How Wall Street Can Save the Earth
Don’t scoff. The fuzzy notion of socially responsible investing is being replaced by a truly green—and profitable—model.
IN APRIL 2010, Bud Sturmak, director of the investment-and-consulting firm RLP Capital, was at his Manhattan apartment when he heard something about an explosion on an oil rig in the Gulf of Mexico. It would be weeks before the nation grasped the full magnitude of the Deepwater Horizon spill, but as the nightmare unfolded, Sturmak quickly realized he needed to get on the phone. He had millions of dollars of his clients’ money tied up in so-called socially responsible funds, and, as he recalls, “I wanted to find out which of these funds were invested in BP.”
Dave ChenDave Chen
Bud SturmakBud Sturmak
As hard as it is to believe these days, before Deepwater Horizon happened British Petroleum was in good standing with many moderate environmentalists. The company was pumping millions into biofuel research and solar technologies, and receiving accolades for doing so. BP executives were even speaking up about climate change and pushing the now defunct Beyond Petroleum campaign.
Greenwashing? Sure, but it worked. BP was perceived as greener than other oil behemoths, and that made it a popular pick for socially responsible stock portfolios. When Deepwater Horizon blew, many principled investors were stuck holding a bag full of dead pelicans and aggrieved Gulf Coast fishermen.
Yet, as Sturmak made call after call that afternoon, he found that not all the portfolio managers he’d placed his clients’ money with held BP stock. Not Ariel Investments. Not Domini Social Investments. Not Parnassus Investments. They didn’t have BP because of a stock-picking tool called ESG.
The initials stand for “environmental, social, and governance.” (Governance refers to transparency and corporate citizenship: whether a company’s CEO makes more than it pays in taxes, for example.) Made simple, ESG is a label for bundles of information about how companies treat people and the planet. These metrics aren’t being employed out of any sense of altruism, though; they’re used to mitigate risk and locate value. Fund managers Sturmak relied on had conducted ESG assessments that led them to conclude that BP wasn’t a good long-term bet. The company’s green-tech activities gave it some high marks, but those were offset by the 2006 pipeline failure at a BP facility on Alaska’s North Slope, which spilled some 267,000 gallons of oil. Ditto for the 2005 accident at a BP refinery in Texas that killed 15 workers and injured close to 200 citizens. The company had a greenish veneer, but ESG helped analysts zero in on the fact that it was taking a lot of potentially expensive risks. “I was psyched we didn’t have them,” Sturmak says.
AT A TIME OF unprecedented animosity toward bankers and Wall Street, it may come as a surprise to learn that some professional investors are putting money into the sorts of green investments that environmentalists have been plugging for years.
ESG analysis—a method for ferreting out risk and pinpointing good investments—is in many cases supplanting traditional socially responsible investing (SRI). That method, which boomed in the mid-nineties, is essentially investor hand-washing made easy: you exclude certain “sin stocks,” such as oil companies or weapons manufacturers, to try to keep your dollars from bankrolling activities that conflict with your personal values.
Trouble is, cutting out high-profit industries can sometimes hurt the bottom line, and the stigma that SRI might erode performance is hard to shake. “SRI is this legacy term that, to some investors, is like religion or politics,” says Grant Cleghorn, director of institutional sales and marketing at Parnassus, a green-minded investment firm in San Francisco.
ESG circumvents that perception by helping stock pickers home in on long-term profit. Money managers use ESG metrics to evaluate potential stock picks on everything from energy efficiency (how much oil does a shipping company use a year?) to environmental risk (what’s the likelihood of fat fines from regulators?). Think of it as a forward-thinking investment strategy for the post-recession age.
“The fuzzy heritage of socially responsible investing is being replaced by economically driven decisions,” says Dave Chen, cofounder of the investment firm Equilibrium Capital Group, which provides institutional investors with “sustainability driven” funds. “We’re seeing the mainstreaming of these ideas. I mean, would you rather invest in a utility that has 80 percent coal or one that has natural gas and a bunch of renewables?”
The concept behind SRI can be traced back to at least the 1700s, when religious groups like the Quakers steered away from companies that made guns and booze. The idea became a fixed notion on Wall Street in the early 1970s, when Pax World Investments established a $1 billion fund for a church organization that didn’t want to be involved with companies connected to the Vietnam War. Soon after, other mutual funds began catering to particular social values—divesting from companies doing business in apartheid-era South Africa, for example. Most early adopters of SRI felt strongly enough about the principle that they didn’t care whether weeding out certain stocks might cost them money.
In the 1990s, interest in socially responsible anything exploded. Rising environmental consciousness combined with sophisticated consumer awareness to fuel SRI’s growth. Mutual funds with an SRI theme grew in number from 55 in 1995 to 109 in 2003. Widespread adoption of SRI didn’t change the perception that do-good funds often underperformed, but with the bull market trotting along that didn’t seem to matter.
The Great Recession changed things in a hurry. While everyone tried to salvage their retirement funds, SRI fell by the wayside. As Peter Kinder, former president of KLD Research and Analytics, recently told a financial journal, “There is a belief that you might violate your fiduciary duties if you applied moral as opposed to investment values.” Or, more simply, traditional SRI operates on terms antithetical to the mission of Wall Street.
But ESG doesn’t. After the crash, money managers eager to protect their investments turned to ESG metrics to help guard against risk and identify stocks that are safer bets. In the past three years, giant financial-information houses like Bloomberg and Reuters have acquired ESG data suppliers. And it turns out that eliminating risk—like stock in a company prone to big oil spills—is often good for the environment.
HERE’S HOW IT WORKS. You invest a few thousand dollars in a fund that relies heavily on ESG. Today’s best funds are more often than not offered by boutique outfits rather than huge banks with socially responsible window dressing. Your money managers perform their standard stock analysis, then crunch the numbers to see which companies are smart about energy efficiency, product sourcing, and workforce satisfaction. (The theory there being that happy employees help profits by limiting turnover; fleeing talent is expensive.)
Each investment firm has a different set of ESG criteria, which means there’s no single way to measure whether companies are good or bad. RLP’s Sturmak works with an ESG rating system that uses more than 30 criteria, including board transparency, compliance with environmental regulations, and workforce satisfaction. In a November 2010 study conducted with environmental-data provider Trucost, Sturmak identified winners such as Google, IBM, Intel, and Nike—not because those outfits are infallible, but because they made real attempts to deploy renewables, reduce waste, and keep employees happy. Companies that have showed high risk and low returns, according to other studies? Coal India and the Russian energy giant Gazprom.
Conservative Wall Street types maintain that there’s not enough long-term data on ESG-influenced funds to definitively show their profitability. But the evidence mounts with every passing year. According to the Forum for Sustainable and Responsible Investment, assets put into funds that use ESG criteria to select stocks rose from just over $200 billion in 2007 to $569 billion in 2010. Parnassus, which relies on an ESG lens for all of its funds, was worth $1.4 billion four years ago. Today it’s worth about $6 billion. While it would be reductive to say that ESG alone accounted for the firm’s growth, Parnassus reps say the tool is a key part of their strategy.
Not surprisingly, Goldman Sachs has also jumped on the ESG bandwagon. In 2007, the Goliath used ESG analytics to launch its GS Sustain list—a group of stocks deemed both sustainable and profitable. (Examples include Ersol Solar Energy, Genentech, and Vivendi.) Between 2007 and 2010, GS Sustain’s stocks outperformed the company’s benchmark—a group of traditional Goldman investments—by 21 percent. Which would be heartening if the much maligned firm were actually investing in the companies on that list. But according to a number of industry veterans, Goldman doesn’t put a lot of cash into the stocks on GS Sustain. “There is little indication that the sustainability research published by Goldman Sachs, Deutsche Bank, and other leading financial institutions has been used over time for investment decisions by their own portfolio managers,” says Trucost senior vice president Cary Krosinsky. (A representative from Goldman Sachs declined to comment on the firm’s investment in GS Sustain.)
The Goldman example illustrates that systemic change is hard to come by on Wall Street. It’s also important to note that it would be simplistic—and often incorrect—to say that companies with crappy ESG scores aren’t profitable investments. The majority of oil companies, Tyson Foods, and Archer Daniels Midland, for instance, are still raking in profits. As of late 2011, BP was back to posting massive gains. ESG evangelists aren’t hot on BP stock, though. “Oil is oil, unfortunately,” says Sturmak. “I wouldn’t put BP in a portfolio. They have a lot to prove to demonstrate commitment to the environment and corporate governance.”
The fact is, smart investing isn’t about avoiding companies labeled malevolent by drum-circle participants. It’s about seeking out gems: firms that promise long-term value. The ESG phenomenon is at least nudging people toward the understanding that sound business models require low risk, increased transparency, and fair wages. Taken together, those practices start to sound a lot like an idea that has been kicking around for quite some time: sustainability.