ESG: The Economic Evolution of Responsible Investing

The effects of human impact to the environment and the best methods to mitigate that impact are at the forefront of public and geopolitical discourse. The United Nations’ net zero coalition consists of over 70 countries which have committed to net zero greenhouse gas (GHG) emissions by 2050. According to the 2021 UN Emissions Gap Report Addendum, since the cutoff date of the 2021 report, 25 additional countries have announced net-zero emissions commitments covering 76% of global domestic emissions.¹ According to the EPA, in 2020, over 75% of GHG emissions could be attributed to transportation, electricity production, and industry.² Obviously, such a drastic reduction target in GHG emissions will have significant influence on every economic sector. This influence is already apparent in the financial services sector with the implementation of ESG scores.

By Foster Voelker II – Director of Engineering, Williams Valve

What is ESG?

ESG is an acronym for Environmen­tal, Social & Governance, metrics by which a company is assessed and as­signed a score. While the specific fac­tors assessed within each metric can vary, common examples referenced include a company’s carbon footprint (environment), diversity (social), and reporting transparency (governance). This is by no means a comprehensive list and the ambiguity in which the as­sessments are made is a chief criticism of ESG investing. This can be seen in the Wall Street Journal article titled “Is Tesla or Exxon More Sustainable? It Depends Whom You Ask”.³ However, as this discussion is focused on the finan­cial services sector, it is best to frame the discussion in economic terms. The purpose of an ESG score is to quantify negative externalities. For simplicity, externalities can be considered side effects, either positive or negative, caused by a producer that are not fi­nancially incurred by said producer. Pollution is an example of a negative externality. A negative consequence of industrial processes that the public did not choose to incur but must bear. ESG investing is based on the premise that one can simultaneously receive a solid market return while improving the future by limiting investments to companies that do not mitigate nega­tive externalities in the realms of envi­ronmental, social, & governance.

The History of Responsible Investing

The history of responsible investing, more commonly referred to today as sustainable investing, can be traced back for decades. A divestment cam­paign regarding Apartheid South Af­rica was prevalent in the 1980s. The 1990s saw the emergence of the “Tri­ple Bottom Line” concept. In econom­ics, the triple bottom line (TBL) main­tains that companies should commit to focusing as much on social and en­vironmental concerns as they do on profits. TBL theory posits that instead of one bottom line, there should be three: profit, people, and the planet. The TBL seeks to gauge a corpora­tion’s level of commitment to corpo­rate social responsibility and its im­pact on the environment over time.” ⁴  The TBL concept was the precursor to ESG and SRI (Socially Responsible In­vesting). During the 1990s, the United Nations Framework Convention on Climate Change (UNFCCC) was also established with a mission to “stabi­lize greenhouse gas concentrations in the atmosphere at a level that will prevent dangerous human interfer­ence with the climate system, in a time frame which allows ecosystems to adapt naturally and enables sustain­able development.” ⁵  In 2006, the Unit­ed Nations’ Principles for Responsible Investment (UNPRI) reporting frame­work was launched. This framework is built around six investment principles with the stated goal to “offer a menu of possible actions for incorporating ESG issues into investment practice. The principles were developed by in­vestors, for investors. In implementing them, signatories contribute to devel­oping a more sustainable global finan­cial system.” ⁶  The following decade saw the establishment of the sustain­able development goals by the United Nations in 2015 and the release of The Intergovernmental Panel on Climate Change (IPCC)’s special report on the human impacts of climate change in 2018. The decades of focus on sustain­ability, driven by UNPRI, brought the discussion to the forefront of global industry with the number of signato­ries increasing from less than 100 in 2006 to almost 4000 in 2021. ⁷

A Catalyst In Finance

In 2018, BlackRock CEO Laurence D. Fink sent an annual letter to the CEOs of the world’s largest corporations titled “A Sense of Purpose”. ⁸  The let­ter essentially outlines the concept of a company’s social responsibility beyond profit, like the TBL, and pro­poses companies should actively con­tribute to society. “Without a sense of purpose, no company, either public or private, can achieve its full potential. It will ultimately lose the license to operate from key stakeholders. It will succumb to short-term pressures to distribute earnings, and, in the process, sacrifice investments in em­ployee development, innovation, and capital expenditures that are neces­sary for long-term growth. It will re­main exposed to activist campaigns that articulate a clearer goal, even if that goal serves only the shortest and narrowest of objectives. Ultimately, that company will provide subpar re­turns to the investors who depend on it to finance their retirement, home purchases, or higher education,” said Larry Fink, CEO of BlackRock.⁸ While the idea that maximizing profits while serving a greater societal purpose was nothing new, the weight of the CEO of BlackRock, the world’s largest asset manager to the tune of 10 trillion in assets¹¹ garnered an unseen response from the leaders of industry.

The Friedman doctrine, outlined by the late Nobel Prize winning econo­mist Milton Friedman in the 1970 essay “The Social Responsibility of Business is to Increase its Profits”, has dominated the ethics of finance for the last half century. Under the Friedman doctrine, a business’s sole responsi­bility, and subsequently the sole re­sponsibility of the executives of said business, is to maximize shareholders’ profits. In 2019, almost 200 corporate CEOs that participate in the US Busi­ness Roundtable broke from adher­ence to the Friedman doctrine issuing a statement arguing corporations hold a responsibility beyond shareholder interests. ⁹  Many financial insiders and journalist attribute this deviation by industry leaders to Mr. Fink’s an­nual newsletters. According to Ross Sorkin at the NY Times. “Within weeks of his telling leaders in 2020 that cli­mate change would become a “defin­ing factor” in how BlackRock assessed their companies, many blue-chip busi­nesses announced plans to become carbon-neutral or carbon-negative.” ¹⁰ Regardless, the concept of sustainable investing as a tool to mitigate nega­tive externalities is at the forefront of almost every economic sector.

Implications: According to Proponents & Opponents

There is no shortage of debate re­garding effectiveness, implementa­tion, and long-term consequences of sustainable investing. Proponents of sustainable investing and ESG scores subscribe to the concepts laid out thus far. To review, sustainable investing is not at odds with the fiduciary duty of an institutional investor to maximize shareholder returns and, to the con­trary, often yielding superior returns over non-sustainable investments while offering the additional benefit of mitigating negative societal impacts. Put simply, proponents claim busi­nesses have a duty to serve society rather than shareholders alone and financial markets are key to solving societal problems.

The spectrum of criticisms is rather extensive and ranges from claims of ineffectiveness to economic dooms­day predictions. The most obvious and straight forward criticism comes from the finance sector itself, regard­ing the reality of the promised higher returns. Stock prices over a long pe­riod, tend to reflect a company’s profit­ability. Adherences to ESG principles can be costly, effecting profitability, raising the question how a company will outperform in a market against competitors not concerned with ESG. Additionally, portfolio managers are typically compensated based on per­formance, thus, logic would follow that the utilization of ESG informa­tion would be implemented without any incentive if it was as useful as proponents advertise. Combine these considerations with the reduction in portfolio diversification and the fees associated with actively managed ESG funds, many in the world of finance question the assessment that ESG in­vestors will consistently see superior returns.

Another concern amongst the finance industry involves efficacy. The entire ESG premise is based on the concept of using divestment in markets to in­fluence real world change. However, lack of demand for shares on the sec­ondary market has little impact on operational capital and would simply drive down share price causing some to question the effectiveness of using financial markets as a tool to solve so­cietal woes. However, the critics rais­ing questions of efficacy extend far beyond finance. ¹⁰

One of the most legitimate concerns is the quantification of the ESG scores. Per James Mackintosh at the Wall Street Journal, “the problem here is not the ESG ratings, but that they are used as though they were some sort of objective truth. In reality it is no more than a series of judgments by the scor­ing companies about what matters – and investors who blindly follow their scores are buying into those opinions, mostly without even knowing what they are.” ³  Tesla is ranked extremely high by MSCI Inc., an American fi­nance company headquartered in New York City. The ranking is justified by two car industry performance indica­tors: carbon produced by the cars and opportunities in clean energy ³  Thus, these metrics are extremely limited and do not consider things that have significant negative environmental im­pact, such as lithium mining for the batteries or battery disposal. Critics point to this arbitrary assignment of ESG scores as a core problem, mak­ing the current use of them little more than an opinion-based sales pitch to investors.

At the other end of the spectrum, in­dividuals who hold a more tradition­al view of markets voice concerns if responsible investing worked as in­tended. Does society truly want Wall Street to dictate company investment and the development of industry? One can simply take note of the cur­rent global energy sector for warn­ings of downstream consequences to investment. Germany heavily invested in wind and solar over the past few decades while simultaneously decom­missioning coal and nuclear power plants.¹²  Ignoring the technological challenges of wind and solar (low power density, intermittent nature, lack of storage capacity, etc.) increas­ing a dependency on Natural Gas. The unexpected war in Ukraine disrupted Natural Gas imports resulting in a sharp rise in energy costs due to lack of supply. Now Germany is recommis­sioning some of the coal and nuclear plants to meet demand.¹³

Recently in the United States, Repre­sentative Thomas Massie, who holds a bachelor’s degree in Electrical En­gineering and a master’s degree in Mechanical Engineering from MIT, questioned Secretary of Transporta­tion Pete Buttigieg about the viability of electric grids to support the transi­tion to electric vehicles. Rep. Thomas Massie, “numbers are important. It would take four times as much elec­tricity to charge the average house­hold’s cars as the average household uses on air conditioning.” The Secre­tary’s responded by simply stating grids would have to be able to handle the demand which sounds more like hope than a strategy. Especially con­sidering California was asking electric vehicle owners not to charge their cars during the recent heat wave.¹⁵

While the debate is sure to rage on for the next several years, the concerns about sustainable investing can be sum­marized with the old idiom, “the road to hell is paved with good intentions”.

Impact to the Valve Industry

The extent to which ESG investing will impact the valve industry is not yet fully understood. Valves have long been a focus of emission reduction by the EPA, targeted in Enhanced Leak De­tection and Repair programs mandated by consent decrees. Per Regulations. gov, “On January 20, 2021, President Joe Biden issued an Executive Order titled ‘Protecting Public Health and the Environment and Restoring Science to Tackle the Climate Crisis,’ which directs the EPA to propose a rulemaking to reduce methane and volatile organic compound (VOC) emissions in the oil and natural gas sector by suspending, revising, or rescinding the previously issued new source performance stan­dards (NSPS) and propose new regula­tions to establish standards of perfor­mance for methane and VOC emissions from the exploration and production, transmission, processing, and stor­age segments by September 2021. The EO also directs the EPA to propose new regulations to establish emission guidelines for methane and volatile organic compound (VOC) emissions from existing operations in the explo­ration and production, transmission, processing, and storage segments by September 2021.

The purpose of this action is to review the existing NSPS and propose new requirements and propose new emission guidelines for existing sources in order to meet the requirements set forth in the Executive Order.” ¹⁶  In September 2021, as a result of the EO, the EPA submitted a pro­posed rule for publication in the Fed­eral Register significantly impacting emissions regulations. The proposal would intensify and expand emission reduction requirements and would require states to implement meth­ane emissions reduction programs for hundreds of thousands of exist­ing sources across the nation for the first time. These sources would include new, modified, and reconstructed oil and natural gas facilities. Much of the equipment utilized at these facilities, including valves, will be impacted by the proposed rule. Thus, from a perfor­mance perspective, valves will likely continue to be a core focus of emission reduction regardless of the impacts of responsible investing. A truly robust responsible investing program would require the quantification of the en­vironmental impact of supply chains, which is no easy task. Due to the chal­lenges in quantification, the most influ­ential impacts to the valve industry will likely result from regulations passed to meet GHG commitments, especially if this type of regulation expands to ar­eas of the world with significant valve production, which is a mandatory re­quirement to successfully meet global GHG commitments.

REFERENCES

1. https://wedocs.unep.org/bitstream/handle/20.500.11822/37350/AddEGR21.pdf
2. https://www.epa.gov/ghgemissions/sources-greenhouse-gas-emissions
3. https://www.wsj.com/articles/is-tesla-or-exxon-more-sustainable-it-depends-whom-you-ask-1537199931
4. https://www.investopedia.com/terms/t/triple-bottom-line.asp
5. https://unfccc.int/about-us/about-the-secretariat#:~:text=The%20ultimate%20objective%20of%20all,naturally%20 and%20enables%20sustainable%20development.
6. https://www.unpri.org/about-us/about-the-pri
7. https://www.unpri.org/annual-report-2021/how-we-work/building-our-effectiveness/enhance-our-global-footprint
8. https://seekingalpha.com/article/4137819-larry-finks-2018-letter-to-ceos-sense-of-purpose?source=acquisition_ campaign_google&utm_source=google&utm_medium=cpc&utm_campaign=14049528666&utm_ term=127999857095^aud-1157855518528:dsa-1427141793820^^547854587981^^^g&internal_promotion=true&gclid=Cj wKCAjw1ICZBhAzEiwAFfvFhHQvL8iPs5dVj7QEa8gNqAQMA-DgBay21jOJKUA0SeBy_-DW66nyFBoCiGUQAvD_BwE
9. https://www.nytimes.com/2019/08/19/business/business-roundtable-ceos-corporations.html
10. https://www.nytimes.com/2022/01/17/business/dealbook/larry-fink-blackrock-letter.html
11. https://s24.q4cdn.com/856567660/files/doc_financials/2021/Q4/BLK-4Q21-Earnings-Release.pdf
12. https://abcnews.go.com/International/wireStory/germany-finalizing-plan-phase-coal-energy-71591216
13. https://www.nytimes.com/2022/06/19/world/europe/germany-russia-gas.html
14. https://www.realclearpolitics.com/video/2022/07/19/massie_to_buttigieg_electric_cars_use_4_times_the_ electricity_of_an_air_conditioner.html
15. https://www.nytimes.com/2022/09/01/us/california-heat-wave-flex-alert-ac-ev-charging.html
16. https://www.regulations.gov/docket/EPA-HQ-OAR-2021-0317