Benefits of ESG:

Creating a More Sustainable and
Productive Business

Abstract

This paper defines the concept of
ESG, Environment, Social, and Governance, and examines the benefits of its
implementation within corporate governance and investment strategy. It supports
ESG as a key component for the promotion good management and responsibility
within a company, as well as its use as a significant valuation in identifying
robust, sustainable companies for investment opportunities. It is the opinion
of this paper that the SWIB would stand to benefit from implementation of ESG
principles in its governance because such principles help create a better work
environment, a happier and more productive workforce, and promote
accountability and transparency at all levels of management.

Thesis

Environment, Social, and Governance
criteria (ESG) is a set of guidelines and best practice principles that help
investors valuate an investment utilizing criteria that fall outside of the
typical financial related factors, mainly: environmental impact and
sustainability;  social consciousness and
commitment to ethical business practices concerning the fair treatment of its
employees, customers and community; and accountability/transparency of its
management and commitment to the rights of its shareholders. ESG allows
investors to find more profitable and sustainable investments as its focus on
the long term sustainability of a business and its commitment to ethical
practices and social awareness, as well as its emphasis on the relationship
between a business and its community, promotes the long term health of an
investment as well as a more resilient and sustainable economy as a whole.

Overview and Core Principles

The basics of ESG have arguably
been around for as long as our ancient ancestors first began trading with one
another. At its core ESG promotes basic human decency and dignity within the
business process; however, a more concrete definition of ESG and the implementation
of its principles arose during the twentieth century.

With the rapid globalization of the
world economy in the decades following the Second World War, a business’s role
as a global citizen and its impact upon society and the planet began to come to
the forefront of its operations. The deeper integration of companies within
society brought on by the increased globalization necessitated that businesses
become more socially conscious and mindful of their impact or risk the ire of a
more effective, globalized society. One key example of this is the almost
universal adoption of the Sullivan Principles and the disinvestment from
apartheid South Africa in an effort to bring an end to the discriminatory and
oppressive regime.  Leon Sullivan was a
civil rights activist and the first African American board member of General
Motors (Lewis). Using his position, Sullivan pressured almost every American
company doing business in South Africa to disinvest unless the South Africans
agreed to the adoption of the seven principles regarding the end to segregation
and equality within the workplace, collectively called the Sullivan Principles
(Lewis). This pressure was one of the deciding factors that brought about the
end of the apartheid regime and stands as a pivotal example of the power a
company can possess when implementing ESG principles.

Likewise as our society continues
its rapid globalization and we become ever more socially conscious, it is
increasingly necessary for companies to implement principles and operating
ethics that adhere to ESG or be left behind in our ever advancing economy. Increasingly
the public is more aware and critical of businesses that are deemed to not have
society’s best interest at heart. Likewise, the benefits of adopting ESG
principles are becoming ever more pronounced as the public has ever increasing
information on a company’s operations and is increasing willing to reward those
companies which take those principles to heart. Examples of this can be seen
almost every day.  One only needs to look
at the increasingly devastating divestment campaign against large banks, most
notably Wells Fargo, as more and more cities, such as Seattle and San
Francisco, are pulling out their funds due to public outrage caused by the
dishonest and unethical practices of those banks (Tobias). Furthermore, as
technology gives rise to ever greater consumer choice, customers are increasingly
searching for platforms and products that allow them to express their social
consciousness and activism with their investment choices. A clear example of
this is the rise of micro-investing apps, such as Stash, that allows customers to invest in funds and ETFs
specifically oriented around ESG ideals, such as environmental sustainability
and the reduction of climate change (Stash).

Clearly, it is becoming
increasingly necessary for business to implement these standards into their
business practices. That being said let us examine the core tenants of ESG more
in-depth.

The first tenant of ESG is
Environment. The Environment factor is used to measure a company’s overall
commitment to creating a “greener” world as well as minimizing its toll upon
our natural resources and ecosystems. This measure can include any number of
factors such as a company’s commitment to combat climate change through various
means, such as reducing its carbon footprint through development of more
efficient and less resource intensive machines and techniques; it could include
how much pollution a company produces as a byproduct of their production
process, i.e. toxic/nuclear waste; or even it could include whether a company
tests its products on animals. Any number of factors can weigh in on this
measurement and they can be used as a valuation of that company’s worth/future
income. For example, one major concern for many environmentalists today is
nuclear waste. Currently in the United States there are over seventy-one
thousand tons of nuclear waste siting in temporary on-site storage facilities
across America (LastWeekTonight). Currently there is no permanent solution to
the disposal of this waste, thus it must sit in what is practically a temporary
holding site at each plant indefinitely (LastWeekTonight). This is major
concern for environmentalists because these sites are historically prone to
leaks. This is one of the reasons why many people no longer view nuclear power
as the savior we once thought it was. Following ESG principles, it is clear
that the environmental impact caused by nuclear power is still too great to
implement on a much greater scale and thus causing one of the reasons for the
market’s continued reliance on fossil fuels as the primary power source.

The second tenant of ESG is Social.
The Social factor is used to measure a company’s commitment to social consciousness
and its role as a member of its community be it local, national, or global.
Following the Social aspect of ESG a company must commit to promoting diversity
in its workforce and management. It must show a commitment to human and civil
rights and actively combat discrimination. Finally, it must uphold consumer
protections and understand it has a responsibility not only to its profits, but
also the community it inhabits. A company following good ESG practices will
actively donate to charity or host volunteer events. It must seek to not stand
apart from its community, but rather actively work towards its benefit and its sustainability
for everyone. Also it must apply these principles to its own operations, such
as: being cognizant of its supply chain and taking responsibility for every
facet that goes into its product; as well as promoting a healthy and safe work
environment and not just physical health, but also mental and emotional health
as well. All these practices help create a healthier and overall more stable
business, leading to a more sustainable investment.

The last tenant of ESG is
Governance. The Governance factor is used to measure the accountability and
transparency with which a company is managed. It can include but is not limited
to: transparent accounting practices, management structure and power sharing,
fair executive compensation, and the protection of shareholder rights. All
these practices help promote good governing ethics as well as reduce the
principle-agent problem. They are essential for the efficient management of a
business and are the core principles that help reduce corruption and waste.

Each aspect of ESG helps make a
business that implements them stronger and more sustainable in the long run.
This will in turn make those businesses that make a commitment to good ESG practices
a more sound investment for potential investors and promote a more stable
economy as a whole.

Performance Impact of Implementing
ESG

One of the main criticisms of ESG
is that investors should care solely about maximizing returns when selecting
investments. Opponents of ESG put forth that investors should act solely in
their self-interest or the interest of their contributors. Furthermore, some
even go so far as to state that acting in any way with a more socially minded
mindset, rather than solely the self-interest of their contributors, goes
against an investor’s fiduciary responsibilities. These opponents believe that
considering anything other than the purely financial factors when choosing an
investment will ultimately lead to lower returns, to the detriment of their
contributors; however, there is ample evidence that suggest the contrary of
this sentiment may be true.

First let’s examine the Dow Jones
Sustainability Index. The DJSI is one of several indices created by S&P Dow
Jones with the intent to provide investors with an index fund of the most
sustainable companies in the world across every industry (DJSI). S&P Dow
Jones, in conjunction with RobecoSAM, index the most sustainable companies
according the key principles of ESG, mainly surrounding environmental and
social criteria (DJSI). The fundamental principle behind the DJSI is to provide
an index that utilizes core ESG principles in the belief that such companies
that operate by these sustainable practices will provide stable long term
return on investment. When comparing the DJSI to the standard Dow Jones
Industrial Average the results are fairly promising. The DJSI tends to be on
par with DJIA in terms of yearly return on investment, and notably outperformed
it in the recovery after the 2008 financial crisis (chart 1). Of course the
DJSI is considerably smaller in terms of number of represented companies and
significantly less valuable than the DJIA, sitting at just fifteen hundred
dollars whereas the DJIA is hovering around twenty-five thousand dollars as of
January 8, 2018 (FRED). These factors of course can lead to higher statistical
error and variance with in the data set. However, the data suggests that in the
long term, the DJSI tends to trend on par with the larger market giving those
investors which are more conscientiously minded a reasonable alternative.

Secondly, there are numerous
academic studies that support the claim that companies that have good ESG
practices tend to have higher returns and earnings. One notable study is one
conducted by Professor of Finance at the London School of Business, Alex
Edmans. Edmans focuses on social responsibility in investing, has taught at
University of Pennsylvania’s Wharton Business school, published several
academic papers, and been feature in several TEDx talks (Edmans, Homepage).
Edmans 2008 paper entitled, Does the
Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,
compares Fortune magazine’s 100 Best Companies to Work For to each
companies’ respective industry benchmark index over the period of 1984-2009 (Edmans
1). His findings suggest that companies that practice good ESG principles and
had a high degree of employee satisfaction tended to generally do better than
their respective industry benchmarks (having on average a statistically
significant 2.1% higher alpha than the benchmarks) (Edmans 2). Edmans goes on
to speculate that these higher returns could be linked to two key factors: the
attraction of greater human capital and a reduction of the principle-agent
problem (Edmans 2). Both these factors are directly linked with ESG. The
reduction of the principle-agent problem being explained by the increased
accountability and transparency in management in companies with good ESG
practices. The attraction human capital can be explained by the more stable and
sustainable work environment created by ESG principles. The less turbulent and
more comfortable a work environment is the more likely people will want to stay
at said work place, preventing a knowledge drain; and following that as other
people hear about the better workplace the more people will want to join said
company, giving the company a large pool of labor to choose from, allowing it
to pick the best candidates.

Edmans study clearly shows the
benefits of good ESG practices. In creating more efficient and sustainable work
environments, companies can improve their overall business by keeping their
workforce happy and productive, which in turn leads to higher returns for
investors.

ESG and the SWIB

The SWIB would do well to implement
ESG principles into both its corporate governance and its investing strategies.
For one the Governance aspect of ESG outlines very advantageous practices that
help build a more robust company and create a more supporting workplace
community. Regarding the SWIB’s investment strategy, as a manager of WRS, the
SWIB should consider the most viable and risk-free of long term investments to
keep the WRS solvent for decades to come. This does not necessarily mean that
companies with good ESG practices will in fact provide this investment
opportunity, nor does it mean companies without the practices won’t be able to
provide this opportunity; however, in terms of selecting robust, long-term
oriented companies, ESG provides a powerful valuation in making these
investment decisions. Furthermore, being the manager of the Wisconsin public’s
retirement benefit funds, SWIB has a certain responsibility to the public to
pursue investments that are aligned with the public’s overarching principles.
That being said the SWIB has a greater responsibility to pursue the investment
opportunities that are going to keep the WRS solvent, rather than solely
pursuing investments that perfectly align with the totality ESG principles.

Conclusion

ESG can be a powerful valuation
when determining investment opportunities. Like any investment, higher returns
are not guaranteed; however, the core ESG principles are factors, that when
implemented within a company, are signs of good management and responsibility.
Good management and responsibility in-turn are signifiers of a company’s stable
foundations and efficiency. These are key factors that can lead to greater long
run returns and reduce risk of default or bankruptcy.