Once viewed as a niche investment strategy, environmental, social, and governance-led investing has never been higher. Business schools are offering classes in ESG. Exchange-traded funds are recording record flows. Banks are contributing billions toward sustainable finance.
And yet, as the sector grows in complexity, concerns about accountability and reporting are on the rise. A company can say it’s committed to ESG, but how is it doing so? Is it disclosing the metrics of its carbon footprint, increasing board diversity, or revealing the inner workings of its supply chain?
“ESG is about building sustainable businesses for the long run with a stakeholder perspective,” saida senior lecturer in finance at MIT Sloan. Stakeholders include “everybody that the company interacts with” and “anybody that the company's operations touch — employees, customers, suppliers” — and should include the emissions those suppliers generate, she said.
Rao has deep experience in the field, having managed socially responsible portfolios for more than two decades. She also developed and teaches MIT Sloan’s course on impact investing. Rao recently shared her thoughts on some of the top issues in ESG that aren’t often at the forefront of the conversation. Here are four questions to consider.
1. Do your ESG index funds vote in alignment with shareholder preferences?
ESG index funds contain stocks of companies that abide by good environmental, social, and governance practices. Investors who allocate their money toward ESG funds (usually using their retirement or investment savings) expect that their money will be invested in alignment with their values, whether that’s reducing reliance on fossil fuels or promoting gender diversity in management.
However, research conducted by Rao revealed that a number of funds with an ESG mandate had proxy voting records that went against their stated objectives. Fund managers are responsible for voting on proxies on behalf of individual investors, leaving shareholders often unaware of how funds are voting on issues they care about.
“There is an inconsistency between the stated objectives of these funds and what they’re doing,” said Rao, whose study of Vanguard and BlackRock funds showed that “historically, they have not been voting in accordance with ESG standards.”
Few companies vote to support gender pay equity, for example, an area Rao said desperately needs attention. Research by the Pew Research Center revealed that in 2020, women earned 84% of what men earned — which would require women to work an additional 42 days in order for them to earn what men did in the same year.
In her research, Rao examined resolutions on gender-pay gap disclosure for the 2020 proxy voting season for the Vanguard Social Index Fund, which has assets under management of about $8 billion. She found that in every case where shareholders requested disclosure on gender-pay gap for an individual company, the fund manager cast a vote against the proposal.
“As shareholders, this is our money, and if we believe in these issues, we need to advocate for them,” Rao said.
Fortunately, change is happening, albeit slowly, Rao said. In October, BlackRock said it would give pension funds, universities, and other institutional investors (who usually don’t have this power) more control over their voting, starting in 2022.
2. Are companies delivering on the “S” and the “G” in ESG?
When it comes to minimizing a company’s environmental impact, companies are increasingly tracking their carbon emissions, among other metrics. “
There’s more disclosure with ‘E’,” Rao said.
The “S,” or social pillar of ESG, can pertain to human rights issues as well as diversity and inclusion. It isn’t as easy to quantify as the environmental pillar, given the challenges surrounding how to define as well as measure it.
“Issues like the treatment of labor in the supply chain are hard to measure,” Rao said. “The “S” pillar is a very broad area covering everything from drug pricing to diversity in the workforce. Companies are not required to report on many of these issues, so there is little in the way of standardized disclosure.”
Rao referenced an incident that occurred in 2013 when a handful of western retailers were forced to examine their labor practices and worker safety conditions after a Bangladesh factory collapsed, killing 1,138 workers.
The tragedy triggered labor code amendments, the creation of the Accord on Fire and Building Safety, and a promise from retailers to pay $30 million in compensation, according to the Center for International Private Enterprise.
Rao said more headway has been made as it relates to corporate governance, which refers to how a company makes decisions and conducts itself. For instance, in the aftermath of Pacific Gas & Electric's role in the catastrophic California wildfires, which killed 84 people and caused PG&E to file for bankruptcy protection, questions were raised about the company’s board and whether members were fulfilling their fiduciary responsibilities by not doing more to ensure that the company had adequate safety protocols.
One final matter to consider as it relates to governance, Rao said, is advocating for the separation of CEO and chair positions. Doing so can contribute positively to the governance of a company because it helps distinguish management and board authority so that one position doesn’t influence the other. Some, for instance, have raised concerns about the amount of power that Mark Zuckerberg, the founder of Facebook, has as both CEO and chairman of the board.
This kind of ownership structure, where one leader has control of the board’s decision-making is “unprecedented at a company of this scale,” Marc Goldstein, head of U.S. research for the proxy adviser Institutional Shareholder Services, said in an interview with The Washington Post. “Facebook at this point is by far the largest company to have all this power concentrated in one person’s hands.”
“On the ‘G’ side we have some progress, but not a huge amount,” Rao said. “You've got a company like Facebook with the misinformation issues, and Zuckerberg owns the majority of the shares. How much leeway and leverage do shareholders have? Many of these companies have governance issues in terms of their corporate structure, and Facebook exemplifies the consequences.”
3. How should we price environmental transition risk?
Transition risk is the risk that can occur when a company is on a path to becoming carbon neutral, but is not yet there. If it’s not on investors’ radar, it should be, Rao suggested.
A coal-fired utility company, for example, is a significant emitter of greenhouse gases. As such, it will be a substantial cost to the utility to transition from coal to a renewable source, given that the plant will probably have to be shut down or retrofitted along the way. Apart from the financial cost, there is risk in this process. Implementing technological change isn’t easy, and missteps can affect a company’s reputation.
“Transition risk is not currently priced into asset prices. It is long-term, difficult to measure, and not easy to quantify using the traditional finance frameworks of balance sheets and income and cash flow statements,” Rao said. “Correctly pricing transition risk will dramatically change the valuation landscape for some sectors.”
The Task Force for Climate Disclosure is helping with standardization. Its 2020 report, “Task Force on Climate-Related Financial Disclosures,” is designed to serve as a resource for companies looking for guidance as they disclose the transition risks and opportunities from climate change.
"There is clear and growing consensus among investors and regulators on the importance of climate-related disclosure and the need for standardized, transparent data to support capital allocation decisions," Mary Schapiro, head of the TFCD, told Reuters.
To help correctly price transition risk, organizations like “the TFCD are doing important work towards standardization,” Rao said.
Clear data and standardized procedures are essential to avoid greenwashing. Rao said investors need to hold companies accountable as they transition their operations.
“The devil is in the details,” Rao said. “It’s not enough that companies set forth these goals. As investors, we must look carefully at what companies are promising, over what timeframe, and partner with them to advance our collective goals.”
4. What are companies doing to address pandemic- and climate-related inequality?
COVID-19 highlighted the “S” in ESG by exacerbating existing inequalities in the labor force. Low-paid essential workers were laid off without health insurance or forced to work in person, exposing themselves to the virus. Many had no access to paid leave when they fell ill or needed days off if they had side effects from being vaccinated.
“The pandemic exposed in stark detail the inequalities in our society,” Rao said. “The question is: What are companies doing about it? And how can shareholders hold them accountable?”
Rao said that regulation is essential if investors want better disclosure. And it appears it is coming. Securities and Exchange Commission Chair Gary Gensler, a former MIT Sloan professor, recently asked SEC staff to begin thinking about a “human capital” disclosure requirement for public companies. This could include metrics on compensation, benefits, or workforce demographic information on diversity.
In a tweet, Gensler said: “Investors want to better understand one of the most critical assets of a company: its people.”
“Both COVID and climate change disproportionately affect people who are poorer and [belong to] communities of color,” Rao said. “Some regulation is required so companies have a roadmap,” and investors have transparency.
A way forward
There is plenty to consider as ESG continues to evolve. Some believe that soon, there will be a pricing differential between companies that are truly green and those that aren’t. Going forward, as companies disclose risks and measure their progress, those that deliver on environmental, social, and governmental practices will be rewarded by investors.
director of the MIT Sloan Sustainability Initiative, noted “a whole broader constellation of things that are happening surrounding investor action,” while speaking at the MIT Impact Investing Initiative spring speaker series.
When “investor action plays together with corporation action, public policy action, civil society action,” that’s when impact can be achieved. Having investors exercise their shareholder power, invest capital or encourage a price on carbon — “those actions are going to affect business, government, and civil society,” he said.
Rao acknowledged that ESG issues are complicated but still encouraged investors to “think of it as a dialogue” with companies, particularly when it comes to climate change.
“Getting companies to report on greenhouse gas emissions will take time,” she said, noting that shareholders have a responsibility to “advocate for analysis, transparency, and disclosure.”