There are a range of problems with the environmental, social and governance movement, often referred to as “ESG.” One familiar criticism argues the three letters lump too much together; including too many fundamentally different considerations makes the moniker useless. Some argue it is too subjective to rank companies by loosely defined and calculated metrics. Others say a political issue of the “woke” vs the conservatives. The arguments go on and on.
Having managed investments for some of the world’s largest wealth and asset managers, we believe ESG is here to stay. (In fact, we’re betting on it, having launched a company focused on helping private markets investors collect and analyze ESG information.)
Fundamentally, ESG is a new tool that investors can use to solve an old problem: managing risk.
As times change, risk changes. Today, companies face risks that managers and investors would have given little thought to as recently as a decade ago. They have to confront the reality that entire manufacturing regions and supply chains could go offline, that essential inputs like energy and water may become unavailable or too costly due to climate change or war, that key employees often leave companies whose behaviors are out of step with their values, and that consumers can (and will) take their business elsewhere with the ease of a click of their mouse, when companies abuse their trust.
These risks may seem difficult to quantify. Fortunately, finance has a range of tools that are perfect for just this kind of uncertainty. Chief among these is the discount rate.
The job of equity investors is, at its core, to manage risk. They do so by assessing a company’s current and future earnings dynamics. They put a present value on those cash flows and compare the opportunity to other uses of scarce funds. This kind of analysis is full of uncertainty, and so the conventions of finance utilize the concept of a “discount rate.” A discount rate is fundamentally a way to acknowledge the time value of money, which says that what you have today is worth more than it will be in the future. Why? Money can earn interest, so money you get sooner earns more interest than money that comes in later.
But the discount rate also has another convenient function – to adjust for future risk associated with the company. The higher the risk, the higher the discount rate and the less the business should be worth today.
Unfortunately, to-date, the topics of ESG and financial data have largely existed in separate worlds. Yet ESG data can provide real insights investors need into how a company is likely to do in the future. What has been missing is a way for investors to integrate a company’s quantifiable and relevant ESG metrics with its financial data so as to provide a better way to assess risk.
Investors have always had to consider a myriad of risks related to a company. How good is a management team and its board oversight? Are a company’s products engendering appropriate loyalty with their customers and in turn gaining market share? Does the workforce have a good safety record? Are there important legal claims outstanding related to a company’s products or employees? Will there be in the future? Does the company have a deferred maintenance problem? Will it have to spend lots of money to modernize facilities and fix legacy environmental issues? Do they have good data security? Are their facilities efficient or wasteful? Is there strong employee loyalty? Is the company a good neighbor in the communities where it operates?
All of these questions may seem obvious as ones an investor should assess. And yet, these questions would also likely be categorized as “ESG” metrics in today’s fraught debate around these three loaded letters. Some would argue such questions should not be asked, nor the answers considered, because they are “woke.”
For all of the controversy around this topic, we would argue ESG is really about risk assessment.
The most important ESG metrics directly affect how a company performs and, in turn, its financial value. ESG data should be tracked, measured, benchmarked and then used by investors to adjust their discount rate, and in turn their valuations. If a company is bottom-quartile compared to its peers when it comes to an issue like worker safety, its discount rate should go up. This is obvious given the future costs associated with the implications of such a track record. If the company is top-quartile when it comes to a risk area like data breaches, its discount rate should be lower relative to its peers. And on and on across all of the measurable and objectively important ESG criteria.
As investors, we want to invest in companies that perform better than their peers. If we substitute the word “competitiveness” for the term “ESG,” we might find a valuable tool-set to do so, readily available.
