Specialized engagement is the way in ESG
Institutional investors without an ESG investment policy have become a rare breed. The integration of Environmental, Social, and Governance considerations in portfolio choices has become ubiquitous. Among these three issues, the environmental ones are dominant. To help investors in these endeavors, an information industry has emerged that keeps track of companies’ energy use, CO2 emissions, environmental pollution, and climate risk exposure, among other issues.
Currently, the most common approach to ESG is that institutional investors use this information to distinguish the clean corporations from the polluters, and then exclude the former from their portfolios. That way, investors can claim that the companies in their investment portfolio are relatively clean, reducing their environmental impact and/or carbon footprint. That is nice for these investors, but they also claim that this approach has a beneficial impact on society as a whole. The standard way of reasoning is that the excluded companies will find it harder to find capital, whether in the equity or in the bond markets, and/or that their capital will be more expensive. This should give them an incentive to change their polluting ways.
That sounds good on paper, but the question is whether it works in practice. A recent study by Samuel Hartzmark and Kelly Shue (2023) shows that this approach can be counterproductive. In any country, the companies that produce relatively large amounts of CO2 are those producing chemicals, building products, steel, energy, and buildings, for example. The cleaner companies are mostly active in the services industries. This creates an industry tilt in the portfolio. It also has important consequences for the real-world impact of the exclusion approach.
As an example, let us look at what this would mean for construction companies. An exclusion approach that would be widely adopted among institutional investors would make their cost of capital higher, since they tend to be on the exclusion list. A higher cost of capital implies a higher hurdle rate for investment projects. That creates two kinds of problems. First, in order to improve their CO2 performance while not decreasing construction output, construction companies need to invest in better and more efficient construction methods, for example by changing the way they make concrete, which is a big CO2 source. However, that requires investments, and with a higher hurdle rate, these investments are less likely to occur. This reduces the speed with which new methods will be adopted, and thus the speed of the transition to reduced CO2 emissions by the construction industry.
The second problem is that the higher hurdle rate reduces the number of building projects, and will likely increase the global housing shortage, which is not very good for the social component of ESG. Small consolation is that the lower construction output will reduce CO2 emissions a bit, but less production in order to reduce CO2 emissions is a societal dead end.
Another problem with the assumption underlying exclusion policies is that the incentives they create do not really work. In terms of CO2 emissions per employee or per dollar of turnover, the differences between companies in the excluded and included group can be one or two orders of magnitude. So even if construction companies would halve their CO2 emissions per level of output, which would be a great benefit for society, they would still remain on the excluded list, since they cannot hope to ever reach the CO2 emissions levels of the firms in the service or tech industry. In other words, the higher cost of capital is not an incentive, but a trap.
There are two solutions to this problem, and they both involve an industry-by-industry approach. For those investors that want to stick to an exclusion policy, the way forward is exclusion within rather than across industries: keep the industry allocation weights as they are in the standard benchmark, like the S&P 500, and exclude the worst CO2 emitters in each industry. Using this approach, the bad emitters have a clear incentive, and they know that it is attainable to improve their performance by emulating their industry peers who are on the inclusion list.
An even better approach is active engagement, also with industry specialization. By engaging with the polluters and working together to improve their way of doing business, change is far more likely to be adopted. Effective engagement needs to be well informed and knowledgeable to make an impact, so again, specialization by industry is key.
In real estate, this thinking has led to the foundation of GREEN – the Global Real Estate Engagement Network. This initiative helps large and small institutional investors, such as pension funds, sovereign wealth funds and other asset managers to bundle and coordinate their engagement efforts towards the real estate industry. GREEN already maintains an active and ongoing dialogue with the main listed and unlisted property companies, using its specialized industry knowledge to improve the sustainability performance of these companies. This will reduce the carbon footprint of the industry faster and more than a broad-brush exclusion policy, and given that the global real estate industry is responsible for about one third of global greenhouse emissions, this is important.