February 28, 2019

Behind the Rise of ESG and Socially Responsible Business Strategy

The business case for environmental, social and governance (ESG) inclusion has rapidly shifted in recent years. It is becoming mainstream to embrace ESG as a significant element when defining holistic, tangible risks and opportunities in a company’s overarching business strategy. Issues like water usage, climate change, energy efficiency and board diversity are no longer considered ad-hoc, fluffy metrics that plug nicely into an annual 150-page corporate sustainability report. In fact, these issues draw considerable financial and market value when companies and investors factor them into long term risk-reward analysis.

ESG has been an investment strategy since the 1970s, despite its recent attention over the past few years. What changed is the method of portfolio inclusion: socially responsible investing transitioned from an exclusionary approach to a “best in class” or “ESG-tilted” strategy. Rather than screen out companies due to their associated industry vertical, such as oil and gas, portfolios are now incorporating companies that show positive ESG performance within their peer group. Limiting exposure to individual companies that do not meet certain internal ESG thresholds is a much more successful strategy to achieve a diversified, profitable investment portfolio.

When corporations engage with ESG best practices, they are developing superior business models. By doing so, investors are proactively shifting capital towards these companies as part of their fiduciary duty to derive portfolio value, and many times, outperformance. This is why we see ESG as a growing force across every industry vertical, and every company within those verticals. ESG factors are critical elements to developing a more complete picture of how companies can manage operational, legal and reputational risk – now companies no longer have to choose between profitability and doing ‘what’s right socially.’ For example, studies have shown that S&P 500 stocks with high Environmental scores can outperform their low ranked counterparts by several points per year—or, an investor who only bought stocks with above-average Thomson Reuters’ Environmental and Social scores five years ahead of a company’s bankruptcy would have avoided 90+% of the bankruptcies that occurred in the S&P 500 since 2005. (Bank of America Merrill Lynch, 2018).

With empirical evidence to substantiate these claims, and ever-increasing investor and corporate adoption, ESG is habitually making headlines on how it increases risk-adjusted returns and can improve a company’s bottom line value—something of great interest to shareholders and corporate management. Various ESG investment strategies are at play, but one overarching theme is obvious: ESG-based investment tools are at an all-time high, and will only continue to grow. Investors are working to meet clients’ insatiable demand to invest through a sustainable lens, and these solutions range from mutual funds to ETFs, not to mention green bonds. Putting debt aside, it is expected that trillions of dollars will flow into ESG oriented equity investments in the next two decades. This has nowhere to go but up, especially since women and millennials are leading the charge in this area. Women control close to half of the wealth in the country, and millennials will ultimately inherit that wealth once the baby boomers retire.

The bottom line: companies are now focusing on how they interact and participate in the ESG space to keep up with market and stakeholder demand. Companies are not choosing if they should engage with ESG best practices, but rather how they engage. At Cornerstone, we help clients identify and manage relevant ESG indicators to better evaluate and disclose how their business and investment plans address these risks and opportunities.