Pensions and other institutional investors are increasingly focused on ESG investing. But what is the point of ESG investing?Obviously, the investing part of that question is focused on a fair return, and potentially some alpha, to the investor. But the ESG part of the question has numerous potential goals. Among those are avoiding harm, mitigating ESG-related investment risk, rewarding strong ESG performance, and encouraging improvement in corporate behavior.

This final factor – improvement – is often overlooked: what about companies that are improving their own ESG scores? Don’t we want to encourage them, and isn’t there an investment opportunity there? It is fine to invest with companies that already perform well, but the real difference will come with companies that improve how well they perform.

Let’s focus here on the environmental aspects of ESG. Here, the improvement factor has the potential to generate better investor returns, have a positive effect on the environment, and fit within the ERISA guidelines being developed by the Biden administration.

Improve returns

It stands to reason that an investment in a company that is improving its environmental performance should perform well. As energy companies and utilities focus on de-carbonisation and renewables, they are rewarded in financial markets. This is supported by the fact that, in recent years, MSCI ESG indices have outperformed standard MSCI indices in the US, in Europe, and globally.

Think of a company’s ESG scores in the same way we think about its price/earnings ratio, especially as a value investor. The companies with lower P/E ratios have the greatest chance to improve. A value investor does not just seek out companies with low P/E ratios. A value investor wants to see the chance or catalyst for change in corporate behavior or a systemic change in that company’s marketplace that gives the company a structural advantage.

Similarly, when utilities use less coal and more natural gas, or when automobile manufacturers move toward electric vehicles and consumers want them, they are rewarded by a market that believes that is where future profits lie.

Positive effect on environment

Just as investors seek access to opportunities for future profits, so should ESG investors seek out better future environmental behavior. Of course, companies with high ESG scores are likely to be solid investments because they are well managed. But the improver thesis is different.

If a company is already managed to a low carbon footprint and its business model is unthreatening to the environment, then an investor will not expect to make an impact on improving that company’s behavior or fossil fuel usage when that investor invests.

But if an energy or mining company sees where the world is headed and makes a commitment to cleaner policies, this holds the promise for a genuine improvement and effect on the environment. The investor must follow company communications closely or, with institutional investors, must engage with management in order to reach a conclusion about the company’s commitment to improvement. If that commitment is real, the company and investor together (like a value investor who sees structural change benefiting a low P/E company) have the chance to genuinely improve environmental outcomes in a measurable way.

What better way to invest: finding structural opportunities to go from lower performing to higher performing.

Coming ERISA guidelines

ERISA does not regulate public plans, but many public plans are guided by its provisions , and of course, corporate plans are governed by them.  The Trump administration issued a regulation under ERISA that would have limited the use of non-pecuniary factors in the selection of investments for ERISA plans. However, the Biden administration has issued guidance stating that it will not enforce those regulations. More importantly, President Biden also issued an Executive Order in which he directed the Department of Labor to “identify agency actions that can be taken under [ERISA] and any other relevant laws to protect the life savings and pensions of United States workers and families from the threats of climate-related financial risk…”.

This moves U.S. policy directly toward the improver thesis. It is likely that the DOL will not only permit the use of socially conscious factors; it may encourage or even require that they be considered material. Note that the language of the Executive Order does not speak about what factors may simply be considered. It directs DOL to “identify…actions that can be taken…to protect…savings and pensions…from…climate-related…risk.”

In short, investing in companies that are improving environmental performance and outcomes  will do exactly that.

If we want to improve environmental outcomes,we need to identify and invest in companies that are improving theirs.

Charles E.F. Millard is a Senior Advisor for Amundi U.S.; he is the former Director of the U.S. Pension Benefit Guaranty Corp.

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