Benefits and potential limitations of ESG investing

Investment decision-making has long revolved around two key factors: returns and profits. But during the past couple of decades, additional factors have begun to influence those decisions. Due to the rise of environmental, social and governance (ESG) investing, many now use a socially-conscious set of guidelines to pick potential investments.

ESG investing has solidly entered the mainstream in the past several years, leading companies to adjust their financial reports and long-term goals to reflect the company’s desired impact on the environment and society. According to a 2022 study published by the Harvard Law School of Corporate Governance, about 28% of investors surveyed considered ESG “central to their investment approach” — up from 26% the year before. Bloomberg Intelligence reported that ESG spending may surpass $41 trillion in assets by 2022 and $50 trillion by 2025, one-third of the projected total assets under management globally.

ESG investing is big business, but what exactly is it? You may recognize it as corporate goals around the environment and society, such as decarbonization, employee benefits, or improvements to diversity, equity and inclusion. The ultimate goal of ESG investors is to encourage companies to drive initiatives that benefit society, in addition to the bottom line.

“I remember making our first investment in renewable energy in 1982, but it’s just become much more relevant now,” said Mick Kane (Accounting ‘91), a partner at Deloitte. He leads the firm’s global sustainability practice for tax. “In the past few years, we’ve invested heavily in this space, and we see it as a major initiative going forward. It’s important to more investors and our clients, and we want to make sure that we’re there to help serve them.”

HOW DOES ESG DRIVE BENEFITS TO SOCIETY?

The key to ESG investing is holding companies accountable for their long-term environmental and societal goals. And that’s important, Kane explains, because it provides these companies with tangible drivers behind efforts meant to benefit society. Kane spends a lot of his time with companies that have specific goals, like becoming carbon-neutral by a certain date. These commitments require significant financial investments — decisions that may have been dismissed if not heavily pushed by investors and customers.

“Investors really bring it home because companies are looking for that return on investment, even if it may hinder their operational results. And companies do this for good reason, to benefit stakeholders and their returns,” Kane said. “At the end of the day, companies have to accomplish these publicly stated goals because they don’t want to be left in the dust by other companies. And customers and investors won’t want to do business with them.”

Companies around the world are taking notice and taking steps to publicize their progress. According to research from McKinsey, more than 90% of organizations on the S&P 500 publish ESG reports, as do about 70% of companies on the Russell 1000 index. The main driver has historically been an environmental component, like decarbonization, reducing water usage and more, but other parts of the equation have become more prominent. In 2021, McKinsey discovered that proposals related to social issues increased by 37% compared to the previous year.

ESG examples have made big headlines in recent years. When Russia invaded Ukraine in early 2022, companies around the world pulled business from the country in protest. After the George Floyd protests in 2020, there was a larger focus on diversity, equity and inclusion among corporate leadership and the workforce.

“Investors want to find good companies, sustainable companies to invest in,” said Lei Wang, assistant professor of accounting, who has conducted multiple studies around ESG investing.

“ESG performance is a good indicator of a healthy company, and it helps investors make decisions. My research has shown that the disclosure of ESG information can increase investor confidence in firms and the market. The benefits are there for everyone — society, companies and investors — if it’s done properly.”

WHAT ARE THE LIMITATIONS TO THESE ESG BENEFITS?

ESG investing does come with potential limitations around profitability and accurate reporting. Many ESG goals can be tough to quantify, and there’s a lack of standardized reporting. For example, hiring a more diverse workforce could be defined in many different ways. What qualifies as diverse? How will these hires have the most impact? How do you report progress?

Ryan Flugum, assistant professor of finance, has researched ESG and its effect on long-term profitability. Reviewing company earning calls, he and his team found that ESG can be used as a talking point to cover for financial losses or other negative trends. A key solution would be to implement standardized reporting for major companies.

“It’s so hard to actually see if companies are following through on these stakeholder initiatives,” Flugum said. “CEOs seem to realize this, and so they adopt this positive ESG narrative, when they aren’t necessarily performing well in traditional shareholder metrics. So, you’ll have firms who share this positive message, even if they miss earnings, but they’ll drop that message if they met earnings. Sometimes it can seem like lip service, rather than delivering results for stakeholders.”

Changes seem to be on the way. In 2022, the European Union passed legislation requiring all large companies to standardize and “disclose information on their risks and opportunities arising from social and environmental issues, and on the impacts of their activities on people and the environment.”

The U.S. Securities Exchange

Commission is also in support of improving disclosures for ESG investing. These efforts seem to complement databases maintained by various entities, such as ESCI’s or Bloomberg’s ESG ratings.

“In the United States, nothing is mandatory, but some things do feel mandatory because investors demand it. Things like the Carbon Disclosure Project or United Nation’s Principals for Responsible Investment,” said Madeline O’Donnell (Finance, Real Estate, Spanish ‘17), commercial real estate ESG analyst for Principal Asset Management in Des Moines. “Those are already mandatory for us at Principal and those in Europe, and I think more ESG investors will be aligned on what should be and is being reported.”

Just like measurability, longterm profitability can be hard to quantify because large-scale adaptation of ESG is a relatively recent development. Accounting firm PwC found that 60% of ESG investors have reported higher performance yields, compared to non-ESG equivalents.

Despite this report by PwC, data has been mixed as to whether ESG investing provides a sufficiently secure way of maximizing investment returns. “I don’t believe there is enough evidence at this point to suggest that these types of policies are worthwhile,” Flugam concludes.

WHAT DOES THE FUTURE LOOK LIKE FOR ESG?

ESG investing doesn’t seem to be disappearing any time soon. Despite mixed evidence that ESG investing leads to higher returns for stockholders, Bloomberg reports that 41% of global business leaders surveyed expect sustainable investments to increase by at least 20% over the next five years. 71% of those leaders say eventually no investment decisions will be made without considering ESG.

Government regulations will impact company ESG goals as well. More countries are moving toward greener policies, which heavily influences the environmental part of the ESG equation. Conversations around climate change have only exacerbated these efforts.

On the other hand, there is pushback against investment decisions dominated by ESG. Some state and local governments expect that state and pension investment decisions be driven by the fiduciary responsibility to maximize returns for shareholders alone and not take into consideration ESG goals.

Kane believes as younger investors, which are typically more socially and environmentally conscious, enter the market, ESG will be one of their biggest priorities and potentially be willing to accept lower returns as long as those investments represent their values. That could lead to a bigger ESG effort for years to come.

“Companies are taking position today in order to make sure they’re aligned to where they think the future will be,” Kane said. “And they see the importance of ESG with their customers, their boards, their employees, and particularly their investors, I just don’t see that dropping off going forward.” BIZ