Thoughts on ESG Investing and Fossil Fuel Consumption
By Fred Rogers, Vice President and Treasurer of Carleton College
The problem of climate change is real and its resolution requires a reduction in the consumption of fossil fuels worldwide. For this to occur, there must be a reduction in global demand, and thus both: (1) serious investment in alternative energy sources and (2) changes in social and economic behavior. While the UN Task Force is focused on GHG emissions and the socio-economic impacts of both climate change and the strategies of GHG reduction, much of the campus dialogue about climate change has been focused on the 350.Org initiative of divesting from the top 200 fossil fuel companies.
There are many reasons to not love the largest fossil fuel companies. In an effort to increase the value and market share of their companies, they have often been aligned with those who question the premise of GHG reduction goals. Divestment is seen as a political step to diminish the influence of these companies and to enable political support for more aggressive measure. Divestment proponents also assert that the current fossil fuel companies’ valuations are overstated because they assign unrealistically high values to their in-ground proven reserves of energy fuels, which ultimately cannot be consumed if we are to avoid drastic environmental consequences. This, they argue, makes such companies a bad investment risk.
An alternative view is that the market is fully aware of this risk, but that the consensus view is different. That is, whatever is the ultimate requirement for reductions, in the near term, such companies are going to find adequate demand for their products at reasonable enough prices to make it profitable to extract them. In fact, the government views having adequate fuel reserves to be in the national interest, having created the national petroleum reserve.
How then to effect the change that we all agree is necessary? Proponents of Environmental, Social and Governance investing (ESG) advocate for a new, evolving paradigm of risk assessment and thus investment evaluation and prioritization. This is based not so much on avoiding or embracing something for a political or ethical reason, but rather trying to more fully asses the long term consequences of these additional factors that may be poorly understood or not fully incorporated into more traditional investment market valuations. ESG investing provides added information and insight about likely long-term performance. Although the early studies of ESG investment results versus unconstrained market investors indicate that there is no obvious predictable difference in returns as of now, there is every expectation that ESG can enhance long-term returns. A comprehensive survey of the use and impact of ESG investing was reported in the Deutsche Bank report from 2012 that evaluated the literature and state of research at that time - reviewing over 100 studies and papers. While this review concluded that there was no obvious investment result advantage or disadvantage it did identify several clear impacts. It also seems clear that the impact of ESG investing is larger than the impact on the portfolio of the investor.
In today’s market, the Deutsche Bank reviewers found a unanimous consensus that higher scoring ESG companies had a lower cost of capital. As more investors seek returns that are subject to less environmental risk, more capital is attracted to such explicit strategies. As more banks and investment firms offer ESG strategies as investment vehicles, more money is available to the companies who meet these criteria. In the long run this might also translate into improved performance, but in the shorter run it serves as an incentive for companies and CFO’s interested in lowering their cost of capital. It also enables market expansion and development in these crucial areas.
The current state of ESG reporting is not fully standardized. As more investors seek to establish ESG certification for their portfolio, a greater coherence will emerge in the markets for credible and standard criteria and benchmarks. To the extent that criteria and benchmarks become more widely accepted, pressure will grow on companies to adopt these practices, or on the SEC or others to enforce them. One recent example is the notion of stockholder “Say on Pay” influence on highly compensated CEO pay. Another is recognition of the practice of an external board chair as good governance. Both of these ideas began as shareholder initiatives and have since moved into the mainstream. Similar initiatives for green house gas inventories, documentation on water usage, investments in alternative energies and support for living wages and basic working conditions may make their way into established corporate expectations.
So the arguments for ESG are threefold:
1) It enable investors to make more fully informed risk/reward decisions, perhaps improving investment outcomes but with likely no sacrifice in returns.
2) It lowers the cost of capital for highly rated firms and enables their expansion
3) It empowers the development of more widely accepted and powerful standards of good practice which influence and ultimately motivate different corporate behavior
In the face of calls for divestment, ESG investing may be an appealing additional or alternative response for trustees and fiduciaries of invested capital. A focus on additional criteria for assessing risk and potential economic success keeps the trustees appropriately focused on their responsibilities as fiduciaries and stewards of long-term capital. Many are not supportive of using their role as fiduciary to make political statements. In this sense then, ESG could be a win-win. It serves the fiduciary interest of fund managers and stewards and it advances the social goals of more holistic investing and impact assessment.
Because of the uncertainty and lack of familiarity with ESG investing in the college and university landscape, it may be helpful to bring more attention and clarity to this set of issues. David Swenson’s letter to the Yale investment managers of August 2014 is cited as a powerful signal in support of ESG adoption. Harvard and other institutions that have chosen to not divest have also expressed an interest in more formal ESG investing.
If a cohort of larger college and university endowments were focused on the collective task of clarifying basic practices and improving ESG metrics and thus reporting and comparison, I believe we would be making much more progress. From such leadership and collective action could come important insights and ultimate redirection of capital and consumption patterns. Exactly what is required to bring about CO2 emission reductions.