A Reply to ‘The Secret Diary of a ‘Sustainable Investor’ 

*Post was originally written on September 10, 2011. You can find this post summarized in a very long tweet thread I posted.

I thought Tariq Fancy’s (ex-BlackRock CIO of Sustainable Investing) 3-part essay was a necessary contribution to the ongoing discussion around sustainable investing and how it can and should be improved – see his subsequent interview with the FT here. However, I did find it overly negative and I disagree with one of his core takeaways being that it somehow delays or cancels out what we really need – regulatory requirements and/or societal commitments to act more sustainably (e.g., carbon tax, personal purchasing decisions). It’s sad but the reality of bipartisan-supported legislation around sustainability anytime soon looks slim. As a result, public and private markets should step in to do what they can to move the needle forward. While I’d agree it’d be intellectually dishonest to assume these products fix our broader sustainability issues in totality, they do seem to be directionally moving us closer to that goal, though.

Public equity investors have the chance to work with and influence some of the largest companies in the world, which thereby has numerous downstream impacts that span geographies/industries. I think some of the critiques of Sustainable Investing highlight the case for why active management and a research-driven approach to Sustainable Investing is required. Given how broad ‘ESG’ or ‘Sustainability’ can be, it has left many confused and disillusioned with the idea. I thought this chart was an interesting way to view where we are in the cycle. I think we need to be honest about its weaknesses but collectively work to improve what is still an emerging industry. Over time, I think it’d be ideal if investors and companies worked together to influence policyto create a level playing field for all companies as we transition to a net-zero world.

If Tariq’s 3-piece essay is considered the pessimistic view of Sustainable Investing, I would recommend reading Accountable: The Rise of Citizen Capitalism by Michael O’Leary (Managing Director – Engine No. 1) & Warren Valdmanis (Partner – Two Sigma Impact) as an optimistic view of how ‘ESG’ and/or ‘Sustainable Investing’ should drive behavior change. I won’t summarize the book here, but they tie together a few core concepts really well:

• Companies are increasingly owned by institutional investors (ex: BlackRock, Vanguard, and State Street are the largest shareholders in almost ~90% of US corporations)
• A lot of institutional investors are ‘asleep at the wheel’ and do not represent the actual values of their shareholders
  • “…Enter proxy advisers, yet another layer of this mind-bendingly complex system. Many institutions lack the resources to do all this voting on their own so they hire proxy advisers, firms whose sole purpose is to tell institutional investors how to vote. ISS and Glass Lewis control 97% of this market… An ISS recommendation for or against a proposal can swing 10-30% of the vote”
  • “Our corporations are run by CEOs, who are appointed by a board of directors, who are elected by shareholders. Nearly every vote cast in these elections is cast by institutions, many of which are just following the recommendation of proxy advisers. All of this makes the ultimate owners of these companies – retirees, pensioners, savers, and the like – totally voiceless…” He calls it absentee ownership.
• ESG metrics, as they currently are presented, can largely be window dressing exercise but if you can boil it down to what is really core to a company’s industry, it can become very meaningful. CSR is at its best when it addresses the core impact that corporations have. ESG data needs to be simplified, standardized, and audited.
  • “In 2015, one of the most exhaustive analyses to date, researchers in Germany aggregated the results of 2,250 individual studies that compared companies’ environment, social, and governance criteria with their financial performance since the 1970s. The researchers found 63% of the studies show a positive relationship between ESG and financial performance and only 10% of the studies show a negative relationship. These results are impressive, given how noisy ESG data can be. And they held regardless of region, time period, and asset class. Other researchers found that what really mattered was a company’s ESG rating on the issues that were core to the company’s industry… Researchers found that outperforming on unrelated ESG metrics did not improve financial results, but that outperforming on core ESG metrics did. Essentially, doing good in unrelated, marginal ways doesn’t pay. But doing good in the core of your company does.”

So, what investors do? Ultimately it boils down into a few main drivers in my view:

1. Assessing what is ultimately material for a company/industry (e.g., sustainable business decisions – raw material inputs, end-of-life treatment for their products, etc.) vs. marketing (e.g., $X donation to a local community non-profit unrelated to the company’s core business). This requires in-depth research of a company sustainability efforts versus trusting third parties.
2. Engaging companies to do more where we think it is financially prudent to do so and using our votes as shareholders to back action we think it is in the best interest of the company’s long-term health (which we can’t do unless we do the research).

On ESG Metrics: Building off the cited research above, there is definitely a problem with folks being rewarded for disclosure instead of performance-based ESG measures tied to their business model. Therein lies the opportunity for independent, bottoms-up analysis of ESG/CSR issues.

• A Booth analysis of 2017 sustainability reporting for the S&P500 sheds light on this issue: “Researchers also found a positive correlation between ESG score and how many metrics a firm disclosed, which supports their hypothesis that ESG scores don’t objectively convey CSR performance. Firms get a score boost for disclosing a greater number of metrics, but the score is not associated with the performance ranking of the firm within their industry.”
• NYU’s research which covered more than 1,000 research papers from 2015 – 2020 found:
  • “In reviewing over 1,000 studies published between 2015 – 2020, we found a positive relationship between ESG and financial performance for 58% of the ‘corporate’ studies focused on operational metric such as ROE, ROA, or stock price with 13% showing neutral impact, 21% mixed results (the same study finding a positive, neutral or negative results) and only 8% showing a negative relationship”

“Just 26% of studies that focused on disclosure alone found a positive correlation with financial performance compared to 53% for performance-based ESG measures (e.g. assessing a firm’s performance on issues such as greenhouse gas emission reductions). This result holds in a regression analysis that controls for several factors simultaneously. While what gets measured does matter, measuring ESG metrics without an accompanying strategy seems ineffective”

On voting: While shareholder resolutions have not been an effective tool on influencing sustainability-based behavior over the past decade, it appears that the momentum is shifting and ESG funds are a driver in that trend:

• I thought the findings from a Harvard professor’s analysis of more than 2,400 public-interest proposals filed over the past decade were interesting.
  • “in 38.8% of the cases management tries to exclude the proposal from the proxy material by seeking a no-action letter from the SEC. Management succeeds approximately half of the times (49.6% of no-action requests), while in the other cases either the proponent withdraws the proposals (26.6%), or the SEC rejects the company’s request and lets shareholders vote on the proposal (23.8%).”
  • “When the proposal makes it to the ballot (either because the management spontaneously accepts to include it or because the SEC rejects the no-action letter request), management virtually always recommends shareholders to vote against. Of the 1,614 proposals in the sample included in the proxy statement, management endorsed only one proposal and took no explicit position (neither in favor nor against) on a second proposal. For all the remaining 1,612 proposals, management invited shareholders to vote against.”
  • “Despite the opposition of management, public-interest proposals receive substantial minority support from shareholders and such support has significantly increased over the examined period. On average, public-interest proposals receive 21.5% of all votes for and against… average shareholder support has remarkably increased from 18% in 2010 to 27.6% in 2019”
• We’re starting to see the momentum change on this front. Morningstar last month published an article: The 2021 Proxy Voting Season in 7 Charts. While it’s a far cry from where we need to be, I think it’s reasonable to conclude that the momentum for these strategies is translating into incremental progress at the company level. Part of that stems from increased scrutiny and attention around ESG strategies in my view.
  • Vote results for the 2021 proxy calendar reflect a changed landscape. Average support across 171 shareholder-sponsored resolutions averaged 34%, roughly 5 percentage points above the previous high set in 2019.
    • Based on companies’ reported votes, 36 resolutions earned majority support―more than 20% of all E&S items voted from July 1, 2020 through June 30, 2021.
  • More ‘for’ votes from BlackRock and Vanguard may have substantially contributed to the rise in overall support―early disclosures indicate that their support for E&S issues is higher in 2021 than previous years.
    • From these early vote disclosures, there appears to be a discernable a shift in the voting stance of the largest institutional holders of U.S. public equities. In fourth-quarter 2020 Procter & Gamble (PG) was urged to strengthen efforts to prevent supply chain deforestation, and Oracle (ORCL) was asked to provide racial and gender pay gap reporting. Both resolutions were supported by BlackRock, Vanguard, and State Street.
  • The 26 climate-related resolutions saw average support rise to 51%, with 14 earning majority support. Average support for 34 diversity, equity, and inclusion resolutions was 43%, with nine passing.
  • A broad cross-section of investors, from individuals to large public pension funds, participates in the proxy process by filing shareholder resolutions. Thirty-eight resolutions that came to vote in the 2021 proxy calendar were filed by 16 different asset managers―all ESG asset managers with the notable exception of BNP Paribas and Amundi Asset Management, two large European asset managers.
  • Per the FT, Almost half of FTSE 100 companies have linked executive pay to environment, social or governance (ESG) targets as investors step up demands for companies to adopt these non-financial goals in the upcoming annual general meeting season.

Sustainable Investing Moving Forward: Given the continued corporate, regulatory, and individual interest in Sustainable Investing, it’ll remain important to stay abreast of the latest developments and have informed views on what companies are putting out there and whether its meaningful to their business models.

• The 2020 KPMG Survey of Sustainability Reporting revealed the continued growth of sustainability reporting among the world’s largest companies. While there remains a lot to be desired on mapping to materiality and cutting through the noise, reporting and datasets should improve as standards evolve and as more companies get their reports audited by third parties.
• Regulatory frameworks are coming. Europe (SFDR, EU Taxonomy, NFRD) is the furthest along but you’re seeing increased momentum in other regions as well (ex: Gensler Says SEC Climate Risk Rules Will Be Proposed by Year End).
• In Sep-20, the five global main global organizations (CDP, CDSB, GRI, IIRC, and SASB), whose frameworks, standards and platforms guide the majority of sustainability and integrated reporting, issued a statement of intent to work together towards comprehensive corporate reporting. We’d expect some level of standardization to materialize over the next few years as this work gets further along.
• The 2019 EY CEO Imperative Study states that 80% of CEOs believe government, business and the public will reward companies for taking meaningful action over the next 5–10 years.
• Sustainable investing goes far beyond millennials: “Although ESG is popular among millennials, ESG investing is being driven by the entire investor population.
  • Another interesting datapoint (but one that is climate-specific) that suggests that the interest spans across age groups: ~70% of adults across the US think corporations should do more to address global warming.