ESG and Long-Term Business Success

by Bill Apfel

A growing number of socially responsive and other investors are making a bold assertion: More often than not, companies enhance their long term profitability if they integrate responsible behavior into the fabric of their business practices.

The term ESG investing (for environmental, social, and governance) describes this belief. At Walden, where we have long strived to deliver strong investment performance with portfolios that reflect our clients’ values, we share this philosophy. Long before the term became popular, our high quality security selection process integrated ESG concepts. That is true throughout Boston Trust, not just for those clients who ask us to reflect their institutional mission or individual values in their portfolios. Indeed, the overlap in holdings between clients who ask us to apply specific ESG guidelines and those who have asked us simply to achieve their financial objectives is large. A typical Walden client portfolio shares 85 percent or more of its investments with an unscreened Boston Trust portfolio. By comparison, apply the same ESG “screens” to the S&P 500 and as much as 40 percent of the investments would be ruled out.

What does ESG integration bring to the investment process? An awareness of a range of long-term financial considerations that are not often apparent when reading standard quarterly earnings reports. For example, we believe that ESG integration has contributed to decisions to avoid investments that entail fundamental but infrequently considered risks. Subprime lenders that made a business of making abusive loans to borrowers with poor credit constitute one recent example. Staying clear of firms with severe environmental liabilities like asbestos is another.

On the other hand, ESG has helped us identify companies with superior practices that lead to more efficient operations, heightened brand reputation, and even sensitivity to emerging themes like resource constraints or climate change. As large a company as PepsiCo has argued that its revenues have grown faster due to the diversity of its workforce. We believe that Praxair, an industrial gases firm, has benefitted from its customers’ desire to boost operating efficiencies as well as comply with strict environmental regulations.

For some companies, ESG awareness has spurred profitable initiatives in new markets or technologies. This is often true among small and innovative companies (see article "Cutting Edge Companies: Zoll Medical" in this issue). Most important, ESG integration is a tool for identifying business models that, regardless of short-term swings in sentiment, are sustainable in the long run—the key aim of our high quality security selection process.

One critical caveat: Investment decisions at Walden are not one dimensional. As much as we admire management that strives for excellence in ESG matters, this alone does not assure superior financial or investments results. The converse is also true. Indeed, sometimes businesses with poor records in these areas, or even those with environmentally or socially destructive business models can prosper—certainly in the short run and sometimes in the long run as well if regulatory or market mechanisms reward their practices. Our job as investment professionals is to weigh these issues in the larger context, considering the benefits of good ESG practices along with the multitude of other considerations that will affect the investment outcome.

This is not an easy task, but we think it is an essential one. ExxonMobil Corporation, which has typically been excluded from the portfolios of social and environmental investors, provides an example of the challenges we face in striking the appropriate balance. Like every producer of carbon fuels, Exxon is a significant contributor to climate change. And Exxon is a giant—the world’s largest, non-state-owned oil company—so there can be no doubt that Exxon’s fortunes will be affected by policies intended to limit the human and environmental consequences of climate change. This is just the sort of discontinuous risk thoughtful ESG investors must consider.

Exxon might produce a steady stream of rising earnings reports in a world of scarce fuel, but what is the company really worth if climate change forces a comprehensive set of global policies that set us on the road to sharply reducing the use of carbon fuels? Nonetheless, we believe sensibly diversified portfolios should include large energy companies given the likelihood that they will continue to prosper for many years in a world of scarce resources.

But should we exclude Exxon in favor of other large integrated energy producers? Striking the ESG balance in this case is even more difficult. Exxon, like most companies, offers a mixed picture. Here are some of our concerns: We view Exxon as a laggard with regard to its corporate nondiscrimination policies. Even while the company claims not to discriminate, we think more inclusive policies add to the vibrancy of a workplace, providing room for new ideas and varying perspectives. Similarly, we have been dismayed by what we consider Exxon’s past years of obstructive contribution to the discussion of climate change. We have no complaint about an open debate regarding the legitimate issues surrounding sensible emissions policy, but we worry that an inflexible ideological position on the issue will leave the company behind as other industry participants seek creative responses.

Despite these concerns, we cannot argue that Exxon fails the test of business model sustainability. Its range of energy industry resources is unrivalled among public companies. Its financial strength far outdistances those of its competitors. In these uncertain times, Exxon’s rock-solid balance sheet will give it the flexibility to prosper when its competitors falter. It also will give Exxon the opportunity to enter the field of alternative energy if its perspective on these issues changes. Balancing our concerns about some of Exxon’s pronouncements on climate change, we recognize Exxon’s industry-leading operational efficiency, good safety record, and comparatively favorable performance, according toWalden’s analysis of U.S. government records on toxic releases. To a large degree, Exxon’s self-inflicted image as a corporate laggard has masked its robust operating culture.

In this most difficult of examples, then, where do we draw the line? On behalf of those clients who do not ask us to incorporate comprehensive ESG screens on their investment selections, we are Exxon holders. All things considered, we judge Exxon to have a strong and sustainable business model. But some clients assess the balance differently. In many cases, that view is the result of a straightforward ethical requirement: Don’t invest my funds in companies whose practices I find abhorrent. Other clients believe the ESG investment risks outweigh other investment advantages. We respect both perspectives. For those clients we believe we can find appropriate and profitable alternatives. Fortunately, most ESG decisions are not as difficult. More often than not, we find that our ESG approach makes making good investment decisions that much easier.