Environmental, Social, and Governance (ESG) investing has become a significant approach for investors aiming to achieve sustainable returns while positively impacting society/environment, but is this true? This paper provides an introductory guide for students in SIF at the University of Tulsa on how they can use ESG reporting as they decide what companies to buy, sell, or hold and the limitations of ESG reporting to look out for.
I started this investigation by interviewing Liu, the Director of Investment Research and Management for the ESG funds at BOK Financial. She determines what companies should put in the ESG Fund based on the following:
- How do they make decisions?
- What is their Philosophy?
- How are they performing on Key Performance Indications (KPI)?
While the first three questions are essential, the first half of this paper will focus on the 3rd question Liu uses to determine what company to put in her ESG fund, while the second half investigates how ESG may be misleading.
ESG Key Performance Indicators
Environmental KPIs evaluate a company’s environmental impact, focusing on energy usage, carbon footprint, and water management. The percentage of energy derived from renewable sources, reduction in carbon footprint, total water consumption, and water recycling are critical metrics. Each sector may underperform or overperform in these environmental KPIs, so it is important to compare the environmental KPI of a company based on similar companies in that sector. Companies like Orsted demonstrate the effectiveness of these KPIs by transitioning from fossil fuels to becoming leaders in offshore wind power, showing significant reductions in carbon emissions and increases in renewable energy usage (“45 ESG Key Performance Indicators (KPIs) to Know”).
Social KPIs assess how a company manages relationships with employees, suppliers, customers, and communities. Employee satisfaction, diversity and inclusion, community engagement, and employee turnover offer insights into a company’s social responsibilities. Salesforce, for instance, is recognized for high employee satisfaction and robust diversity initiatives, underscoring the importance of social KPIs in fostering a Positive and inclusive work environment (“Top ESG Key Performance Indicators (KPIs) for Companies to Evaluate ESG Strategy”).
Governance KPIs focus on a company’s leadership, audits, internal controls, and shareholder rights. Board diversity, ethics and compliance, and risk management are essential for assessing governance. Accenture’s strong governance practices, including board diversity and comprehensive risk management frameworks, highlight the role of governance KPIs in maintaining business integrity and trust (“Measuring Sustainability Performance & ESG KPIs”).
Risk Management, Regulatory Compliance, and Consumer and Investor Demand are necessary. For example, the financial and reputational damage BP faced due to environmental disasters illustrates the critical need for effective risk management through ESG KPIs. Proactive ESG practices enable companies to comply with evolving environmental regulations, avoiding penalties and litigation. Incorporating ESG KPIs into investment decisions can lead to enhanced risk management, reputation, and long-term value creation. Companies with solid ESG records often experience lower capital costs, attract and retain talent, and navigate regulatory changes more effectively (“Linking ESG Initiatives to Financial Performance”). Comparing a company’s ESG key performance indicators to its peers will allow an investor to identify risks a company is more exposed to than its peers.
Limitations of ESG funds and reporting
ESG funds have been growing in popularity with over 8 Trillion dollars of investments, but the reasons for greater attention on ESG investing are often
1.) to mitigate risks and have more future earnings
2.) have a positive impact on the world. Regardless of the reason,
There has been some evidence that ESG finds managed by portfolio managers may be underperforming and exposed to ESG risks.
Professor Raghunandan and Rajgopal at the London School of Economics and Columbia Business School have identified a few problems with these ESG funds. In their paper “ESG funds make stakeholder-friendly Investments,” they found no evidence that ESG funds outperform non-ESG funds managed by the same portfolio manager in the same year but found these ESG funds are not performing well when it comes to ESG. They find the ESG funds, compared to non-ESG funds, have more violations of labor and environmental laws, pay more in fines for violations and, “on average, exhibit worse performance in carbon emissions, in terms of both raw emissions output and emissions intensity (i.e., CO2 emissions per unit of revenue).” The paper claims these findings do not pick socially responsible stocks and contribute to greenwashing.
ESG funds have been found to be underperforming, and the result may be due to when companies communicate their ESG performance the most. The paper “Stakeholder Value: A Convenient Excuse for Underprefoming Managers?” finds that companies, on average, focus on their ESG performance when managers underperform the earnings expectations. However, when they exceeded earnings expectations, they made few, if any, public statements related to ESG. As a result, directing investments to companies publicly embracing ESG principles may be over-investing in financially underperforming companies. This is important to remember as students in the SIF determine what companies to invest in.
Overall, the ESG key performance indicators allow investors to investigate the ESG risks associated with a company before making investment decisions, but students must question if a company who claims have great ESG performance leads to greater future earnings and aligns with ESG regulations. As an investor, it is important to ask yourself what the goals of your investments are before deciding. Are you interested in greater future earnings or ensuring your money positively impacts the world?
References
“Accenture.” Measuring Sustainability Performance & ESG KPIs. Accessed February 9, 2024.
Flugum, Ryan, and Matthew E. Souther. “Stakeholder value: A convenient excuse for underperforming managers?” Journal of Financial and Quantitative Analysis, 31 Oct. 2023, pp. 1–56, https://doi.org/10.1017/s0022109023001308.
“KnowESG.” Top ESG Key Performance Indicators (KPIs) for Companies to Evaluate ESG Strategy. Accessed February 9, 2024.
“McKinsey & Company.” Linking ESG Initiatives to Financial Performance. Accessed February 9, 2024.
“TechTarget.” ESG Metrics: Tips and Examples for Measuring ESG Performance. Accessed February 9, 2024.
“The Impact Investor.” 45 ESG Key Performance Indicators (KPIs) to Know. Accessed February 9, 2024.