With over $7 trillion in assets under management, BlackRock is the world’s largest investment management firm. So, when BlackRock CEO Larry Fink released his annual letter to CEOs, Wall Street reacted intensely. The letter was about risk and “the fundamental reshaping of finance.” Through this lens, Fink addressed climate risk and “sustainable” capitalism. BlackRock looms large on Wall Street, so Fink’s letter was a milestone in the push towards ESG investing, that is, using environmental, social, and governance factors to value an investment. Using ESG factors in valuation has become increasingly prevalent for two reasons. First, more investors see themselves as activists who can use their money for social and global good. Second, and perhaps more importantly, investors believe that using ESG factors in investment decisions is profitable.
When investors demand social responsibility and invest with ESG factors, they pressure companies to institute plans for a sustainable future. If firms do not comply, they will lose important streams of investment revenue. This was the reason Larry Fink’s letter created such a stir on the Street. BlackRock owns huge portions of shares in the world’s biggest companies, so they have substantial power as a voting stakeholder. This potential means that BlackRock and asset managers with similar ESG frameworks can vote out boards who are not dedicated to social responsibility and fair corporate governance. The limitation is its fiduciary status: BlackRock’s assets are not its own and must defer to the individual investor. However, the next generation of investors is more devoted to values-based investing. A 2019 survey released by Morgan Stanley found that 95 per cent of millennials are interested in sustainable investing, and $13.47 billion flowed into sustainable funds in 2019, up from just $5.48 billion in 2018. Investors clearly have an appetite for sustainability in their financial investments.
Investments are about minimizing risk while maximizing returns. As Fink put it, “climate risk is investment risk.” For example, if climate change causes dangerous weather patterns and more frequent or severe weather activity, then mortgage and home insurance companies will find it more difficult to shift risk away from their portfolios. The results are untenable investment decisions. However, every investment risk can also be an opportunity. By pouring money into funds that are insulated against ESG risks, long-run returns can be higher than otherwise possible. This profit potential is the logic behind ESG investing and is why it is important for investment firms to fully adopt ESG as an important and necessary pivot toward the future. Even the most selfish investor, who turns a blind eye to environmental destruction and social injustice, will want to implement ESG factors as a purely financial decision.
Recent wildfires in California illustrate the difficulty that some firms face in shifting risk away from their portfolios. Pacific Gas & Electric bears responsibility for over 1500 fires in California in the past few years. California Governor Gavin Newsom charged the enormous utility with privileging profit over safety measures, and PG&E filed for bankruptcy in 2019 for the second time in under 15 years as it faced blackouts, soaring debts, and public criticism. In a letter to the CEO of PG&E, Governor Newsom wrote “PG&E caused extreme uncertainty and harm for Californians who rely on power for their health care and for their livelihoods…PG&E has simply violated the public trust.” The company was aware of the safety risks in its transmission lines that sparked fires. Without a robust ESG policy in place, PG&E failed to properly prepare for inevitable fires, which were exacerbated by climate-related drought.
Some issues with ESG include the criteria ESG funds use to evaluate investments. For example, if a fund claims to use ESG but invests in coal and oil, is it actually a socially responsible investment? Investors who buy exchange-traded funds, which group funds into a single investment vehicle that can be traded like shares, can claim to be ESG-friendly when, in reality, the underlying portfolio contains problematic shares. BlackRock’s own iShares ESG MSCI USA ETF seeks to obtain “exposure to higher rated environmental, social, and governance (ESG) companies while accessing large- and mid-cap U.S. stocks.” Yet, the underlying portfolio contains companies like oil-and-gas giants ExxonMobil and Chevron, as well as the controversial drug-maker Pfizer. The lack of clarity over what exactly constitutes a socially responsible company or fund is a persistent problem for ESG investors. Funds certainly exist that use ESG factors as a marketing gimmick instead of an honest investment philosophy. Any solution to this problem must include government-mandated disclosure frameworks and industry-standardized ESG metrics. Private frameworks like the Sustainability Accounting Standards Board (SASB) and Task Force on Climate-related Financial Disclosures (TCFD) could act as foundations upon which government entities can develop full disclosure mandates.
ESG investing yokes an investor’s moral values with financial value. ESG factors are expected to behave like other financial factors. Investors use factors to predict future growth and seek alpha, the excess return of an investment relative to the return of a benchmark index like the S&P 500. Non-ESG factors, like size (small-cap stocks tend to outperform large stocks) and momentum (the inertia that causes winners to keep winning and losers to spiral further), have been demonstrated empirically, but there is a lack of academic research on ESG factors. The assumptions behind ESG investment strategies are sound, and the materiality of ESG factors will likely be borne out in the research in coming years.
Large companies are leading the charge. For instance, Walmart has already implemented strategies to achieve an 18% emissions reduction in operations by 2025 and 11% between FY 2017-2019, saving $140 million in efficiency costs. This move is primarily a financial decision that has a material financial impact, but it also falls under an ESG management framework. Considering ESG data can no longer be optional for investment managers. Investors demand these considerations and financial fiduciaries are obligated to invest their investors’ assets responsibly. Managers who do not consider ESG factors are a dying species; extinction is the necessary next step if financial advisors want to step into the future with confidence. In order to proceed with caution as well as confidence, universal standards must be enacted to accompany the new investment model.
Photo: Image via Flickr (Oregon Department of Agriculture)