The evolution of ESG investments. Here’s what’s next

Sustainable investing has come into focus as investors put their money in stocks based on what are known as ESG factors, but shareholders need to get involved to make meaningful change in companies.

According to Morningstar, U.S. sustainable funds saw net inflows of $ 15.7 billion in the third quarter of 2021. These funds were worth more than $ 330 billion in September.

Screening stocks to ensure they meet ESG qualifications is just the beginning for investors seeking sustainable investing. Check out ESG-focused activist funds to see how shareholders can hold boards accountable and create value for society – and investors.

ESG investing

Environmental, Social, and Governance (ESG) investments are when an investor uses a set of socially conscious standards in a company’s business to review potential investments. Environmental criteria take into account how a company behaves as a steward of nature. Social criteria examine how relationships with employees, suppliers, customers and communities are managed. Governance is concerned with running a company, the composition of the board of directors, alignment with stakeholders and the rights of stakeholders. The benefits of investing in ESG cannot be overstated. It has dramatically changed the focus of investors and executives on thinking about things other than returns and profits. It has created much more diversity on corporate boards and has given many small investors the opportunity to invest in line with their values. However, due to its passive nature, it has several shortcomings.

ESG constraints

Its first limitation is that it uses quantitative screenings to identify ESG companies that appear to be exhibiting the most positive ESG behaviors. This is problematic for two reasons. First, quantitative screenings don’t tell the whole story. Perhaps the biggest contribution the ESG movement has made is its impact on board diversity, but a quantitative process here is far from perfect. ESG fund screening for companies with different boards, but the analysis ends here. Diverse boards may still be entrenched or unengaged, and in a quantitative ESG analysis, an unengaged, stuck, contradicting, self-reliant diversity board ranks on par with a dedicated diversity board that works for stakeholders. One example that comes to mind is a tech company controlled by the founder’s couple, with questionable material payments going to a company controlled by members of the founder’s family. The wife was banned from serving as an officer or director of a public company for five years by the Securities and Exchange Commission for backdated options. When the ban expired, she was reinstated as a director and officer, and the company’s ESG score rose because they added a woman to its board of directors.

The second limitation with traditional ESG investing is that it only looks for the best ESG companies in their class, and investing in these types of companies will do very little to change anything. Passively investing in listed securities from top ESG companies will not harm the environment or the social problems of our world. For example, over the past 14 years the dollars invested in ESG funds have increased significantly, but not only has the carbon dioxide levels in the atmosphere not decreased, but carbon dioxide levels have increased significantly over the same period.

AESG investments – that’s next

ESG investing is still very young and is likely to evolve over the next generations. The first step was to change the mindset, which has clearly been done and is still happening. The next logical step is behavior change, and that requires active ESG investments that are already happening. By active ESG investors, we do not mean investors who actively shape their portfolio, nor investors who are not purely passive ETFs or index funds. These investors share the same problems as the passive ETF funds. You invest in the best ESG actors, not those who need to change. Active ESG (or AESG) investors are those who actively work with portfolio companies to bring about change to improve the environment, social issues and / or corporate governance. The path to real ESG change is to invest with the ESG investors who have someone on the boardroom.

AESG investing will solve the two main problems with traditional ESG investing. First, it is a fully qualitative analysis of portfolio companies. It doesn’t look at a diverse board and end the analysis there. AESG funds actively and qualitatively analyze board members not only for diversity, but also for committed, conscientious and experienced directors. In an AESG investment world, not all different boards are created equal. Second, because it’s an active and engaged strategy, it doesn’t necessarily look for the best ESG companies in its class, but rather all companies that it can make positive change in. These companies are often below average ESG companies. Investing in an oil and gas explorer and producer and actively convincing the company to convert its operations to renewable energies, for example, is much more for the environment than passively investing in the listed equity of a solar company. In other words, passive ESG investing is about not being part of the problem, while AESG investing is about being part of the solution. Furthermore, the process of converting a bad ESG company into a good one is not only more valuable to society than just investing in good ESG companies, but it also creates more value for shareholders.

AESG invests in action

There are already a handful of activist funds with an ESG focus, such as Impactive Capital, Inclusive Capital and Engine No. 1. Funds like these create significant ESG improvements by engaging companies with negative or nonexistent ESG traits and trying to convert them to positive ESG companies. For example, Engine # 1 won three board seats at Exxon through a proxy battle, calling on the company to increase its focus on renewable energies, net zero emissions and clean energy infrastructure. Impactive Capital has a stake in Asbury Automotive, an automotive retail and repair company, barely ESG’s beacon. However, Impactive is working with them to make changes like introducing maternity leave and women’s toilets to attract more women to become mechanics while addressing the labor shortage problems the industry is facing. Inclusive Capital is active at wood pellet manufacturer Enviva, where it helps convert coal-fired power plants into biomass and ensure that tree farms are managed responsibly. These are all companies that would never be included in a traditional ESG screening, but with the activist involved and an ESG thesis, there are more options here than with the passive ESG companies that fill ESG portfolios today.

The bigger shift, however, will come from activist funds that have primarily focused on shareholder value and governance but are now beginning to actively engage with “E” and “S” as well. Starboard Value, for example, re-constituted the board of directors of Papa John’s, with Starboard founder Jeffrey Smith becoming chairman. In addition to the successful economic and governance campaign, Starboard fired a CEO who had created a hostile work environment for employees for years, according to a Forbes report from 2018. Another example is Trian’s campaign at Proctor & Gamble, where Nelson Peltz won a seat on the board. Trian mentioned to the company that they spent significant resources on research and development and didn’t really develop new products. Peltz found out about a technology for eliminating plastic packaging that is more expensive, but is worthwhile from an ecological point of view. It was implemented. Funds like these have regularly held supervisory board mandates in companies for many years and have a major influence on shareholder value and corporate governance. Now they are starting to address environmental and social policy in companies and to have an impact there too. We believe that conscientious “G” focus activists often do more for “E” and “S” than completely passive ESG investors, and we expect this philosophical shift to continue and escalate.

ESG investing and AESG investing work together

Investments in global ESG funds have surged to over $ 1 trillion and are still growing as it should. Because of the ease with which a passive ESG portfolio is created through quantitative metrics and ESG scores, passive ESG will always get the lion’s share of ESG assets. But when there is a real ESG change, AESG investment strategies should get some of those assets too. Because there are a limited number of investors who have the skills, characteristics, and inclination to be actively involved in managing portfolio companies, AESG investment strategies will always represent a small subset of aggregated ESG investments. But it will be an increasingly important subgroup, and those who are AESG investing will add ESG investing around a much-needed active component. In addition, passive ESG funds and AESG funds are not mutually exclusive and can have a symbiotic relationship. AESG investing will expand the universe of potential ESG companies that passive ESG portfolio managers can invest in. These are companies that traditionally do not have ESG requirements but are now recognized as ESG companies because of the activist component that seeks to bring about change. To the extent that they get involved in the trillions of dollars of ESG passive investments in the market, these ESG passive funds can now play a role in making change by investing in stocks of companies made by a AESG investor are committed, and the active ESG investor in achieving their ESG goals.

Ken Squire is the founder and president of 13D Monitor, an institutional shareholder activism research service, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of 13D activist investments.