The consensus may be waning, but even today, some investors still agree with the Milton Friedman doctrine that a firm’s only responsibility is to legally increase its stakeholder profits, leaving individual investors, consumers, and employees – rather than corporations – as the leaders of positive societal change.
Previously, this approach was deemed to be logical. However, there are obvious problems with it. For example:
- Firms that prioritise corporate responsibility may gain community support and, as a result, benefit their shareholders.
- There is evidence that firms that subscribe to the Friedman doctrine place excessive focus on short-term profit delivery, which has a negative effect on longer-term thinking around investment and innovation.
A finance-first approach to ESG
However, be that as it may, we need to be mindful of not constraining investments too narrowly when integrating environmental, social and governance factors because this will begin to diminish prospective risk-adjusted returns. If social and economic considerations take precedence over a finance-first approach to investing, there is a heightened risk that future investment returns will be compromised. Therefore, it’s important for investment managers to take a sensible approach to ESG investing, one that aligns with a finance-first approach. For example, if a company is involved in polluting the environment, exploiting its workers, or incentivising its managers to focus on short-term profit delivery, then these issues are likely to reduce the sustainability of its business model and therefore its attractiveness as an investment.
Higher market valuations
ESG considerations should not be treated as an add-on to a pre-existing asset allocation approach but should be at the core of how members’ retirement savings are allocated. While it cannot be comprehensively proven, there is substantial academic evidence to support the view that companies with higher-than-average ESG ratings tend to be rewarded with higher market valuations compared to their competitors.
A fundamental reason for this seems to be that these companies are better at managing the non-financial risks of their business models, and, as a result, this makes them relatively more sustainable and less susceptible to a damaging de-rating by the market. We’ve all seen real-world examples of companies not managing non-financial risks and the negative effects on their share prices, such as the Deepwater Horizon oil spill on BP or the emissions scandal on Volkswagen.
A ‘leader’ in managing ESG risks
At The People’s Pension, we have successfully incorporated ESG into the stewardship of our members’ retirement savings and, using MSCI ESG ratings, our default investment profile has been rated AA, making it a ‘leader’ in managing ESG risks. However, this is only part of what we’re focusing on as responsible investors.
An exclusionary approach
Instead of adopting the best in class, the ‘how’ approach to ESG investing, responsible investing involves making the active choice to remove (or choose) investments based upon the ‘what’. The ‘what’ typically involves removing or excluding investments in controversial weapons, addictive substances, gambling, and enterprises damaging to the environment. Therefore, in addition to ESG integration, we have used negative screens to help us divest £226m from 147 companies involved in controversial weapons or linked to controversies involving human rights, labour, the environment, and corruption.
Due to the increasing influence of responsible investment on investor choices, this approach should not sacrifice returns and can help prevent assets from becoming stranded by climate transition. Therefore, an exclusionary approach, in theory, can add to the improved risk-adjusted returns achieved through ESG integration. We have progressed even further with this approach by implementing tilts to reduce the carbon emissions from the assets we hold for our members.
Our goal is to be engaged asset owners, and we therefore expect our external managers to participate on behalf of our members in order to help ensure responsible governance and reduce non-financial risks. This activity should have a positive impact on our members’ returns over the long term.