June 20, 2022

Why ESG is becoming a Bigger Deal for Investors

By Andrew Finkle, CPA, JD, LLM, Partner, Advisory Services

Why ESG is becoming a Bigger Deal for Investors Private Equity

When BlackRock CEO Larry Fink wrote his 2022 letter to CEOs, his company was doing well. BlackRock, with about $10 trillion in assets under management, reported a 20% increase in full-year revenue, record performance fees, and growth in technology services revenue, along with a 31% increase in full-year GAAP operating income and a 20% increase in diluted earnings per share. Not a bad year for BlackRock or its investors.

But Fink’s letter focused less on ROI and more on ESG (environmental, social, and governance). The company is attracting investment. At the same time, it is touting its ESG focus as good for its business and investors, although Fink more often discusses “stakeholder capitalism.”

“Our conviction at BlackRock is that companies perform better when they are deliberate about their role in society and act in the interests of their employees, customers, communities, and their shareholders,” Fink wrote. “In today’s globally interconnected world, a company must create value for and be valued by its full range of stakeholders in order to deliver long-term value for its shareholders.”

So if he is right that ESG is good for investors and society, then what is the state of ESG investing? Is it just marketing, or something more? ADEC Innovations, which specializes in sustainable practices, talks about the “ESG investing boom” and “organizational resiliency” in a world where “financial performance of organizations is increasingly affected by environmental and social factors.” But what’s behind all the hype?

ESG by the Numbers

The age of COVID brought a growing awareness of interconnectedness, and that is reaching investing. At the end of 2021, Reuters reported that a record $649 billion was “poured into” ESG-focused funds as of Nov. 30, up from $542 billion in 2020 and $285 billion in 2019, based on Refinitiv Lipper data.

“No matter how you slice and dice it, the ESG investing community is growing each month,” Refinitiv Lipper indicated last July in a piece entitled “ESG/SRI U.S. Funds Steadily Attract Inflows.”

Is there a correlation between companies that do “good” (or claim to do good) for the world and those that do well for Wall Street? The MSCI World ESG Leaders Index, a capitalization-weighted index of companies considered strong in ESG performance relative to their sector peers, gives some insight. In 2021, the ESG index reported gross annual returns of 25.29 percent, ahead of 22.35 percent for companies in general in the MSCI World Index, while the ESG Index rose 15.90 percent the prior year compared to 16.50 percent for the World Index.

The Big Picture

In case you think this ESG index is filled with small companies that bleed green, think again. Members range from Tesla (electric vehicles are environmental and economical) to Microsoft, Johnson & Johnson, Home Depot, and more. In the age of COVID, it may be fair to say ESG has moved into the mainstream — or rather, the mainstream has widened into a river that includes ESG as well as “responsible” and “sustainable” companies.

ESG has been getting mixed results in shareholder resolutions. Support is up, but these resolutions typically don’t pass, and even then, they are typically advisory. The echo of ESG is being heard in boardrooms, however, particularly as it relates to climate change. Activist hedge fund Engine No. 1 placed three new members on the 12-person Exxon Mobil board last year, pushing the company to better account for climate change in its business. That said, these board members are hardly extreme environmentalists. In fact, a strategist at Google’s owner, Alphabet Inc., and former U.S. Assistant Secretary of Energy won the fund’s third seat.

A Time of Transition

The automobile industry is rolling out electric vehicles as ESG and economics intersect. And ESG is becoming part of a second bottom line as economic, environmental and employees, ranging from diversity to benefits, factor into performance. Still, the “E” in ESG is getting much of the focus amid rising carbon emissions and climate change, while the “S” and “G” also attract some interest and action.

“Shareholders and stakeholders expect a transition towards more environmentally, socially, and economically sustainable business activity to support future generations,” according to ADEC.

With the focus on the environment come concerns over greenwashing. S & P Global writes that “Investors, regulators, and the broader public are exercising greater scrutiny of corporate sustainability efforts, calling out what they perceive as greenwashing.” ESG ratings include the Dow Jones Sustainability Index (DJSI), Morgan Stanley Capital International (MSCI), and FTSE4Good and ISS ESG solutions.

How Green is Your Company?

Organizations are weighing in on ways to evaluate ESG. The International Sustainability Standards Board (ISSB) was launched at the United Nations Climate Summit last year. And the International Organization of Securities Commissions published an environmental, social, and governance report with recommendations for regulators, plus ESG data and rating providers. According to S & P Global, “New global ESG-related standards will continue to evolve in 2022.”

Meanwhile, the U.S. Securities and Exchange Commission is working on clarifying ESG guidance and disclosures. Refinitiv Lipper may have hit the nail on the head with its report on growing ESG investment. There may still be some fog around ESG, but more sun appears to be shining in as ESG becomes a standard way to evaluate businesses while attracting investment and building goodwill.

“We certainly need more standards and transparency, both surrounding how companies report their ESG metrics and how individual funds choose to incorporate ESG analysis as part of their overall investment process,” Refinitiv Lipper wrote. “ESG data, at the very minimum, helps to paint a more complete picture of the overall standing of a specific company and fund.”