ESG Analysis ‘More Dynamic,’ but Ambivalence Remains

Over the past 20 years, companies have become more focused on environmental, social and governance criteria in the management of their own businesses as a result of changes in the global regulatory framework, Zachary Karabell, head of global strategy of Envestnet, said Wednesday on a webinar.

However, these issues have been “funneling in and out” of investors’ and corporate managers’ priorities for about 40 years, he said.

Still, “in the investing world in general, particularly in the United States, there’s still some ambivalence about impact [investing],” he said, and about whether a company’s environmental footprint, corporate governance, and relationships with workers and communities are worth incorporating “into portfolio construction in the belief that there is a tension, and a negative tension, between those criteria and financial performance.”

That tension stems from beliefs that took hold in the 1970s, Karabell said, that capitalism wasn’t a constructive force. Concerns about ecological damage, pollution and the “negative consequences of capitalist growth” led to a “countercultural reaction against capitalism that became the first iteration of what we would now call ESG or SRI investing,” he said.

Religious institutions were already using negative screens to exclude companies in morally objectionable sectors in their portfolios, thereby “removing companies that might be generating positive return, and often those negative screens did lead to some underperformance,” which contributed to the idea that ESG investing required investors to sacrifice returns.

A new wave in the 1990s, particularly in Europe, developed a “more embedded belief in investing for the sustainable future,” Karabell said. That meant investing in companies that were looking not just at quarterly performance, but long-term sustainable growth, he noted.

In the last 10 years, the criteria used to analyze companies for ESG investing has become “much more dynamic, much more fluid [and] much more embedded with very traditional, rigorous financial analysis.”

However, Karabell noted “there’s still a real disconnect between what a lot of people and institutions want and what a lot of advisors and third parties want.”

Millennials and women are driving the interest in impact investing, Karabell said. Millennials’ interest is “mostly aspirational,” Karabell said, but for women it’s very real. “Women are controlling ever larger portions of investable assets at an individual level,” he said. “There’s a real trend where women in particular express their desire that their investments both do good and do well.”

The tools used for impact investing have evolved, too, Karabell said, and more rapidly than skeptics believe. “We’re not in a world where you can only use negative screens.” In today’s business world, especially among multinational companies, “it’s not a question of should you attend to these issues, it’s a question of how.”

The U.N. Global Reporting Initiative demands that companies report on ESG criteria like environmental impact, employee retention and corporate governance, Karabell said.

“All of these issues that seem to have this externality to financial performance are actually intimately connected to it,” he said. “If you’re seen as a higher credit risk because of variable costs you can’t control, and too-high levels of debt, that’s a negative. If you’re seen as having a strong buy-in to your local community, where you have strong employee retention and you’re managing costs, that’s always going to be good for your credit rating. It’s going to lower your cost of capital. It’s going to potentially be a positive for your return on capital and for shareholders, their return on investment.”

Karabell said that research from Envestnet and others has shown that at worst, impact criteria may have a neutral effect rather than negative. There is even some evidence that ESG investments provide some downside protection, possibly because “companies that are invested in these criteria have better bond ratings or better management, are less volatile, are less beta-ish.”

He noted, though, that clean energy companies have been “unbelievable correlated to the price of oil and very beta-heavy.”