Morningstar - Q4 2022 - 33

anything from the market upheavals of the last
40 years, from the dot.com implosion to the
Enron-era accounting failures to the financial
meltdown caused by wildly inaccurate
ratings of bundled sub-prime derivatives, it is that
GAAP is inadequate to give us the information
we need to assess risk and return, particularly
over the long term. ESG is still in its earliest stages,
but already it is a vital element that enhances
our understanding of value as we make
our investment decisions. " 6
2 Identifying the Risks Leads to Opportunities
For smart companies, the same risks also
present opportunities. That's part of the reason
why ESG is becoming entrenched in
mainstream investing. In 2021, the International
Energy Agency released its road map for
the global energy sector, reflecting emissions
reduction goals, aimed at forestalling the
worst effects of global warming. The IEA
forecast that renewable energy will account for
nearly 90% of global electricity generation
by 2050. The march to net-zero emissions
will create " the greatest commercial opportunity
of our age, " declared Mark Carney, the former
chief of the Bank of England.7
ESG is now part of the framework for identifying
opportunities as the new economy blossoms.
Controversially, some ESG investors consider the
riskiest companies an opportunity if these
companies are in the process of transforming
themselves.
" The allocation of capital amongst publicly traded
companies is one piece of that overall climate
transition that the vast majority of scientists will
tell you needs to happen, " says Eric Veiel, head of
global equity for investment manager T. Rowe
Price. " More and more investors want
to invest in those companies because they feel
they will be around and will have long-term
business viability. "
3 Rise of Stakeholder Capitalism Is Good
for Companies
Companies are reshaping themselves to appeal
to talented workers who are more diverse
than ever and to customers who are increasingly
consuming in line with their values. This
refashioning is called stakeholder capitalism,
in which management considers the needs of an
array of stakeholders equal in importance to
shareholders. Companies do so on the theory that
it will create more loyal relationships over the long
term that will ultimately enhance company value.
(Corporate social responsibility, a related concept,
is about the company's own framework of
sustainability plans, which ESG measures.)
Stakeholder capitalism can be good for
shareholders, too. According to one study of
large-cap companies in the U.S., racial and ethnic
diversity on corporate boards had a significant
positive impact on their stock prices.8
Martin Lipton, the celebrated corporate lawyer,
recently wrote: " Stakeholder capitalism and ESG
are fundamentally frameworks to enhance the
sustainable long-term value of a corporation. Both
are tools for boards and management to guide
business strategy, risk management and capital
allocation in a manner that best serves the
financial well-being of a business, and in turn, the
interests of shareholders. " 9
Publicly traded companies also are incorporating
ESG metrics to track their progress. In a preliminary
study of S&P 500 companies, consultant Mercer
found that use of an ESG metric increased to 46%
from 35% in executive incentive plans. A further
9% of companies disclosed that they intend to use
an ESG metric in 2023.10
These metrics are something that Lisa Pollina,
who serves on the board of directors for
insurer Munich Re and water technology firm
Energy Recovery ERII, already looks at.
" From a board perspective, I'm looking at
governance, compliance, ethics, business
continuity, " she says. " I'm looking at developing
diverse talent, understanding and looking
at climate change. Does any of that go away
if you don't call it ESG? No. "
Julie Sweet, the CEO of Accenture, recently
said that sustainability " matters to our
employees from a recruiting standpoint, it matters
to our clients, it's part of our regulatory
landscape, it matters to consumers. That's not
changing because of what politicians want
to call it. " 11
4 Regulations Are Leading to Improvements
Regulations are increasingly addressing ESG
issues-meaning that disclosures and fund
managers' literature will get better, too. Central
banks have already awakened to the risks
that climate change poses to the global economy
and are considering how to add ESG bonds
to their reserves. Regulators are especially
active because, in the U.S. at least, legislatures
are divided.
" The policy solution is focusing on things like
disclosure because you can't get legislation
through and the net-zero targets are so far away.
[This is] what they can get done right now, "
says Joyce Chang, global head of research for
JPMorgan.
Rule-setting and enforcement have speeded
up. In Europe, regulators have adopted
two groundbreaking classification and disclosure
regulatory frameworks as part of the
European Union's action plan on sustainable
finance. For example, the EU is requiring
fund managers to classify products so investors
can see how green they are. What we think
of as general ESG funds are in one classification;
more thematic or impact-focused funds
are in another.
6 Minow, N. 2022. " Larry Fink: Here's Your Answer to the Despicable Letter from the GOP Attorneys General. " Medium., Aug. 31.
7 Marsh, A. & Robertson, B. 2020. " Carney Calls Net-Zero Greenhouse Ambition 'Greatest Commercial Opportunity.' " Bloomberg. Nov. 8.
8 Morgan Stanley. 2022. " Does Ethnic Diversity on Corporate Boards Affect Stock Prices? " Jan. 5.
9 Lipton, M. 2022. " Stakeholder Capitalism and ESG as Tools for Sustainable Long-Term Value Creation. " Harvard Law School Forum on Corporate Governance. June 11.
10 Mercer. 2022. " ESG Metrics in Executive Incentive Plans at S&P 500 Companies. " April.
11 Murray A. & Meyer, D. 2022. " Accenture CEO Julie Sweet Makes No Apologies for Her Company's Focus on Environmental and Social Goals. " Fortune. Sept. 15.
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