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The evolution of ESG investing. Here’s what’s next


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As investors shift their money to stocks that are based on ESG factors (or sustainable investing), it has become a focal point. However, shareholders must get involved in order to make measurable changes at their companies.

Inflows to U.S. Sustainable Funds were $15.7 billion during the third quarter 2021. according to MorningstarThese funds are. These funds held assets totaling more than $330 trillion as of September.

ESG-qualified stocks must be screened before investors can embrace sustainable investing. Look to activist funds with an ESG focus to see how shareholders can hold boards of directors accountable and create value for society – and investors.

ESG investments

ESG investing refers to when investors use a set of socially responsible standards that govern a company’s operation in order to evaluate potential investment opportunities. The company’s performance as a natural steward is one of its environmental criteria. Social criteria assess how a company manages its relationships with customers, employees and the communities it serves. Governance is the management of a company’s leadership and board composition. It also includes alignment with stakeholders. ESG investing has numerous benefits that cannot be understated. ESG investing has allowed executives and investors to see beyond just profits and returns. The diversity of corporate boards has been greatly improved and many retail investors have the chance to make investment decisions that align with their beliefs. It has some flaws due to its passive nature.

ESG limits

First, it does not use quantitative screenings to determine ESG-friendly companies. It is problematic because of two things. Second, the quantitative screenings don’t tell all. ESG’s biggest impact has been on board diversity. But, quantitative screenings are far from flawless. ESG funds do not screen for diverse boards. However, the analysis stops there. However, diverse boards may still be unengaged or entrenched. In an ESG quantitative analysis, an unengaged diverse, conflicted and self-dealing board will receive the same rating as an engaged board that works for stakeholders. An example is the control of a tech company by a husband and wife team. This led to questionable material payments being made to the company by relatives. Because of option backdating, the Securities and Exchange Commission banned her from being an officer of or director of any public company for five year. She was allowed to return as both an officer and a director after the ban ended. The company also saw an increase in ESG scores due to adding a woman board member.

Another limitation of traditional ESG investing, is the fact that it only screens for best-in class ESG companies. This means investing in such companies has very limited potential to bring about change. Passively investing in ESG-compliant securities will not have an impact on our environment, or the social challenges facing the planet. These include the 14-year-old increase in dollars spent in ESG funds, which hasn’t reduced the atmospheric carbon dioxide level, but it has also significantly increased the carbon dioxide levels over this time.

AESG investing — it’s what’s next

ESG investment is still in its infancy and will continue to evolve over time. It was important to shift the way people think, and this has already been achieved. Next, we need to change our behaviors. This requires active ESG investment. It is happening already. We don’t mean passive index funds or ETF investors, but active ESG investors. This investor faces the same challenges as passive ETF investors. These investors invest only in the most effective ESG actors, and not those that must change. Investors who are active in ESG or AESG investing (or Active ESG, for short) engage actively with their portfolio companies to effect change. It is possible to create true ESG-related change by investing with ESG investors that are in the boardroom.

AESG investing solves the problems of traditional ESG investing. The first is that it can only do a qualitative analysis on portfolio companies. The analysis does not stop at the diversity of a board. AESG funds qualitatively and actively analyze boards to identify not just diversity, but also engaged, conscientious, and experienced directors. All boards in an AESG investing world are different. A second reason is that it engages actively in the ESG investment world. It does not seek out best-in class ESG companies. Instead, it looks for companies where it can bring about positive changes. These companies often have lower ESG scores than average. Passively investing in equity shares of solar companies is more environmentally friendly than investing in oil and gas producers and explorers. Passive ESG investing means that you are not part of the problem, whereas AESG investment is about helping to solve it. Furthermore, the transformation of a weak ESG company into a strong one creates greater value for society and shareholders.

AESG investment in action

A handful of activist funds already have ESG-focused focus such as Impactive Capital, Inclusive Capital or Engine No. 1. These funds are able to make significant ESG improvements through engaging businesses with negative ESG characteristics or trying to transform them into positive ESG firms. Engine No. For example, Engine Number. three board seats at ExxonThrough a proxy battle and is asking the company to focus more on clean energy infrastructure, renewable energy and net-zero emission. Asbury Automotive is an auto repair and retailer, but Impactive Capital has been involved. Impactive Capital works with Asbury Automotive to implement changes such adding maternity leave and women’s bathroomsTo bring in more women as mechanics and solve the current labor shortage. Inclusive Capital has been active at Enviva wood pellet producer, helping it convert coal plants into biomass and ensure responsible tree farm management. This is a list of companies which would be excluded from an ESG screening. But, because there are activists involved in these projects and an ESG thesis to support them, this company has more potential than passive ESG companies.

But activist funds, which have been primarily concerned with shareholder value and governance, will see a bigger shift. They are starting to address both “E”, and “S” in an active manner. Starboard Value was one example of an activist fund that reconstituted Papa John’s Board with. Starboard founder Jeffrey Smith becoming chairman. Starboard also removed an executive who was not a part of the economic and governance campaigns. according to a 2018 report in ForbesFor years, he had created hostile working conditions for his employees. Another example is Trian’s campaign at Proctor & Gamble where Nelson Peltz won a board seat. Trian mentioned to the company that they had spent significant resources on R&D and hadn’t really come out with new products. Peltz discovered a way to get rid of plastic packaging. It was more costly but better for the environment. The technology was successfully implemented. These funds have been regularly taking seats on boards at companies over many years. They have made a significant impact on shareholder value as well as corporate governance. Funds like these are also starting to focus on social and environmental issues at companies. This is making an impact. Our belief is that ESG investors who focus solely on the “G,” do more good work for ESG activists than those who remain passive. This philosophical shift will be lasting and growing.

ESG investing and AESG investment work together

Global ESG funds are now worth more than $1 trillion. This is a good sign that they will continue to increase. Passive ESG will continue to hold the majority of ESG assets due to the ease of creating an ESG portfolio using quantitative metrics and ESG score. But AESG investments strategies are also needed if ESG is to change. AESG strategies are a tiny subset of ESG assets. This is because only a few investors have the ability, traits, and inclination, to engage in active management of portfolio companies. It will become a more important subset and those involved in AESG investment will bring an active element to ESG investing. AESG and passive ESG funds can be mutually complementary and may even have a symbiotic relationship. AESG investments can expand the potential ESG companies that passive ESG portfolio manager could invest in. This is a category that does not normally meet ESG criteria but has been recognized by ESG portfolio managers as ESG-compliant companies due to their activism component. Passive ESG funds are included in ESG screens to ensure they can invest in stocks and help active ESG investors achieve their ESG goals. 

Ken Squire founded 13D Monitor and is its president. The institutional research company focuses on shareholder activism.