24 May 2022

The growth of ESG

A few years ago, I suspect that very few people would have understood what was meant by ESG and those who did probably saw it as an esoteric sub-group of marginal interest. Recently, there has been an explosion of awareness and it has moved into the mainstream consciousness, but there is still a lack of understanding and a long way to go before there is a universally accepted frame of reference.

Even for those who know that ESG is an acronym for Environmental, Social and Governance there is a lot of subjectivity in the way the term is understood.  It works as an umbrella term for many close relatives, including sustainable investment, socially responsible investment, impact investment, social impact investment, ethical investment, and even conscious capital, which each have their own nuances but are united by the common thread of embracing an approach that goes beyond the traditional 'bottom line' of shareholder returns.

Steve Denning, writing for Forbes notes that Milton Friedman, the darling of late 20th century capitalism and winner of the 1976 Nobel Prize for Economics is widely credited with cementing the idea that the sole purpose of a firm is to make money for its shareholders.  For him, the free market would regulate itself, and bureaucracy, red tape or factoring anything into the corporate process other than price would simply make the process inefficient and reduce the pot of money available to shareholders. As Denning notes, the views expounded by Friedman from the early 1970s paved the way for the era of Reagan, Thatcher and free market opportunism, and a portrayal of Wall Street in the 1980s as a world where greed was lauded. [1]

It was in this world of extreme capitalism that Jack Welch, who became General Electric's (GE) youngest chairman and CEO in 1981, led the organisation (according to its website) from a market capitalisation of around US$12 billion to over US$400 billion by the time he retired in 2001.  Yet in a 2009 interview with the Financial Times, Jack Welch claimed that: "On the face of it, shareholder value is the dumbest idea in the world." 

This is in line with a wider realisation that the way this 'shareholder value' mentality was being implemented was not sustainable beyond a short investment horizon.

At the risk of oversimplifying, if you think of a bay where one hundred fish are caught every day, many years ago there would have been no means of knowing at what point there would start to be a decline in fish populations. And often-times it would not have mattered because the bounty of the sea was sufficient to supply whatever humanity needed from it. But as the human population has increased and fishing methods have become brutally efficient it has become increasingly clear that fisheries businesses need to consider the natural capital aspects of their operations. The fishing industry in the bay needs to understand what is sustainable and may need to choose between a hundred fish a day for three years followed by nothing when the stocks are depleted or twenty-five fish a day for an indefinite period.

In the Channel Islands, work by the pensions sub-committee of the Guernsey Green Forum - an informal association of employers in the Bailiwick - has recently identified that there are billions of pounds in Guernsey pension pots that could be nudged into more ESG-centric investments simply by offering contributors the option to self-select their investment schemes. How many people reading this article will know where their pension contributions are invested? How many would be comfortable if they knew that their funds were invested in tobacco companies? How many readers will make a note to themselves to go and check on their personal pensions after reading this article? 

Trustees of pension schemes need to keep their finger on the pulse, to sense the mood of contributors who are increasingly taking an interest in understanding where their pension monies are being invested and who, anecdotally, seem to be increasingly willing to accept smaller returns in exchange for a higher threshold in the ESG stakes. 

What Is ESG?

As already noted, there are a lot of theories around the meaning of ESG, but what unites them is that they can all be placed as counterpoints to capitalist theory in its purest form. It can be helpful to think of the various sub-group terms as being part of a spectrum. At one end is impact investing, which because it focuses on an altruistic outcome (e.g. raising standards of living or increasing gender equality) rather than seeking the maximum financial return, can feel more like a charitable donation than an investment in the conventional sense of the word. On the other end of the spectrum there are categories like sustainable investment, which might still have financial returns as their guiding principle, but allow more scope for negotiation in implementation. Investors might be willing to limit the investment opportunities available to them by restricting the investments they are willing to select. That may also entail being happy to accept a smaller return in exchange for greater ethical accountability.

In a world of exponentially increasing options, blended solutions can also be attractive for those wanting to make their money work for good whilst not necessarily wanting to simply give it to charity. This is especially so for those who can sit within the category of patient capital. A tobacco farmer may wish to stop growing tobacco for ethical reasons, but may be prevented from taking risks with her business model by being tied into long-term contracts or having families who depend on her existing farming operations. She might also not be able to persuade a traditional lending bank to fund a transition to an alternative cash crop that could take a decade to implement and have no guarantee of success.

This might suit a private wealth investor who is interested in helping such a transition and who can take a long-term view. A few years of impact investment (which feels very close to an outright donation) might be followed by a few years of low returns, followed by an investment on full arms-length terms.

Such a high-risk approach might not work for a pension trustee, unless the trustees were given a specific mandate to do so by contributors, but it might work if the pension fund happened to own a tobacco farm that it wanted to transition.

Ultimately it depends on the circumstances, but ESG can align well with pension funds and family offices which both have long-term investment horizons.

You may have noticed that in the title I referred only to 'ESG' and not 'investing' - although often the two are linked. I think it is important to note that it is not just business being undertaken on behalf of clients, but a way of life, a system and an approach. Trustees will want to demonstrate that they walk the talk if they want to attract the increasing number of clients with ESG objectives. They will also need to do so to attract new talent in a world where employees are increasingly informed and selective about the employers whom they are willing to work for.

Why Is ESG Increasing?

There is a real convergence of influences driving the rise of ESG. 

Technology is improving all the time. This increases the possibilities in almost every aspect. It means that transaction costs can be lowered, crowdfunding and the like become possible without the need for high entry level thresholds, reporting and monitoring become more sophisticated, cheaper and easier to deploy; and blockchain can be used to monitor the integrity of supply chains.

Demand is increasing. As public awareness grows about the extent of the negative impact human behaviour is having on the environment and the imminence of the point of no-return increases, more and more people are thinking carefully about how their lives contribute to the global picture and how small changes can make incremental changes. And whilst the Environmental 'E' tends to overshadow the 'S' and the 'G', we should not forget the importance of the other two strands nor that there are often unexpected crossovers; women's education, for example, is one of the single greatest contributions that can be made in the battle to tackle climate change.

The clincher however – and the main reason that ESG will ultimately continue its exponential growth – is the growing body of evidence that investments with good ESG credentials tend to outperform those with less impressive ESG credentials when measured over a longer-term investment horizon. If it makes commercial sense it will be here to stay, and the greatest challenge in the mid-term will be sorting out the genuine ESG credentials from the bluster and false claims.

When Jack Welch said: "On the face of it, shareholder value is the dumbest idea in the world", he went on to say: "Shareholder value is a result, not a strategy ... your main constituencies are your employees, your customers and your products [2]."

When you look after all these components, the ESG business case writes itself. And when there is a business case, you're cooking with (insert non-fossil fuel solution of your choice).


[1]   Guerrera, Francesco (March 12, 2009). "Welch rues short-term profit 'obsession'". Financial Times. Retrieved March 12, 2009

[2]   Steve Denning writing for Forbes in an article published online on 26 June 2013 and entitled "The Origin Of 'The World's Dumbest Idea: Milton Friedman"


An original version of this article was first published by IFC Review, April 2022. 

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