Benefits of ESG:Creating a More Sustainable andProductive BusinessAbstractThis paper defines the concept ofESG, Environment, Social, and Governance, and examines the benefits of itsimplementation within corporate governance and investment strategy. It supportsESG as a key component for the promotion good management and responsibilitywithin a company, as well as its use as a significant valuation in identifyingrobust, sustainable companies for investment opportunities. It is the opinionof this paper that the SWIB would stand to benefit from implementation of ESGprinciples in its governance because such principles help create a better workenvironment, a happier and more productive workforce, and promoteaccountability and transparency at all levels of management.ThesisEnvironment, Social, and Governancecriteria (ESG) is a set of guidelines and best practice principles that helpinvestors valuate an investment utilizing criteria that fall outside of thetypical financial related factors, mainly: environmental impact andsustainability; social consciousness andcommitment to ethical business practices concerning the fair treatment of itsemployees, customers and community; and accountability/transparency of itsmanagement and commitment to the rights of its shareholders. ESG allowsinvestors to find more profitable and sustainable investments as its focus onthe long term sustainability of a business and its commitment to ethicalpractices and social awareness, as well as its emphasis on the relationshipbetween a business and its community, promotes the long term health of aninvestment as well as a more resilient and sustainable economy as a whole.Overview and Core PrinciplesThe basics of ESG have arguablybeen around for as long as our ancient ancestors first began trading with oneanother. At its core ESG promotes basic human decency and dignity within thebusiness process; however, a more concrete definition of ESG and the implementationof its principles arose during the twentieth century.
With the rapid globalization of theworld economy in the decades following the Second World War, a business’s roleas a global citizen and its impact upon society and the planet began to come tothe forefront of its operations. The deeper integration of companies withinsociety brought on by the increased globalization necessitated that businessesbecome more socially conscious and mindful of their impact or risk the ire of amore effective, globalized society. One key example of this is the almostuniversal adoption of the Sullivan Principles and the disinvestment fromapartheid South Africa in an effort to bring an end to the discriminatory andoppressive regime. Leon Sullivan was acivil rights activist and the first African American board member of GeneralMotors (Lewis). Using his position, Sullivan pressured almost every Americancompany doing business in South Africa to disinvest unless the South Africansagreed to the adoption of the seven principles regarding the end to segregationand equality within the workplace, collectively called the Sullivan Principles(Lewis). This pressure was one of the deciding factors that brought about theend of the apartheid regime and stands as a pivotal example of the power acompany can possess when implementing ESG principles.Likewise as our society continuesits rapid globalization and we become ever more socially conscious, it isincreasingly necessary for companies to implement principles and operatingethics that adhere to ESG or be left behind in our ever advancing economy. Increasinglythe public is more aware and critical of businesses that are deemed to not havesociety’s best interest at heart.
Likewise, the benefits of adopting ESGprinciples are becoming ever more pronounced as the public has ever increasinginformation on a company’s operations and is increasing willing to reward thosecompanies which take those principles to heart. Examples of this can be seenalmost every day. One only needs to lookat the increasingly devastating divestment campaign against large banks, mostnotably Wells Fargo, as more and more cities, such as Seattle and SanFrancisco, are pulling out their funds due to public outrage caused by thedishonest and unethical practices of those banks (Tobias). Furthermore, astechnology gives rise to ever greater consumer choice, customers are increasinglysearching for platforms and products that allow them to express their socialconsciousness and activism with their investment choices. A clear example ofthis is the rise of micro-investing apps, such as Stash, that allows customers to invest in funds and ETFsspecifically oriented around ESG ideals, such as environmental sustainabilityand the reduction of climate change (Stash).
Clearly, it is becomingincreasingly necessary for business to implement these standards into theirbusiness practices. That being said let us examine the core tenants of ESG morein-depth.The first tenant of ESG isEnvironment. The Environment factor is used to measure a company’s overallcommitment to creating a “greener” world as well as minimizing its toll uponour natural resources and ecosystems. This measure can include any number offactors such as a company’s commitment to combat climate change through variousmeans, such as reducing its carbon footprint through development of moreefficient and less resource intensive machines and techniques; it could includehow much pollution a company produces as a byproduct of their productionprocess, i.e. toxic/nuclear waste; or even it could include whether a companytests its products on animals.
Any number of factors can weigh in on thismeasurement and they can be used as a valuation of that company’s worth/futureincome. For example, one major concern for many environmentalists today isnuclear waste. Currently in the United States there are over seventy-onethousand tons of nuclear waste siting in temporary on-site storage facilitiesacross America (LastWeekTonight). Currently there is no permanent solution tothe disposal of this waste, thus it must sit in what is practically a temporaryholding site at each plant indefinitely (LastWeekTonight). This is majorconcern for environmentalists because these sites are historically prone toleaks. This is one of the reasons why many people no longer view nuclear poweras the savior we once thought it was.
Following ESG principles, it is clearthat the environmental impact caused by nuclear power is still too great toimplement on a much greater scale and thus causing one of the reasons for themarket’s continued reliance on fossil fuels as the primary power source. The second tenant of ESG is Social.The Social factor is used to measure a company’s commitment to social consciousnessand its role as a member of its community be it local, national, or global.Following the Social aspect of ESG a company must commit to promoting diversityin its workforce and management. It must show a commitment to human and civilrights and actively combat discrimination. Finally, it must uphold consumerprotections and understand it has a responsibility not only to its profits, butalso the community it inhabits.
A company following good ESG practices willactively donate to charity or host volunteer events. It must seek to not standapart from its community, but rather actively work towards its benefit and its sustainabilityfor everyone. Also it must apply these principles to its own operations, suchas: being cognizant of its supply chain and taking responsibility for everyfacet that goes into its product; as well as promoting a healthy and safe workenvironment and not just physical health, but also mental and emotional healthas well. All these practices help create a healthier and overall more stablebusiness, leading to a more sustainable investment.The last tenant of ESG isGovernance. The Governance factor is used to measure the accountability andtransparency with which a company is managed. It can include but is not limitedto: transparent accounting practices, management structure and power sharing,fair executive compensation, and the protection of shareholder rights.
Allthese practices help promote good governing ethics as well as reduce theprinciple-agent problem. They are essential for the efficient management of abusiness and are the core principles that help reduce corruption and waste.Each aspect of ESG helps make abusiness that implements them stronger and more sustainable in the long run.This will in turn make those businesses that make a commitment to good ESG practicesa more sound investment for potential investors and promote a more stableeconomy as a whole.Performance Impact of ImplementingESGOne of the main criticisms of ESGis that investors should care solely about maximizing returns when selectinginvestments. Opponents of ESG put forth that investors should act solely intheir self-interest or the interest of their contributors. Furthermore, someeven go so far as to state that acting in any way with a more socially mindedmindset, rather than solely the self-interest of their contributors, goesagainst an investor’s fiduciary responsibilities.
These opponents believe thatconsidering anything other than the purely financial factors when choosing aninvestment will ultimately lead to lower returns, to the detriment of theircontributors; however, there is ample evidence that suggest the contrary ofthis sentiment may be true.First let’s examine the Dow JonesSustainability Index. The DJSI is one of several indices created by S&P DowJones with the intent to provide investors with an index fund of the mostsustainable companies in the world across every industry (DJSI). S&P DowJones, in conjunction with RobecoSAM, index the most sustainable companiesaccording the key principles of ESG, mainly surrounding environmental andsocial criteria (DJSI). The fundamental principle behind the DJSI is to providean index that utilizes core ESG principles in the belief that such companiesthat operate by these sustainable practices will provide stable long termreturn on investment.
When comparing the DJSI to the standard Dow JonesIndustrial Average the results are fairly promising. The DJSI tends to be onpar with DJIA in terms of yearly return on investment, and notably outperformedit in the recovery after the 2008 financial crisis (chart 1). Of course theDJSI is considerably smaller in terms of number of represented companies andsignificantly less valuable than the DJIA, sitting at just fifteen hundreddollars whereas the DJIA is hovering around twenty-five thousand dollars as ofJanuary 8, 2018 (FRED).
These factors of course can lead to higher statisticalerror and variance with in the data set. However, the data suggests that in thelong term, the DJSI tends to trend on par with the larger market giving thoseinvestors which are more conscientiously minded a reasonable alternative.Secondly, there are numerousacademic studies that support the claim that companies that have good ESGpractices tend to have higher returns and earnings. One notable study is oneconducted by Professor of Finance at the London School of Business, AlexEdmans. Edmans focuses on social responsibility in investing, has taught atUniversity of Pennsylvania’s Wharton Business school, published severalacademic papers, and been feature in several TEDx talks (Edmans, Homepage).
Edmans 2008 paper entitled, Does theStock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,compares Fortune magazine’s 100 Best Companies to Work For to eachcompanies’ respective industry benchmark index over the period of 1984-2009 (Edmans1). His findings suggest that companies that practice good ESG principles andhad a high degree of employee satisfaction tended to generally do better thantheir respective industry benchmarks (having on average a statisticallysignificant 2.1% higher alpha than the benchmarks) (Edmans 2). Edmans goes onto speculate that these higher returns could be linked to two key factors: theattraction of greater human capital and a reduction of the principle-agentproblem (Edmans 2).
Both these factors are directly linked with ESG. Thereduction of the principle-agent problem being explained by the increasedaccountability and transparency in management in companies with good ESGpractices. The attraction human capital can be explained by the more stable andsustainable work environment created by ESG principles. The less turbulent andmore comfortable a work environment is the more likely people will want to stayat said work place, preventing a knowledge drain; and following that as otherpeople hear about the better workplace the more people will want to join saidcompany, giving the company a large pool of labor to choose from, allowing itto pick the best candidates.Edmans study clearly shows thebenefits of good ESG practices. In creating more efficient and sustainable workenvironments, companies can improve their overall business by keeping theirworkforce happy and productive, which in turn leads to higher returns forinvestors.
ESG and the SWIBThe SWIB would do well to implementESG principles into both its corporate governance and its investing strategies.For one the Governance aspect of ESG outlines very advantageous practices thathelp build a more robust company and create a more supporting workplacecommunity. Regarding the SWIB’s investment strategy, as a manager of WRS, theSWIB should consider the most viable and risk-free of long term investments tokeep the WRS solvent for decades to come. This does not necessarily mean thatcompanies with good ESG practices will in fact provide this investmentopportunity, nor does it mean companies without the practices won’t be able toprovide this opportunity; however, in terms of selecting robust, long-termoriented companies, ESG provides a powerful valuation in making theseinvestment decisions.
Furthermore, being the manager of the Wisconsin public’sretirement benefit funds, SWIB has a certain responsibility to the public topursue investments that are aligned with the public’s overarching principles.That being said the SWIB has a greater responsibility to pursue the investmentopportunities that are going to keep the WRS solvent, rather than solelypursuing investments that perfectly align with the totality ESG principles.ConclusionESG can be a powerful valuationwhen determining investment opportunities. Like any investment, higher returnsare not guaranteed; however, the core ESG principles are factors, that whenimplemented within a company, are signs of good management and responsibility.
Good management and responsibility in-turn are signifiers of a company’s stablefoundations and efficiency. These are key factors that can lead to greater longrun returns and reduce risk of default or bankruptcy.