy Infrastructure Council is a working group of organizations that have banded together to collectively increase, measure, and clearly report their ESG efforts. This collective consists of The Williams Companies, Crestwood, Cheniere, Kinder Morgan, OneOK, DCP Midstream, Energy Transfer, Enterprise Products Partners L.P., Plains – All American, Magellan Midstream Partners L.P., Targa, Enbridge, and Western Midstream. This group provides best practices guidance and resources to its member companies to assist in their ESG journeys. They do this through roundtables and webinars to keep communication in this area constant and perhaps most interestingly have created an ESG Toolkit as a template for midstream companies. As mentioned, other large companies are also joining in on these efforts. JPMorgan Chase, Wells Fargo, and Goldman Sachs have all published annual reports that clearly define and review their ESG efforts and results. With more companies proudly displaying this information, it is logical to assume socially responsible investing will continue to grow.
Environmental Social Governance is a system with ample breadth that covers an extensive list of procedures and practices for operating companies. On the surface, it seems as though the main goal of ESG is to keep corporations accountable for their actions at varying degrees of operation. It is clear, though, that there is a profitable side to these efforts. Increasing the longevity and durability of a company through ESG not only strengthens the company but in more ways than one also increases the value of their stock. If implemented successfully, it could also have a larger impact on building a more resilient economy. With the $3.5 trillion increase to the ESG stock hold over a two-year period and millennials continuing to increase their clutch on the stock pool, this type of reporting and investing will only continue to rise in the coming years.