LIDO INSIGHTS | Why ESG investing is a megatrend
By: Gina Sanchez, Chief Market Strategist
Megatrends have been around since the beginning of time, though it wasn’t until 1982 that John Naisbitt gave the phenomenon a name in his bestseller of the same name. There is no single enduring definition of a megatrend, but I would argue that such trends are disruptive phenomenon created by human activity that force innovation and are measurable over time. Though there are many megatrends within this broad topic of sustainability, the fact is that there is no doubt that over time, some if not many companies have utilized public resources as well as created environmental and social damage with minimal economic consequences in pursuit of shareholder value, with less regard for other stakeholders including employees, vendors, customers, and communities. Moreover, the trend toward deregulation in the United States for the last five decades has emboldened this problem of corporate accountability. The damage wrought over time has created an imperative to measure the impact of corporate activity with the goal of creating accountability for negative impacts. Socially responsible investing was naturally born out of this imperative as investors have grown wise to the notion that unpriced risks resulting from poor corporate governance can have sudden and devastating impacts to corporate value when sentiment changes or disclosure occurs whether voluntary or through investigation or legal action.
The roots of the modern sustainability megatrend start on December 10, 1948, when a newly created United Nations (UN) published the first “Universal Declaration of Human Rights” in Paris. Though it would take nearly 40 years of work and advocacy on various topics from racism to women to achieve the next meaningful milestone in 1992: the adoption of the “Agenda 21” to achieve sustainable development in the 21st Century. A decade later in 2002, the UN convened the World Summit on Sustainable Development in Johannesburg with goals to reduce poverty and protect the environment. Shortly thereafter, the United Nations formed the Principles for Responsible Investing (UN PRI’s) and began seeking signatories in 2005 to encourage investors to hold businesses accountable to these new goals. It would take over a decade to finally coalesce into the “Sustainable Develop Goals” in 2015 which have evolved into the seventeen sustainable development goals we all aspire to today. And, in the meantime, by March of 2020, 3038 signatories had signed on to the UN PRI’s representing $103 trillion in investment assets.
Meanwhile, the investment landscape has also evolved over an even longer time horizon with the earliest documentation of ethical investing captured as early as 1500 BCE in the Pentateuch, or the first five books of the Bible, which laid out the Tzedek in Jewish Law which means “justice and equity” and is a set of rules meant to correct the imbalances caused by human activity. The Tzedek applied to every aspect of life, including government and the economy and ownership under these rules not only conferred rights but also responsibilities to prevent harm. Around 600 CE, established guidelines based on the religious teachings of Islam in the Qur’an which have now evolved into Shariah-compliant standards which have an overarching goal of Riba, to prevent exploitation and is rooted in a philosophy meant to govern the relationship between risk and profit. In the United States, the socially responsible investing traces back to the 18th Century when Methodists, an offshoot of Protestants, stood against slavery, smuggling, conspicuous consumption and companies manufacturing liquor, tobacco or promoting gambling. This was followed by the Quakers, another Protestant offshoot, who stood against slavery and war and eventually resulted in the first Socially Responsible Investment (SRI) fund in 1928, the Pioneer Fund, a fund that excluded “sin” industries. Today, these funds exclude alcohol, tobacco, gambling, sex-related industries and weapons manufacturers. Assets in SRI ramped up in the 1960’s when Vietnam War protesters demanded University Endowments to divest from defense contractors. In 1977, Congress passed the Community Reinvestment Act, which forbade discriminatory lending practices from low-income neighborhoods. In 1985, Apartheid in South Africa resulted in $625 billion in investments to be redirected away from South Africa by 1993. However, until that point, SRI primarily meant divestment of companies and exclusion is the primary investment method that is most associated with sustainable investment.
However, much has changed since the early 1990’s and investment processes have evolved from simple screening and exclusion. Thanks to increased and improving disclosure requirements as well as increased ratings scrutiny, SRI has evolved into the current iteration of sustainable investing: Environmental, Social and Governance (ESG) Investing, which derive their name from the categorizations of metrics included in corporate disclosure. Currently, there are multiple ways to assess risks and build portfolios that aim to increase positive social and economic impacts while aiming to limit the risks of negative social and economic impacts:
- Positive Selection: seeking companies with best-in-class ESG ratings or metrics
- Activism: using shareholder proxy voting to influence changes in the governance of a company
- Engagement: publicly engaging with corporate leadership to seek changes
- Consulting: privately engaging with corporate leadership to seek changes
- Exclusion: screening based on ESG metrics or ratings
- Integration: inclusion of ESG metrics as determinants of equity value and risk
While each of these approaches has strengths and weaknesses and the SEC is still a long way off in defining and mandating comparable disclosures in financial reporting on ESG metrics and factors, the landscape for sustainable investing has grown exponentially in the last decade with global sustainable fund hitting $1.65 trillion in assets under management by the end of 2020. When combined with thousands of investors and asset managers who have committed to building processes to hold companies accountable, it is not a matter of if but when sustainability is integrated into mainstream risk evaluation and as well as value creation. But, for now, the level of innovation arising from the multiple crises of climate change, social justice and shareholder primacy in corporate governance, just to name a few, has created an arena for investments unto themselves. There is as much potential in investing in solving sustainability problems as there is avoiding the companies causing the problems. This megatrend that has been years (or centuries) in the making has the potential to create significant wealth for forward thinking investors.
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