Companies face increasing pressure to operate sustainably and demonstrate their social purpose. Yet Environmental Social Governance (ESG) data only provides a limited view of corporate sustainability. And the frameworks through which investors measure these efforts often fail to capture the full picture. By including scientific insights, a more valuable assessment of sustainability can emerge for investors.
Relying on ESG data alone does not give investors the opportunity to glean unique insights into a company's business model, such as how it makes money and its potential for the future. Furthermore, ESG data, which is self-disclosed and highly curated, is not standardized and has an emphasized focus on downside risk. ESG data helps investors assess sustainability in terms of risk management and process optimization, but not in terms of financial prospects or benefits to human health and the environment. This requires additional analysis which we argue should be firmly grounded in sustainability science.
According to the 'Mosaic Theory' of investment, an investor should gather many seemingly disparate fragments of data to form a unique and compelling view of a company's business model and prospects. By this measure, success in sustainable investing depends on a rich mosaic of data, which includes not only standard financial metrics but also non-financial metrics, such as Environmental Social and Governance (ESG) factors. ESG databases and scoring methodologies can be created when combined with financial data and other qualitative data can yield unique insights. These can be incorporated as a risk-mitigating strategy and can reduce the volatility of portfolio returns.
Dr. Dinah Koehler, executive director on the Global Sustainable Equities Team at UBS Asset Management presented her thesis on 2 November 2018, at the 2018 Yale Initiative on Sustainable Finance Symposium: State of ESG Disclosure Standards. Her paper "Breaking Away: new data and models to improve investment in corporate sustainability" co-authored with Dr. Ramon Sanchez Pina, Research Associate, Department of Environmental Health at the Harvard T.H. Chan School of Public Health, can be read here.
ESG data is rapidly becoming another tool for the quantitative passive investor to construct a rules-based investment strategy. By the end of 2017, there were 270 sustainable index mutual funds and exchange-traded funds worldwide, amounting to approximately $102 billion in assets under management (AUM). While the majority of sustainability funds are actively managed, the fraction of passive sustainable strategies increased from 6% five years ago to 12%, out of a total of $970 billion in AUM, according to Morningstar (2018).
The mosaic of information used by investors can be enriched by drawing from science based metrics and insights from environmental and public health scientists, to construct entirely new models linking corporate activity with impacts on society and the environment. Scientific models of air pollution, population health and climate change allow investors to link technologies that reduce reliance on fossil fuels to positive impacts on human health and the environment.
For example, in 2013 the U.S. Department of Transportation conducted a case study on rail freight transportation companies. The study revealed that rail freight trains reduce greenhouse gas (GHG) emissions more than other energy efficiency and clean energy generation technologies. In fact, trains are four times more efficient than trucks, the alternative baseline technology. They save on average 75% of the energy that would otherwise be used if cargo were transported by truck and are a much cheaper transport option (U.S. Department of Transportation, 2013; AAR, 2016).
What's important about the author's analysis is that one US rail transport company alone can reduce GHG emissions by 99 million metric tons, the equivalent of the annual emissions of 24 coal-fired power plants. The additional reduction in air pollution means that 41,000 sick days were prevented and 411 premature deaths were avoided in 2017 because local populations breathed cleaner air. Even very small decreases in air pollution in the US can have significant benefits for elderly (>65 years) people in the US, saving up to 800 lives per year, according to research by Harvard School of Public Health.1
If ESG benefits can be linked to revenue, cash flows, profits and long term opportunity, the measurement of a company's social and environmental impact is an attempt to assess the long-term utility function of a company, which directly influences its ability to attract capital and resources to continue its business. Should companies start disclosing information on their positive impacts, it would give investors a more complete picture of how they are aligning their future growth options with sustainability.
There are rising expectations of asset owners that business and finance should serve a social purpose, a sentiment echoed among millennials in particular. ESG metrics, regardless of the imperfections of corporate voluntary disclosure, provide important information on operational efficiency and risk management of interest to investors. By adopting a multi-disciplinary approach to investment analysis, science based impact metrics can bring unique insight, rigor and depth to securities analysis and the assessment of the social purpose of business models.