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Is the focus on executive pay misguided? Can ESG ratings be made uniform? And which companies are best placed to get us beyond fossil fuels?
Environmental, social and governance (ESG) investing is at a crossroads, with conflicting definitions, misconceptions as to praiseworthy corporate behaviour and inefficient capital markets failing to take account of climate risk.
Easy assumptions about the undesirability of high executive pay sit alongside equally glib suggestions that ESG ratings should somehow be made uniform, while the assumption that today’s energy giants will be able to transition seamlessly to the post-fossil fuel era needs to be challenged.
These were some of the key points to emerge from a virtual event on 23 February on the topic of ESG Investing, co-hosted by London Business School’s AQR Asset Management Institute and the Centre for Corporate Governance. Split into three sections, it could well have been subtitled “Everything you thought you knew about ESG investing is probably wrong”.
Opening proceedings was Alex Edmans, Professor of Finance at London Business School and author of Grow the Pie: How Great Companies Deliver Purpose and Profit, speaking on the theme: “ESG investing: does it work and how to do it?” Professor Edmans took aim at, among other targets, the excessive focus on executive pay in ESG circles.
As an example, he took the much criticised 2010 pay packet of Bart Becht, then Chief Executive of household products group Reckitt Benckiser, which totalled £90 million. In the wake of the furore, said Professor Edmans, this “shy workaholic” stepped down. The affair was seen widely as a corporate governance failure, he added, but the figures told a different story.
Mr Becht’s departure triggered a £1.8 billion slide in the company’s stock-market value. Furthermore, since leading the merger of Benckiser with Reckitt in 1999, £22 billion of value had been created, excluding dividends.
Finally, £87 million of that £90 million was not “pay” as such, but the result of shares he had been granted in the past going up in value due to Reckitt Benckiser’s strong performance.
A very different company, Professor Edmans suggested, provides a clear example of corporate governance failure – but it is almost never cited as such. In 1975, Kodak patented the first digital camera and then did precisely nothing with it, preferring to rely on the large profits to be made from conventional photographic equipment.
Kodak collapsed in 2012, a disaster for its employees which had numbered 145,000 at their peak. “The most irresponsible course of action,” Professor Edmans said, “is not to innovate. Responsible investors engage with companies to encourage innovation.
“ESG investing is not just about a fair split of the pie [among employees, investors and top management] but also about growing the pie.”
Turning to the evidence for ESG investing, he pointed to the 24 provisions studied by the Investor Responsibility Research Center in the US, which protect management from shareholders.
“Do such arrangements reduce accountability of management to shareholders, or are there circumstances in which they protect companies from shareholders seeking a ‘quick buck’?”
A 2003 study, he said, had found that companies in which the management did not enjoy such protections produced 8.5% better performance than those providing these protections. But a 2011 follow-up found that, only in non-competitive industries, such as utilities, did this have any real effect. “Optimal governance isn’t one-size-fits-all”, he added.
Moving to executive pay, Professor Edmans cited a submission to a House of Commons inquiry asserting “productivity is negatively correlated with pay disparity” between top executive remuneration and lower level pay. This belief is what causes some ESG investors to avoid companies with high pay ratio. But this view, he said, was based on a half-finished draft. After it went through peer review, the finished version found the opposite result – firms with high pay ratios actually are associated with higher firm performance.
In terms of employee satisfaction, he added: firms assessed as being the 100 best companies to work for had, over the period 1984 to 2011, outperformed their peers by between 2.3 per cent and 3.8 per cent. But stock markets take four to five years to fully reflect the value of employee satisfaction in share prices.
Professor Edmans ended his talk by discussing how to practise responsible investing. He pointed out that, historically, this involved screening companies. He criticised the metrics that are typically used in such screenings as being “easy to manipulate” and as ignoring the strategic contexts of the businesses concerned, along with an excessive focus on “pie splitting rather than pie growing”. Furthermore, the repeated insistence that studies showed no loss of returns from sustainable investing as opposed to the conventional variety was merely an example of “confirmation bias”, the seeking out of evidence that support a pre-existing view and the discarding of such evidence as undermined it.
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“We need a holistic approach – ‘bads’ can be outweighed by ‘goods’. Does the company provide a net benefit to society?”
He added; “We need a holistic approach – ‘bads’ can be outweighed by ‘goods’. There should be what’s often called a ‘net benefit test’ – does the company provide a net benefit to society?”
Three speakers addressed the next topic, “Aggregate Confusion: The divergence of ESG ratings”, Florian Berg, researcher at MIT Sloan School of Management; Roberto Rigobon, Professor of Management and Professor of Applied Economics at the Sloan School, and Julian Koelbel, head of research at the Centre for Sustainable Finance and Private Wealth at the University of Zurich.
Julian Koelbel noted: “ESG ratings agencies have, since 2010, become influential institutions. Investors with $80 trillion in assets under management integrate ESG information into their decisions. ESG ratings are the backbone of such investments.”
Existing major players in the ratings world are buying up such agencies and regulators are taking them into account. But, he said, there was far from being a single method for awarding ESG ratings.
“They disagree and diverge substantially,” he said. “Not always, but sometimes.” An example, he said, is the technology company Intel, rated outstanding on ESG grounds by one agency but as merely average by others.
This divergence has two profound consequences, he said. “Investors have trouble finding out which companies are ‘good’, and companies are left asking ‘what is expected of us?’”
Why the divergence? Mr Koelbel explained that three elements go to make up the ratings regime of each agency, and each employs these elements differently. The first is “aggregation”, the weight given to different factors in calculating the rating “How are indicators aggregated into one score?”.
The second is measurement; “Raters use different ways of measuring the same categories. How are these attributes measured?”
The third, he said, is scope; “Which attributes are included?”
Florian Berg listed some of the factors that ratings agencies take into account: air quality, ecological impacts, labour practices, waste and wastewater management, human rights and community relations. “ESG raters need to be much more transparent as to how they measure these factors,” he said, adding: “Credit ratings and ESG ratings are fundamentally different and divergence in the latter will persist.”
“Credit ratings measure one attribute, default risk, but ESG ratings reflect a large number of different attributes, and there is no agreement on what they should measure.”
However, he did not foresee any immediate moves to a more uniform system of awarding ESG ratings, as has been called for in some quarters. “We have to embrace the divergence of ESG ratings,” he said, “because no-one really knows the truth.”
Roberto Rigobon was asked if some ratings agencies were more friendly towards managements than others. “No”, he replied, “I don’t think so.”
The final session was entitled “Managing Climate Risk” and was presented by Martin Skancke, chair of the board of the Principles for Responsible Investment and a member of the Financial Stability Board’s task force on climate-related financial disclosure (TCFD). Speaking of the physical fact of carbon dioxide (CO2) emissions, he said there had been a “structural break” since the start of the industrial revolution.
“This has been the fastest change in the history of the planet,” he said, adding: “This necessitates a significant transition away from fossil fuels.”
TCFD, he said, has provided a framework for climate risk reporting, “governance, strategy, risk management, metrics and targets”. But this framework, he said, differs from others in the ESG space. Unlike them, it has less to do with measuring how companies affect the climate and focus instead on how climate affects companies.
“How will firms make money in a world that has managed to meet its carbon reduction objectives?” he asked. “Some companies [such as some oil and car companies] will be able to make the transition, but others will not.
“The danger is that we have a capital market that is inefficient and does not allocate capital in light of this climate risk. It is important to remember also that climate risk is just one of many risks that face companies and investors.”
There has been an assumption that existing energy giants will be leading the way into the zero-carbon future, not least because many of their marketing and public relations efforts have made much of this. But Mr Skancke was not entirely convinced.
“Will the fossil fuel companies be the energy companies of the future?” he asked. “It is possible, given they have the engineers, the project managers and the market knowledge that could be leveraged to bring about the transition to a low-carbon economy.
“But would it not be relatively easy for new companies, set up specifically for low-carbon energy generation, to replicate these advantages?”
He concluded: “It may make more sense for investors to put pressure on fossil fuel companies to increase their dividends and restrain or reduce their investment plans.” The funds thus released, he suggested could be put to use by investors in taking positions in sustainable energy companies.
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