Time to integrate ESG into analysis

High sustainability companies outperform their counterparts

American institutional investors are woefully behind their European counterparts in incorporating environmental, social and governance factors into their investment processes. European institutional investors had more than $6.5 trillion in ESG investments at the start of 2010, while America lagged with only $2.3 trillion.

In January, 450 investment managers and asset owners representing approximately $26 trillion gathered at the Investor Summit on Climate Risk and Energy Solutions at the United Nations headquarters in New York to discuss how collectively they can help mitigate climate change risk and promote long-term sustainability of economic growth by embracing ESG investing.

In Europe, ESG investing is taken seriously, partly because resource scarcity is nothing new and governments have taken policy steps to address these issues, along with climate change. Asset owners and investment managers in Europe view ESG investments not as a token allocation, but as a critical part of their overall investment policy and objectives. This is in contrast to the United States, where a common misperception is that ESG integration could breach fiduciary duty. That couldn't be further from the truth in our view. To paraphrase the wording used by the United Nations-supported Principles for Responsible Investing Initiative — a global network of institutional investors seeking to put the principles into practice — appropriate consideration of these issues is part of delivering superior risk-adjusted returns, which is firmly within the bounds of investors' fiduciary duties.

The ESG tide is slowly shifting in the U.S., as evidenced by initiatives showcased at the summit, especially by state retirement plan executives representing the North Carolina Retirement Systems, California Public Employees' Retirement System, California State Teachers' Retirement System, New York State Common Retirement Fund, Pennsylvania Public School Employees' Retirement System, Pennsylvania State Employees' Retirement System, and the Connecticut Retirement Plans & Trust Funds as well as others, including CtW Investment Group.

However, it's not happening fast enough. A broader new approach needs to be taken by institutional investors in order to make a real impact on reducing the risk factors involved with climate change and reduce the impact of that risk on the investment portfolio. I'm not talking just about global warming, I'm pointing to the portfolio risk that arises when underlying companies haven't fully evaluated the risks their businesses face from climate change. Take water shortage as an example. Power plants depend on water to operate, but 68% of utilities surveyed said they couldn't identify their level of risk if the water supply became an issue. Likewise, could American beverage producers — aiming to increase revenues by saturating emerging markets in countries like India — continue to deliver profits if their supply of clean drinking water evaporated?

In other words, ESG investing isn't just about investing to mitigate climate change; it's about investing in companies that can sustain their business models and continue to be profitable in a world that is already feeling the impact of climate change.

A recent study from the Harvard Business School — “The Impact of a Corporate Culture of Sustainability on Corporate Behavior and Performance,” by Robert G. Eccles, Ioannis Ioannou and George Serafeim — concluded: “High sustainability companies significantly outperform their counterparts over the long term, both in terms of stock market and accounting performance,” such as return on equity and return on investment.

Companies that are looking ahead to create a competitive advantage and long-term stakeholder value are considering these risks. Are American institutional investors paying enough attention to them through ESG integration? I don't think so.

Let's look at what is being practiced today: exclusion and engagement. Based on exclusion, socially responsible investing is only the first step. It has long been practiced by managers with clients who mandate that their portfolios be free of holdings in companies whose products or practices they oppose on moral or ethical grounds.

An example is one described at the UN. summit by Thomas DiNapoli, trustee of the $140.3 billion New York State Common Retirement Fund, Albany. Mr. DiNapoli spent years pressuring Massey Energy Co. to clean up its coal plants and restructure its board, which was chaired by the company's CEO, a fierce opponent of regulations designed to address climate change and protect worker health and safety. When the Upper Big Branch Mine disaster occurred in 2010, Mr. DiNapoli was the first institutional investor to demand his resignation. After Massey's CEO finally resigned, the company was sold to Alpha Natural Resources Inc. and shareholders received a hefty premium of 21.1% over Massey's closing price the day before the transaction was announced.

However, exclusion and engagement are just the first step. To catch up with their European counterparts, American institutional investors need to embrace full integration of ESG factors into investment analysis and decision-making. Results of last year's survey by the UNPRI are telling. Of the UNPRI's 345 investment manager signatories, the median score on the question of how many practice full integration of ESG factors in their investment processes was just 63%.

Interestingly, at least one major plan sponsor at the UN Summit, CalSTRS CEO Jack Ehnes, told the audience that in his fund's procurement and annual performance evaluations, each manager will be expected to provide specifics about how they integrate ESG factors into their investment process.

What I'm calling for is both managers and asset owners to undertake full ESG integration, including the analysis of material non-financial information that could affect a company's long-term sustainability in every investment decision. Doing that, along with thematic investing in companies that are working to address the most pressing sustainability issues — including water shortage, energy supply and production, climate change, food and agriculture and resource scarcity — puts America's capital to work to make a real impact.

It's time for American institutional investors to wake up to the reality of climate change, catch up to their European counterparts and put their money to work to push forward solutions.

Michael Baldinger is CEO of Sustainable Asset Management AG, Zurich.