How ESG Makes its Impact on Financial Markets

By Maureen O’Brien and Julian Regan

To date, 2021 has proven a banner year for environmental, social, and governance (ESG) considerations in investing. ESG is an umbrella term meant to capture the multitude of data points that give investors information about a company or asset that traditional financial reporting does not capture. A company’s water use, the fairness of its labor practices, and the portion of corporate directors who maintain business ties to the CEO are examples of ESG factors that investors may consider. ESG factors may be considered material to an investment either because firms with superior ESG characteristics provide the potential for strong risk-adjusted returns or because an ESG weakness signals risk that might detract from performance.

Climate change is among several dominant themes in ESG investing. Regardless of the issue, investors generally have three options to consider when evaluating an ESG risk, such as a company’s failure to assess and disclose the impacts of a low-carbon economy on its future business operations.

• First, an investor can monitor the risk.
• Second, an investor may choose to divest itself of weak performers, an option sometimes described as the “Wall Street Walk.”
• Third, an investor may hold shares in the firm or asset and engage management to encourage improvement. Proxy voting and engagement on corporate governance through the submission of shareholder proposals are long-standing tools for ESG incorporation. These approaches are often referred to as active ownership.

Active Ownership: One Mechanism of ESG

This year active ownership saw dramatic success at Exxon Mobil and Chevron. Activist hedge fund Engine No. 1, holder of 0.02% of shares outstanding in Exxon Mobil, sought four seats on the company’s 12-member board. Engine No. 1 ran a slate of candidates to oppose the incumbent directors and overturned three board seats. The three candidates who received enough votes to be seated brought environmental and operational expertise to the board. Engine No. 1 convinced enough shareholders that Exxon Mobil’s preparedness for the energy transition was lacking. The new directors are tasked with moving Exxon more aggressively in the direction of diversifying energy sources.

On the same day of the activist fight at Exxon Mobil, May 26, a majority of Chevron shareholders voted in favor of a shareholder proposal that Chevron cut emissions.

A third development on the same day further marked a trend in expectations of carbon emitters: A court in The Hague ordered Royal Dutch Shell to cut its global carbon emissions by 45% by 2030.

The Mainstreaming of ESG

ESG incorporation by money managers has seen a steady and steep increase in the past decade and a half. Total U.S. assets under management that considered ESG factors grew from $639 billion in 1995 to $17 trillion in 2020, according to the 2020 Trends Report issued by the U.S. Forum for Sustainable and Responsible Investment. The 2020 figure represented 33% of total U.S. assets under professional management, and the top issues considered in descending order were climate change/carbon, anti-corruption, board issues, sustainable natural resources/agriculture, and executive pay, according to the report. As further evidence of ESG incorporation, a 2017 CFA Institute survey found that 73% of respondents considered ESG criteria in investment decision-making and analysis. Not surprisingly, governance, which investors considered before the term ESG proliferated, represented the most commonly cited set of factors in the survey. 

Retirement Plans and ESG Incorporation

Defined benefit (DB) plans, which held $10.5 trillion of U.S. retirement assets as of the first quarter of 2021, have incorporated ESG at a faster pace than have defined contribution (DC) plans until the recent past. One explanation for the difference is that larger DB plans can invest in equities more frequently through separate accounts, giving plan sponsors control over proxy voting and the submission of shareholder proposals. In contrast, as of the first quarter of this year, 66% of the nation’s $6.9 trillion in 401(k) plan assets were held in mutual funds, effectively ceding proxy voting as a tool of ESG to investment managers for the portion of these assets invested in equities.

Perhaps for pragmatic reasons, investment companies have historically refrained from taking the active shareholder approach that DB plan sponsors have taken. This may be changing as mutual fund companies introduce scores of new ESG strategies and face challenges in demonstrating ESG incorporation to institutional asset owners’ consultants.

ESG Adoption Mechanisms

In considering ESG adoption, retirement plan sponsors arguably have four mechanisms for implementation at their disposal:

• Adoption of investment policy provisions that document ESG criteria;
• Inclusion of ESG considerations in selecting investment managers;
• Proxy voting; and
• Shareholder engagement.

While data vary on incorporation through these mechanisms, the following findings are evidence for increasing adoption, as well as a wide range of conclusions about the current state of play in plan types and asset classes.

Defined Benefit Plans

• Public pension funds reportedly accounted for 54% of the $6.2 trillion in institutional investor assets that incorporated ESG, according to the 2020 U.S. SIF Foundation survey.
• In Europe, consultants estimate that 89% of pension funds take ESG risks into account in their investment approaches.
• According to a 2020 study, 16 of 74 U.S. public funds, or 22%, mentioned ESG in their publicly available documents, while other surveys indicate a higher level of incorporation.
• A survey cited in Pensions & Investments found investors are incorporating ESG beyond public equities into fixed income (60%), real estate (43%), and infrastructure investment decisions.

While corporate retirement plans may report a more-modest level of ESG adoption, many have voted proxies as a long-standing practice, as have their public and multiemployer counterparts.

Defined Contribution Plans

While DC plans may integrate ESG through a range of mechanisms, a common approach is to offer a dedicated ESG option under the plan’s investment menu. Whatever the approach, the following statistics paint a picture of slower, but accelerating, adoption:

• In 2018, the Principles for Responsible Investment reported that between 2% and 8% of DC plans offered ESG investment options;
• In 2020, Morningstar reported that while only 4.5% of DC plans offered a sustainable (ESG) option, 22% are incorporating ESG factors into their traditional options;
• A PGIM survey found that 24% of plan sponsors indicate they have taken action to incorporate ESG into their plans over the last three years, while 52% said they had not; and
• A 2018 Natixis survey found that 82% of DC plan respondents wanted investments in their plans that reflected their values.

Conclusion

ESG incorporation has evolved since it was launched with divestment campaigns in the 1970s and 1980s, guided by the McBride Principles’ focus on religious discrimination in Northern Ireland and divestment from South African companies during apartheid.

Regulatory uncertainty, inconsistency in definitions, and metrics pose challenges for the uptake in ESG. However, the direction of ESG toward a set of mainstream considerations for performance and risk assessment is clear. A survey cited in Pensions & Investment found that more than half of respondents incorporated ESG factors as part of their fiduciary duty and 38% saw it as helping to generate excess return. Pragmatism, fiduciary duty, and a new generation of investors’ interest in making a positive impact through their portfolios will continue to drive the trend.

Maureen O’Brien is Vice President and Corporate Governance Director, Segal Marco Advisors.

Julian Regan is Senior Vice President and Public Sector Market Leader, Segal Marco Advisors.

June 2021, 21-04