Abstract: The use of the Sustainable and Responsible Investing strategy of ESG Integration (ESGI) is well established; empirical data supports its success in achieving superior risk-adjusted returns over the long-term, there is notable use of it among investment managers, an industry to support its use, and demand among investors for it. Many investment managers, however, have not implemented ESGI and attempts by ESGI’s advocates to inform them of its benefits have seen limited success. Using sociological theory as a guide, this article provides an explanation for the limited success of these attempts by suggesting that acceptance of the effectiveness of ESGI represents a threat to an investment manager’s identity. The article goes on to offer proposals for how to circumvent this challenge to getting investment managers to implement ESGI by appealing to their competitive nature.
One who instinctively or habitually doubts, questions, or disagrees with assertions or generally accepted conclusions, is known as a skeptic. Being one myself, I understand and appreciate this instinct, and over the years it has served me well in many situations and I expect it will continue to do so. Therefore, I also respect this approach. When it comes to the Sustainable and Responsible Investing (SRI) strategy of ESG Integration (ESGI), this mindset is warranted.
Although there is a considerable amount of empirical evidence that demonstrates the achievement of superior risk- adjusted returns over the long-term through the use of ESGI, there are challenges associated with its implementation. Given the evidence in favor of ESGI and the persistence of the efforts of its advocates, however, one would expect a greater degree of adoption. The author believes that part of the reason for the low level of adoption is the approach used by its advocates to overcome Investment Managers’ (IM) skepticism. In search of a reason(s) for this disconnect, answers where sought in socio- behavioral theory. The answers found provide information useful to better understanding resistance to ESGI as well as in enabling advocates of SRI to formulate a more effective approach to getting IMs to integrate ESG criteria into their investment decision-making processes.
In this article, environmental, social, and governance (ESG) and ESG Integration (ESGI) are defined and evidence supporting the benefits of both presented. Next, an overview of typical arguments made against this investing strategy by skeptics is presented. Responses from a hypothetical advocate of this strategy, which one would expect to convert ESGI skeptics, accompany these arguments. The article proceeds with a brief discussion of the approach that has been used to argue in favor of ESGI and why the strategy employed has seen limited success. From there, an exploration of socio-behavioral motivators and thought processes provides a deeper understanding of IMs’ resistance to ESGI. Finally, based on the reasoning offered, suggestions for a new approach to getting IMs to implement ESGI by appealing to their competitive nature are provided.
For the purposes of this article, environmental, social, and governance (ESG) refers to the consideration of how these factors affect and are affected by the operation of a business entity. The proper management of ESG performance involves the consideration of these factors at the operational level and within a company’s overall business strategy. The actions needed to accomplish such an organizational synchronization require a sophisticated and nuanced understanding of the operational, financial, regulatory, and reputational risks related to global environmental, social, and economic issues that affect the viability of a business. On top of this understanding, a substantial commitment of organizational resources, courage, and conviction is required from corporate leadership and management in order to envision, devise, plan, and execute the paradigm shift away from a “business as usual” mindset in order to institutionalize these considerations into all management processes.
These resources and efforts, in turn, enable the identification of opportunities that arise from the aforementioned risks. Such opportunities include improving upon environmental and social outcomes of operations and the optimization of corporate decision-making capacity through the implementation of technologies, programs, and behavioral incentives. Environmental improvements include CO2e emissions and water use reductions and improved waste diversion rates. Societal improvements include holding suppliers to internationally recognized environmental, health, and safety standards as well as the development of products and services that address the needs of underserved markets. Opportunities to optimize corporate decision-making capacity include the implementation of governance policies, that link executive pay to long-term company performance, ensure executive boards are independent and reasonably diverse in terms of race and sex, and engender the prudent identification and selection of executives and directors. Finally, the communication of these efforts and the associated successes and challenges to share- and stakeholders as well as the public through appropriate reports and disclosures is essential to realizing the full compliment of associated benefits.
As one can see, ranging from energy efficiency to board oversight, a defining characteristic of ESG opportunities is their breadth and interdisciplinary nature. This nature requires management excellence across a broad range of skills and experience and highlights the need for well-qualified and capable leaders, managers, and staff. As such, there is a widely accepted notion that the active management of a company’s ESG performance is a strong indicator of a generally well-managed operation. From this maxim arises the premise that companies that have programs in place to identify and manage ESG-related risks and opportunities are better positioned to outperform their peers across the value chain.
So as not to create the misperception that ESG performance management is a potential means for all companies to outperform the market, however, let it be understood that implementing the principles and practices of sustainability only makes sense for companies offering a viable product(s) and/or service(s). This being the case, there is no doubt that in addition to determining leaders and laggards, the successful management of ESG will crown winners and force the exit of losers. Such outcomes are not to be lamented though as they are a beneficial outcome of equitableii competition in market-based economies.
Noting the caveat above, the resources that must be invested and the organizational change required to successfully institutionalize sustainability does bring rewards. These rewards come in quantifiable formsiii such as increased operating and profit margins; improved access to capital; stronger brand reputation, enhanced employee satisfaction, and workforce and community development. These benefits drive overall, long-term outperformance of the market, thus demonstrate the value inherent in managing ESG performance. Case-study evidence substantiating this claim to the tune of billions of US dollars using the Value Driver Model can be found at the United Nations Global Compact website.
A more immediate example, that substantiates the positive correlation between active ESG management and superior overall management and that demonstrates how ESG performance management can affect stock price is provided by results of the Harvard Business School study shown in Graph I. The study compared the stock performance of a portfolio of firms that successfully manage ESG with a portfolio of firms that do not manage ESG over the same 19-year time period. The red line shows that US $1 invested in a portfolio of firms that manage ESG would have grown to US $22.60, whereas US $1 invested in a portfolio of firms that do not manage ESG would have only grown to $15.40.
ESG Integration is a Sustainable and Responsible Investing strategy that involves determining sector-specific, material, quantitative and qualitative ESG key performance indicators (KPIs) associated with the results of managing ESG performance then incorporating them into traditional financial analysis. The objective of ESGI is to generate long-term, risk-adjusted financial returns that outperform the market through the integration of ESG criteria into investment decision-making processes throughout the investment cycle.
Financial analysis that incorporates the use of these KPIs helps investment managers identify market leaders and laggards in terms of their ability to capitalize on risk-reduction and efficiency-enhancing opportunities associated with their management. These determinations are possible because the disclosure and reporting of ESG performance by companies provides IMs with the opportunity to ascertain more comprehensive operational-level information about a company, thus the possibility to gain insights across the value chain. Furthermore, as ESGI considers factors that fundamentally affect a company’s ability to create economic value, integrating ESG KPIs with traditional financial analysis enables IMs to better assess operational, financial, regulatory, and reputational risks and opportunities. In turn, enabling them to build more informed risk profiles and financial models with greater explanatory and predictive power than conventionally built models, thus producing a more comprehensive assessment of an investment than financial analysis alone is capable, thereby enabling better evaluations of an investment’s potential to outperform the market over the long term.
ESG KPIs can also be used to:
The theoretical benefits of ESGI are born out in its practice. An example provided by AXA Investment Managers, which illustrates the identification and integration of ESG KPIs into financial analysis is provided in Graph II:
Graph II illustrates that the share price of the companies with the best board scoresiv outperform companies with the worst board scores, i.e. those with the best board scores returned 40% on an annualized basis, whereas those with the worst board scores returned -0.3%. Although this may not seem all that insightful as one would expect poor leadership to result in poor company performance and vice versa, the fact is that analyses such as these are not undertaken outside of firms that have adopted ESGI. The potential negative consequences of not doing so are missed investment risks and opportunities that can affect portfolio value as exhibited in the above example. Despite this evidence, which supports the relevance and value of ESGI, approximately only 10% of global assets under management (AuM) employ an ESGI strategy. Considering that examples such as these abound across the spectrum of ESG KPIs and the potential implications the results hold on portfolio performance, one is justified in questioning why more investment managers have not adopted ESGI; answers to this query are laid out over the following two sections.
Typical challenges made by those who have been exposed to the existence and benefits of ESGI have their origins in a lack of understanding of what ESGI is, and question the veracity and indeed existence of data that establishes its effectiveness. Without trying to exhaust all of the challenges, the following six ESGI skeptic positions (SP) and ESGI advocate responses (AR) are offered as representative of the arguments from both sides:
Although the challenges are reasonable, one would expect the responses, which amply address the criticisms andconcerns embedded in the questions, if communicated effectively and in accordance with one’s audience, to clear up skeptics’ misunderstandings and properly reset their expectations, thus convert skeptics. Moreover, if ignorance and/or limited cognition were the cause(s) of ESGI skepticism, one would expect that some further education in line with the previous responses would be sufficient to convert skeptics. Given the steadfast persistence of the attempts to overcome ESGI resistance, however, this does not seem to be the case.
A clear factor contributing to ESGI skepticism is the fear-mongering, plays at sympathy, and information overload typically included in ESGI advocates’ attempts to convert skeptics. Which is not to claim that the assertions made regarding, e.g. habitat loss, sea-level rise, the health effects of pollution, etc. are not true and relevant, rather, that they are not effective towards inducing behavior change among IMs for which these negative consequences have no immediate bearing or import. Also included in ESGI advocate’s strategy to relay its benefits are the use of terms such as sustainable, responsible, environmental, ethical, etc., which for many IMs carry negative connotations. The logical thinking behind including these components in their strategy is that if the information and implications are properly explained and the data and methodology verified and substantiated, it will be accepted by IMs and ESGI implemented accordingly.
Ostensibly, the combination of the previously described challenges and strategy are the basic reasons behind IMs’ resistance to implementing ESGI, and they have typically led to its dismissal as a viable investment strategy. Given the steadfast persistence of the attempts to overcome this resistance, however, the author believes that an explanation is needed that provides a more complete account of ESGI resistance among IMs vis a vis its empirically based benefits and the existing and future demand for its use.
In recognition of this need, the author called upon sociological theory for insights into the possibility that there are deeper motivations and thought processes driving resistance to ESGI. The following five examples offer just that:
These five explanations provide useful information regarding underling subconscious biases that add to the previously stated challenges associated with implementing ESGI and help to better explain why attempts to overcome resistance to ESGI have seen limited success. To wit, they reveal that accepting ESGI’s effectiveness may represent a threat to an IM’s basic human instinct of identity preservation.
An aspect of identity being preserved, through denial, is an IM’s level of intelligence and self-worth as manifested in career performance. That is, if an IM admits that ESGI is an effective investing strategy they will also conclude that their returns could have been greater. Such an admission, after years of claiming to have been doing the best for their employer, clients, etc., could be very uncomfortable and possibly embarrassing. Mental health professionals refer to this type of internal conflict as cognitive dissonance, i.e. the discomfort felt as a result of attempts to simultaneously maintain two conflicting cognitions. In this case, “I have done my best” and “I dismissed, without sufficient reason, information that would have improved my performance.” This discomfort often leads to decision-making that serves to moderate emotions that fuel anxiety. Denial of the effectiveness of ESGI would avoid the anxiety associated with accepting its effectiveness, thus preserve one’s sense of career accomplishment.
Another aspect of identity being preserved is an IM’s self-image as a “good person.” That is, admitting ESGI’s effectiveness will force an IM to realize that businesses that do not manage ESG performance are significantly contributing to the environmental and social issues facing society. With this realization may come another, i.e. as a consequence of not adopting ESGI, they may have made an outsized contribution to these issues. As such, they may have, albeit unwittingly, further jeopardized the health and future wellbeing of their family members, friends, themselves, and indeed the rest of the world, a notion certainly capable of inducing a fair bit of anxiety. Analogous to the previous example then, denial of the effectiveness of ESGI would preserve one’s self-image as a “good person.”
The combination of obstacles stated in the previous sections severely diminishes if not eliminates the power of an attempt to appeal to skeptics’ sense of logic and reason with a sensible argument backed up by empirical evidence. That is, providing text and data-laden pre- and proscriptions for IMs to follow, as has been employed by ESGI advocates to date, has not proven to be an effective strategy. This being the case, a new approach is called for. As such, in an attempt to circumvent the threat posed to skeptics’ identity, their distaste for terms and concepts commonly used in the context of ESGI, and the disregard for the environmental and social benefits ESGI can effect, the following suggestions for ways to increase the adoption of ESGI are offered. They seek to appeal to the competitive nature of IMs to the exclusion of trying to raise awareness and increase understanding of the implicit environmental and social benefits of ESGI:
This suggestion is supported by studies, which have shown that one of the most effective methods to induce behavior change is to regularly deliver messaging that employs easily understandable, ‘every day’ language and graphics to convey a gentle command that also relates a benefit into a single ‘takeaway’ or lesson. Essential to the effective consumption of the message is the full consideration of one’s audience in terms of the language employed, the incentive described, the delivery method, and who or what is delivering the message. Finally, it is noteworthy that some degree of trial and error may be necessary to realize the maximum potential behavioral change through this method.
As it happens, the most powerful among the four benefits proven to be the most motivational is financial, the other three are, in order of relative power, health, environmental, and social cachexviii. Using this insight, the previously mentioned factors and others could easily be incorporated into basic comparisons using tables and/or charts configured in such as way as to raise awareness among investment managers of the effectiveness of ESGI in generating superior risk adjusted returns. The takeaway being something in keeping with the notions of increasing clients’ returns, earning a larger bonus, attracting more capital, etc. Regarding the latter, for messages delivered in the digital realm, functionality could be included in the message to, “connect with investors now!”
Advantages of the above suggestions include being consistent with investment managers’ desire to outperform the market and their competitors, relatively easy and inexpensive to implement, and save for suggestion 5, not fraught with political and regulatory barriers that must be overcome in order to be implemented.
This article has explained what ESG and ESGI are and presented empirically based evidence for advantages of both. It has also presented the challenges associated with implementing the latter and described why the efforts of its advocates to get IMs to implement ESGI have seen limited success. Although a course of action that enables IMs to capitalize on the opportunities than can result from implementing ESGI comes with an initial expense of time and resources, these costs can, with proper planning and execution yield positive ROI through the aforementioned benefits of ESGI. As such, there is a strong case for adopting ESGI as doing so is in the best interest of the long-term success of an IM. Towards this end, with the aid of sociological theory, suggestions have been offered to help induce IMs to implement ESGI, thereby increase the percentage of global AuM employing ESGI.
Continued resistance to ESGI serves to exacerbate past and perpetuate continuing “business as usual” corporate behaviors that are a significant cause of negative environmental, economic, and social outcomes. So not only is the failure to adopt ESGI potentially detrimental to portfolio value, continued investment in companies that do not manage environmental, social, and governance performance is a positive reinforcement to bad corporate behavior.
Given the environmental, social, and economic challenges facing society, it is the author’s hope that this article will induce IMs to (re)consider implementing ESGI, the suggestions be acted upon, and that further use of the sociological insights provided will be made by ESGI advocates in their efforts to get IMs to implement ESGI.