ESG (Environment, Social and Governance) performance of companies has gradually become a prominent framework for assessing their long-term value and impact. While we know there is a growing momentum towards ESG related disclosures and reporting for shareholders, it would be interesting to look at which ESG factors drive investors’ decision-making. A study from Stanford Graduate School of Business did exactly that. The study, conducted by Stanford researchers with the assistance of MSCI Sustainability Institute, surveyed 47 major institutional investors, primarily from North America and Europe, with nearly half managing over $250 billion in assets. It revealed that for most large institutional investors, ESG might better be described as GCS (Governance, Climate and Social) because these are selective factors truly driving their investment choices.
The Importance of ESG: Governance Takes the Lead
The study revealed that governance stands out as the most critical ESG factor, even more so than environmental or social issues. According to David Larker, one of the researchers, governance quality has become “table stakes” for companies seeking investment from major institutions. Governance factors like board structure, ownership structure, and financial reporting transparency are seen as essential indicators of corporate reliability. A landslide 70% of investors ranked governance as a top priority because they believe it has immediate, short-term impacts on investment performance. In contrast, environmental issues, such as climate change, are expected to have longer-term effects, typically over a two- to five-year horizon.
Environmental Factors: Climate Change at the Forefront
Although environmental considerations came second to governance in this study, they are still of importance to institutional investors. Among environmental factors, only climate change and carbon emissions emerged as the dominant concerns. Roughly 78% of survey respondents prioritize climate risk in their assessments, monitoring companies’ emissions, investments in renewable energy, and factoring in climate-related financial risks. Other environmental issues, such as pollution and waste management, receive far less attention, underscoring the investors’ focus on climate change as the most impactful environmental issue for long-term financial stability. The investors relate climate risks with catastrophes that may materialize in the long-term, but could be devastating. Larker explained “If you’ve got a portfolio of 50 or 100 companies and a couple go to zero, your return is really going to be affected. So as a portfolio manager, you’d like to screen these things out..”
Social Factors: A Decline in Priority
The survey study also revealed a surprising insight: social factors, which once held a strong position within ESG, were not important to investors. Issues like workplace diversity, pay equity, and labor practices were not ranked highly by most institutional investors who participated in the study. On the contrary, data security and privacy were given some weightage by European investors, in particular, who view these factors as critical given regulatory pressures in the region. This shows that investors are moving away from broad ESG principles and focusing on the aspects that directly impact financial performance, such as governance and climate risks. Another reason for this trend could be the qualitative nature of social factors which makes it challenging to measure them.
Relative perspective of ESG performance
A noteworthy observation from the study was investors’ preference for a relative scoring approach to ESG, which considers a company’s performance compared to peers within its industry. The researchers at Stanford discerned that having a relative perspective on ESG performance enables investors to include well-performing companies belonging to industries harmful to the environment, such as coal or tobacco, to their portfolio. David Larcker explains that if funds adhered to absolute standards, they would have to exclude a significant portion of the market, thus limiting their investment portfolio. Relative scoring allows for flexibility, giving investors the leeway to avoid the most problematic entities without disregarding entire sectors.
The Stanford survey offers a peak into the shifting priorities of institutional investors as ESG has become a compliance issue. Governance and climate change are the clear winners in this evolving landscape, while social factors are being sidelined. As one of the researcher’s suggests, the future of ESG may involve focusing on a few high-impact factors rather than a comprehensive checklist. ESG is important to institutional investors, though perhaps not as holistically as one might envision. Rather, it has become a tool for mitigating risk and aligning with more traditional shareholder value objectives. As ESG continues to evolve, its role in investment strategies will likely keep shifting, reflecting the priorities of those holding the capital and the realities of the global marketplace.
Stanford Study reference: https://www.gsb.stanford.edu/insights/big-investors-say-they-use-esg-reduce-risk-mostly-focus-e-g.
