The Next Step for ESG Investing: Moving from What and Why to How

March 5th, 2010
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Contributed by: Daniel T. Allen, Ativo Capital Management LLC
The implementation of Environmental, Social and Governance (ESG) factors has evolved to a point where it may be possible to begin to develop standardized principles and methodologies that quantify ESG results. These results are the manifestations of efforts by companies to improve performance long term by becoming increasingly sustainable. This development would represent the critical “how” component of the process.

To date, a great deal has been made of “what” needs to be done and “why” it needs to be done but the difficult challenge of addressing how to quantify ESG criteria has largely been ignored. The United Nations Principles for Responsible Investing (UNPRI)(1) has become perhaps the most visible framework intended to describe the general recognition that ESG factors represent risk factors that must be adequately addressed and provide an overarching framework to address what needs to be done. The importance that the market places on ESG becomes obvious from the large number of major signatories to the UNPRI process.

ESG Overview

Globally, there has been an accelerating public consciousness that simply using traditional financial metrics are not adequate investment criterion and institutions and individuals have become increasingly interested in the risks associated with the behavior and values that are manifested by business entities. According to Business for Social Responsibility (BSR), “The global financial crisis of late 2008 has led to intense scrutiny of the foundational beliefs and basic structures that underpin current global markets and investment models.”(2) This trend is confirmed through the broad calls for greater disclosure and accountability, and the market’s growing recognition that there is a significant demand for ESG products and services. The demand is particularly high in Europe, but growing rapidly in the United States, Canada and other markets.

ESG Investing has been primarily the provenance of institutional investors where ESG criteria are often considered a metric to illustrate quality management and a commitment to long-term sustainability. Socially Responsible Investing (SRI) contrasts to ESG investing in that it is typically retail oriented and takes a narrower, more exclusionary approach focused on the “rights and wrongs” of various actions.

This institutional orientation is borne out through examination of ESG/SRI invested assets. According to the Social Investment Forum, in 2007, $2.7 trillion in Assets Under Management(“AUM“) was managed in the United States using some aspect of ESG/SRI principles. Of that less than $200 Billion was mutual funds, closed end funds and ETFs and less than $3 Billion in separately managed accounts.(3) The remainder was in institutional accounts.

Institutional investors tend to take a longer term view of investing and are interested in the sustainability of companies. Effectively dealing with ESG issues is fundamental to a company being sustainable. The classic definition of sustainability as, “development that meets the needs of the present without compromising the ability of future generations to meet their own needs”(4) is accurate but may be insufficient as it does not clearly address the financial or economical imperative of a business’s operation. George P. Nassos, Director - Environmental Management and Sustainability Program & Center for Sustainable Enterprise at IIT Stuart Graduate School of Business summarizes it like this, “"For long-term investors, it is imperative to look for companies that are truly sustainable -- environmentally, socially and economically… these companies will provide the best long term return for their shareholders and, at the same time, will be able to sustain their competitive position.” It is the marriage of strong ESG fundamentals with strong financial fundamentals that truly makes a company sustainable.

Background of ESG

The roots of ESG Investing can be traced back to early efforts at Socially Responsible Investing (SRI) started by religious organizations such as the Quakers which established restrictions on investing. In the early to mid-1700s, Quaker church members were prohibited from participating or investing in the slave trade or providing any support for the ability to wage war. John Wesley (1703-1791), founder of the Methodist Church, preached in his famous Sermon 50, “The Use of Money,” that we must be moral in all dealings with money so that we might “gain all we can without hurting our neighbour.”(5) Wesley recognized that there was a component to an investment’s value that went beyond the financial metrics. He defined it in moralistic terms. Throughout the 1800s and early 1900s, religious investors were encouraged to avoid what was considered to be “sinful” investments in guns, liquor, and tobacco. This continued to be the main thrust until the 1960s when, during the Civil Rights Movement, Dr. Martin Luther King, Jr. in his August 1967 sermon, Where do we go from here?, began to call for the use of economic power as a means to create pressure for social change.(6) The idea expanded into the anti-war movement of the day, and investors who opposed the Vietnam War began to avoid investing in companies that were supporting the war effort.

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Related People: Christopher Brown; Jack Corbet*; Joseph Keefe; Julie Gorte; Luther Tyson*
Related Entities: Pax World Funds ; Pax World Global Green Fund; Pax World International Fund; Pax World Small Cap Fund; Pax World Growth Fund
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