Big Ideas
John Gerard Ruggie published a draft chapter for Sustainable Investing: A Path to a New Horizon called Corporate Purpose in Play: The Role of ESG Investing in November 2019.
Ruggie’s work provides an interesting frame to explore the role investors can play in the capital markets to support positive change. The chapter refreshes some of the themes that we touched upon in our January posting (Happy New Year, January 4th, 2020). These include: stakeholder primacy vs. shareholder primacy, the legal code around fiduciary duty and corporate structure, and an assessment of environmental, social and governance (ESG) investing as a catalyst for further change. By pulling on some of these threads, we want to explain why investors need to look beyond the ESG framework - to be able to unlock the fullest potential of mission aligned investing. Our arguments are intentionally provocative and we sincerely welcome feedback, rebuttal and overt critique of our thinking.
We acknowledge that the battle lines are drawn between the fundamentalists who defend the primacy of shareholders (owners) and the progressives who project the rights of stakeholders (workers, suppliers and neighbors). The white knuckled, middle aged white men who are defending the stasis are quick to man the barricades with calls for “fiduciary duty” and cries that capitalism is predicated on shareholders’ ownership rights. With legal precedent: e.g., Prudent Man Rule (1830) and ERISA’s “exclusive benefit rule”: institutional US asset owners, (pension plans and endowments), members of investment committees, and the legions of advisors and consultants servicing this concentrated pool of financial capital take refuge in the legal sanctuary of the status quo.
This defensive position in the US is under siege. The attacks reflect a revisionist view of neo-liberal capitalism and the underlying truth that fewer and fewer US citizens are impacted by share prices. A paper by Edward Wolff at New York University Household Wealth Trends in the United States, 1962 TO 2016: Has Middle Class Wealth Recovered? suggests that most Americans have very little exposure to the public equity markets. Efforts to craft legislation in the US to expand existing fiduciary standards to include consideration for the environment, for governance and social concerns has been frustrated by entrenched resistance.
Australia, New Zealand and European countries, however, are advancing legislation to address climate concerns, human rights violations in the corporate supply chains and other social ills. This progressive attitude has influenced the attitudes and behaviors of asset owners there. While 25 % of the worlds’ investable assets are managed with ESG factors, according to Ruggie’s research, Australia and New Zealand lead with 60% and Canada and Europe are close behind with 50% - the US is at about 25%.
Given trends, especially measured amongst millenials and women who are inheriting wealth from their white knuckled relatives - more and more people are seeking to align their investment decisions with their personal values. Isn’t it terrific that ESG factors support this shift? Yes, and no.
The Wall Street institutions that built the capital market landscape during the last 50 years are very happy to apply their skills: problem solving, scalable technology, and product design and marketing - to meet this growing demand. ESG factors can be organized to generate ratings: worst to best. With these objective labels, the Wall Street “machine” can generate products and offer them at low costs based on their inherent scale advantage and incumbent position in the marketplace.
If we “dig into” the ESG rating business, we discover some challenging truths. Most of the data collected is self-reported by corporations. The variances in data reporting are compounded by the subjective analysis of the underlying data by ESG rating companies - who sell their analysis to investment managers. Thus, when people decry the “problems” with ESG data - they have a point. Perhaps we should “step back” from the fray and consider a few defining questions.
When an investor seeks to earn a financial return, the existing capital markets provide an excellent place to optimize his risk adjusted return goals. When an investor seeks to earn a set of non-financial returns, the existing capital markets are terrible. Why? Because a non-financial return is entirely subjective to that investor’s unique perspective. Put differently, if all the market participants were seeking the same non-financial return - then perhaps we could arrive at a set of common measures to satisfy everyone. If you are seeking to align your investments to mitigate carbon emissions and I am seeking to align my investments to improve the health and well-being of children living in rural Minnesota - how does the ESG framework help us to achieve our singular goals?
ESG ratings are derived by past performance; they are backward looking. The ratings are ranked to provide an objective measure of best to worst - based on someone other than the asset owner’s point of view. (Note: human beings are inextricably drawn to relative comparisons - we like to be better than average, we want to be “best.”) If you are thoughtful enough to define your non-financial goals, do you want or need some “third party” to tell you what is better or worse? Or do you think you know enough about yourself and the positive change that you want to support to be able to define success on your own terms?
Another perspective to bring up here is the inherent focus on maximizing financial return. To be clear, TILT is very interested in generating strong financial returns for our clients. We also chafe at the argument that companies with high ESG ratings are better because they will be more profitable. While higher ESG ratings may generate improved profitability over time, our clients are seeking to make measurable returns on human, environmental and civic capital in addition to the financial capital returns. Moreover, TILT clients seek to confirm that these returns are experienced in the places where they invest, and shared by the people who are impacted by the enterprises that we invest in.
Put simply, we celebrate ESG factor-based investing for moving “mainstream investors” from a singular focus on maximizing financial return. We applaud efforts to forge statutes and regulations that will cause companies to “do the right thing.” And we champion the asset owners who are willing to move beyond the constraints of benchmark relative investing and who can see beyond the limits of a modern portfolio theory framework. Mission aligned investing takes an extraordinary amount of work. If we are going to regenerate the non-financial capital stocks that have been depleted in the last 100 years, we will need to repurpose the corporate charter, we will need to follow Australia and Europe with progressive legislation around investing, and we will need to move beyond a Wall Street controlled ESG paradigm. We believe that the multi-capital framework offers enormous potential to realize an investor’s unique return goals - and our clients are helping us to prove that.