Analyzing the "S" in ESG

While the Environmental and Governance components of ESG are often quantifiable, the Social component may not be. Ravi Varghese, Head of Sustainable Investing joins the podcast to explain how we look at the "S" including how it is analyzed against the backdrop of the war in Ukraine and pressure on Big Tech and energy companies. (April 26, 2022)

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Transcript

Speaker 1: 0:02

Hello, and welcome to Actively Speaking. I'm your host, Steve Bleiberg . Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.

Speaker 2: 0:18

Going to another episode of Actively Speaking. Uh , my guest today is Revy Vergas, who is the head of sustainable investing at Epic. Uh, welcome Revy . Hi, Steve. Thanks so much for having me on the show. We're gonna talk a lot about ESG today, and I think there's been some developments in the news in recent weeks and months that make this a very timely topic. Um, and , uh, in in particular, I think, you know, ESG is, is the , there's three initials there. E is for environmental, S is social, and G is governance. And I think e and G get a lot of attention. I mean , and they're sort of easier to measure. You know, you can, you can measure a company's , uh, you know, carbon footprint, that kind of thing. And with, with governance, you can look at things like, how many independent directors do they have? How many female directors, how many minority directors. There's , there's all , you know, are they , uh, you know, to have different share classes, all that kind of stuff. It's, it's, it's pretty concrete. It's the SI think that it's, it's sometimes hard for people to get a good handle on, you know, the , the social , uh, impacts of a company and, and what should we be looking for in companies? What sort of , um, activities do we want them to be doing? What do we not want them to be doing? And, and sort of how do we decide what's good and bad? So that's what I wanna talk about. Um, and in particular, there's, so, there's a , a bunch of things in the news recently that I think put this in a good , uh, framework to , to talk about. So, one is, you know, the war, there's a war in Ukraine, and , um, it has highlighted a number of things. Uh, in, in Europe, for example, the , uh, you know, they've become very reliant on , um, Russian , uh, sources for energy, for fossil fuel, energy, oil, and natural gas. There have been efforts to move away , uh, from that towards, you know , more sustainable forms of energy. Of course, that takes time. And , um, the role of energy companies has been highlighted, I think, by this, because people tend to have a negative view of, you know, companies, energy companies that focus on fossil fuels. You know, does the war change anything in terms of our, our perception of , uh, how much we still need those products in the short term ? And then similarly, before I ask, you know, ask for your , your comments on this re um, the other , uh, thing that the war, I think brings out is defense companies, you know, again, right . People have had tended to have a negative view from an ESG perspective on defense companies. But the war, I think, has made some people reconsider that thinking, well, if we want to maintain our kind of open democratic societies, which we, I think were a little complacent about the threats to those, to that in recent years. But now people think maybe, hmm , maybe, you know, there are greater risks to , uh, our, our way of life and , and we need to defend it. And, and so maybe defense companies are, are not as bad as we thought. So that's a very broad introduction, but Ravi , why don't you tell me what, you know, what you're seeing or , or thinking about these, these kinds of companies.

Speaker 3: 3:14

Sure. Yes. Um, well, thanks again for having me, Steve. And I , uh, I don't think you're gonna get too much disagreement from me that , uh, it is true. The, the s is often the most , uh, nebulous and perhaps subjective of the three , uh, elements of, of ESG . Um, and I think it really comes down to the fact , the , um, the fact that there , there are various ways that you can think about analyzing the s component , uh, in ESG. So generally, when we talk about ESG, we focus on the concept of financial materiality. And so what that basically means is how much of an impact on the financial performance of a company does a component of ESG have. Um, and those things can range from being very quantifiable to being extremely subjective. And I think , uh, particularly in the s group of factors , um, those , uh, tend to be a little bit more subjective. Um, so I think there are, again, you know, even within financial materiality, various , uh, timeframes or different lenses you can use. So , uh, you could use, for example, the very narrow lens of a , of an investor and say, well, as a, as an investor in this specific company or security , uh, I , I do or do not believe that this has a material impact on the prospects of the company. Uh, you may also , um, take the approach of being a universal owner. So increasingly we see large asset owners, for example , uh, taking the position that even if they don't believe that something is , uh, material in a very narrow sense for a company, a company's actions may be imposing externalities on the world at large. Um, and then therefore maybe , uh, penalizing other companies or other sectors , um, that the , uh, asset owner , um, has a stake in . So, again, you can already see how this is starting to become a , a more complicated question , uh, than , than just a very , um, narrow financial one. Um, another, another lens that people sometimes use is to , uh, try and assess a very specific group of s factors as they, they may define them . Um, this could be diversity and inclusion, for example. It could be example , uh, human capital management at specific companies. It could be wealth inequality , um, and really try to understand how those factors , uh, affect , uh, the companies that they're invested in. Um, so it really becomes quite a tricky , um, effort in some ways. And I think that the goal really is to try and understand at each specific company or industry that , uh, an investor has a stake in what the important factors are. Um, so those are, I think, how people should broadly think about these questions. Um, you rightly mentioned the , the , the war on Ukraine, which I think , um, has really shone a light on some of the imprecise ways that this s uh , factor is being talked about. Um, not necessarily by , uh, specific investors , um, but really maybe the way they're talked about in the media that I think is , um, creating a lot of confusion , um, on what exactly the role of of ESG is. And so, just to be a little bit more concrete , um, you brought up energy and , and defense, and I think these are really terrific examples of, of how , uh, concepts of ESG have become , uh, quite confused , uh, particularly in , in the media, but also in , uh, in parts of the investing world. So rightly so. Um, there has been a lot of , uh, attention being paid to the role of traditional energy companies , um, and , and defense companies. And whereas previously there was the view in some quarters that these companies were engaged in socially harmful activities. Uh, now that now there is a more of , uh, a view perhaps that they're engaged in socially desirable activities. Now, you know, that's obviously a , a huge turnaround. And , and I think the , the way to square those is that really what we can say is that it was probably incorrect to label them as , uh, as socially harmful in , in the first place. Um, let's, let's take energy for example. You know, it's a , it's a , a sector that we know very well. Um, it is obviously a sector that has challenges in the sense that , uh, traditional energy , uh, produces carbon emissions , uh, which are a source of climate change. But I think to, to label a whole category of, of companies as, as socially harmful as as some have done, or , uh, maybe given the impression , um, you know, prior to the Ukrainian crisis was clearly incorrect. I mean, we know that even fossil fuels, which are, are problematic from a climate change perspective provide us all with things like heat mobility, electricity , um, these are obviously very important things in our lives , um, as well as energy security. And we're seeing now how that's being challenged , uh, particularly in Europe with the conflict in Russia.

Speaker 2: 8:49

Let , lemme break in for a second. So Sure . You've written some very interesting material about sort of looking at , uh, ESG from a kind of sociological framework. And in particular, I was struck by the , what you wrote about , uh, in , within that framework, the looking at , uh, a company for example, in terms of what sort of , uh, manifest functions does it serve in society versus what sort of latent functions does it serve in society? And, you know, so like with the case of, I mean, if I think I'm getting this right, but correct me if I'm wrong. So like with an energy company, the manifest function is , well, they sell you the gas to drive your car, but the latent function as you were sort of getting at a moment ago is, and that gives you mobility. And that's, and , you know, mobility enables you to get a job , get and go work somewhere and support your family. These are sort of the latent functions that these things support, which are very positive. So, you know , could you elaborate a bit on that manifest versus latent , uh, framework?

Speaker 3: 9:42

Yeah, AB ab absolutely Steve. Um, and so this is , uh, you know , hearkening back to my , uh, my days as a undergraduate sociology major, unfortunately de long passed me. But , um, you know, there, there was a theory in, in sociology called , uh, called functionalism. And it really point that the functionalists we're , we're trying to express was that all institutions in society , um, have a purpose. And understanding that purpose is very important , um, to, to understanding why they exist in the first place. And , uh, I often think about this when I, I hear , uh, people lapse into what I consider the misconception of referring to , uh, companies as being ESG friendly or ESG sensitive, or , um, sometimes, you know, people will say to me, is this company ESG or not? Um, so, you know, it's a very, it's a very binary way of looking at the world, which I , I think I've already expressed is, is probably not the way, you know, I prefer to do it. And so how this ties back to the , uh, the role of functionalism in sociology is, as you said , um, the , the sociologist Robert k Merton , um, really thought about social institutions as having these two functions, which you mentioned. So the manifest function is , is really a very kind of obvious function. Um, whereas the latent function could be these hidden more subtle functions that in social institutions play , um, which require a little bit more , um, analysis to, to unpick. And so, exactly as you said, with an energy company, for example, you know, the , yes, the , the obvious function is, is to provide fuels, but the underlying function of those companies is , uh, is , is far more complicated as , as we said, to provide things like mobility and heating and , uh, power, which obviously enables all sorts of other things in the world. So I , I think we really need to think deeply about all of those things , um, before casting aside entire industries , um, and or really labeling entire classes of companies as being socially harmful , uh, or by that token socially valuable. Um, I think those distinctions are not always quite as clear cut as people make them out to be .

Speaker 2: 11:59

And , and I think that's a good point about the, about the sort of binary nature being a bad way to look at this. Either it's a good company or a bad company, because I mean, it has struck me , uh, in recent years that either you see a lot of movement, for example, on like at college campuses and students want the company , the university endowment to divest from any, any, you know, companies that sell fossil fuels. Like we just shouldn't own stock. The , the endowment shouldn't own that stock. And it has always struck me, I mean, I'm , I didn't come up with this, I mean notion, but , uh, it , I do think it's interesting though . I agree with this idea that , well , but if you sell the stock now, you have no voice at the table. When you are a shareholder, you, you do have a voice at the table. And to me, my impression has always been that ESG is , is really not so much about shunning companies as evil and , and , oh , we're not gonna be, we're not gonna dirty our fingers owning this. It's, I've always viewed it more of , uh, it's more about engagement. You know, it's like you should want to , uh, have a voice for those companies to be able to argue for different policies. And if you divest , uh, don't you give that up.

Speaker 3: 13:04

I think it's very true, and I think that that speaks to maybe the two different roles that , uh, I think the ESG industry is being asked to play that don't always necessarily , um, sit quite as , uh, as well together as, as one , I hope. And so the first one we've already discussed is, is really , um, a question of financial materiality and using the , the ESG lens , uh, as a complimentary lens to traditional investing , uh, analysis. Uh , the second role is , uh, is maybe to think more about the, the ethical or reputational aspects of companies or investments. Um, that's a far more subjective role. Um, and so , uh, you know, whereas it may be appropriate for, for one investor to think about , uh, divestment , um, it's generally not the , the preferred strategy for investors like ourselves. And so , uh, you, you brought up a very important point. Um, you, when you sell , uh, the stock of a company or a security , um, you lose your seat at the table again, you know, if , if you divest and , and I'll, I'll define divestment as , uh, the ex the wholesale exclusion of companies or industries for non-financial reasons. There is a trade off , I think. And , um, as fiduciaries , uh, I think we need to be very conscious , uh, and cautious of making that trade off . You know, I'll also say there's a very important question about , uh, when you sell security , uh, you have to think about who you're selling that security to. So , um, it , it doesn't strike me as ideal if , uh, all the socially conscious investors sell their stakes and , uh, you know, the ownership of these , uh, potentially problematic companies ends up in the hands of, of people who aren't concerned about ESG issues. I don't think that's, that's really a situation that, that we'd like to see. As you said, engagement is really , um, the strategy that we've opted for, which means retaining our ownership stake in, in these companies, and really trying to think very carefully about how we would like them to act. And then working with the companies to try and, first of all, understand their positions. Um, you know, these are incredibly complex companies, and sometimes, well, oftentimes , uh, we , we find out that they have a very complex set of stakeholders that we don't quite understand , uh, as, as outside investors. So I think that's very important. Um, but we also work closely with them to , uh, share our viewpoint and , uh, when necessary nudge them to towards path, which we think , uh, benefits us as long-term shareholders.

Speaker 2: 15:49

Yeah, I've, I've often struggled with that notion of, you know , what do you, what do you accomplish by divestment? I think for many people, it's, sorry if this sounds overly critical, but it's , it's more about themselves feeling good about themselves , uh, because now they don't own these companies. But as you point out, you know, when you sell the, you know, if I sell shares of Exxon, it doesn't stop Exxon from, it doesn't affect Exxon's going out and, you know, drilling new oil wells or not. It just puts the shares in the hands of somebody who presumably cares less about that issue than I do. I've always wondered about what divestment really accomplishes. Um, I wanna , uh, turn the discussion a little bit , uh, towards tech, because that's another area that people have brought up as a , as , as a ripe for some sort of s uh, you know, engagement. And again, stuff that's happened recently kind of makes this timely. So in particular, you know, this week as we're recording, we've gotten news that, you know, Elon Musk now owns 9% of Twitter, right ? And Twitter and Facebook have been often criticized from both left and right. You know, like after the 2016 election, people on the left were convinced that, you know, Facebook had had enabled, you know, Trump to win because they , you let Russia, you know , uh, put all these ads on Facebook that were deceiving people, et cetera. And then on the right, you have people who are mad at platforms like Facebook and Twitter because they perceive that they're being censored and people getting kicked off the platform, that kind of thing. Um, and but when I hear these criticisms of these platforms , uh, well , or another one take Instagram, which , uh, you know, we, we've, there's been research that, you know, it, teenage teenagers in particular teenage girls, it seems to have a pretty negative influence on, because it's, you know, presents this kind of very shallow picture of life. People just posting all these things where they, they look great and they're in exotic places and all this, and makes people feel bad about their own lives and gives them unrealistic expectations about what they should look like, that sort of stuff. And, you know, these are all valid criticisms. And I, I guess I, I sit around and I read these and I wonder, well, what are they supposed to do? I mean, I don't, I don't, you know, I , it's, yes, these are problems. I'm not dismissing them, but I'm not quite sure what it is that , um, the critics want the companies to do. What are, what sort of things have you seen , um, whether it's shareholder resolutions, you know, what , what are the proposed solutions to these kinds of negative social effects of these platforms?

Speaker 3: 18:20

Yeah, well, I think to , uh, to , to tack on to what you were saying , um, I , I think we all agree that these are very important issues. And so I , I don't want to anyone to , to come away from this thinking that, that we minimize or, or underestimate the importance of these issues, particularly with, with, you know, the large technology companies, they are incredibly large, powerful , uh, systemically important companies. Um, and so we view adequate regulation as being , uh, something that, that we as, as investors, find desirable. Now, I think reasonable people can, can disagree about, you know, what that adequate regulation might be. And what I , I do think , um, is that many of these companies are being asked , uh, to have better oversight internally of their processes, their governance, their business models. Um, I think those are, are pretty , uh, universally accepted as being positive things. So , um, for example, for example , for companies that are engaged in , in social media, I think it's , it's generally accepted that their content moderation policies , um, were insufficient, let's call it five years ago. And were leading , uh, people to some, some pretty, you know, negative places, whether it's in terms of , uh, misinformation, disinformation, conspiracy theories. Um , you know, and again, I think once you get into content moderation and , and free speech questions , uh, it can get pretty thorny. But, but I think it was clear that , um, uh, the Facebooks and , and YouTubes of the world , uh, could have been doing more and I think have stepped up , um, the amount of investment that they put in, in things like that. So that's from a , a broad kind of societal standpoint, when you get to the question of what investors are really pushing from an ESG standpoint, I actually think there's much less , um, consensus. Um, and so again, while you will see people criticizing content moderation policies, for example, or disinformation on platforms, what you're not really seeing, I think at least from, from mainstream investors, is a suggestion that these companies should change their business models outright. You don't see that, and I think, you know, this is this tension that really what makes these such valuable businesses is the user engagement that they, that they drive. Um, and so to , to then say, well, people are are addicted to these things, you know, probably create some, some tension with the, the underlying probability of , of the businesses. I think one area where we, where we have seen , um, some consensus , uh, particularly in , uh, shareholder proposals at , at all the large tech companies, is on issues , uh, of , uh, uh, let's say gender , uh, and racial pay gaps . Um, I think sexual harassment is an issue in the tech industry that has garnered a lot of attention, rightfully so. Um, I think it's , uh, if you look at the case of , uh, Activision Blizzard for example, that was the subject of a, a very major , uh, sexual harassment and toxic workplace culture scandal. And I think that has, has ended up being a very , uh, major part of its , uh, performance over the past , uh, two years. You could actually look even at a , at a , a major company like , um, like Alphabet, where I think it was in , it was 2018, where there was a 23rd , uh, 20,000 person walkout , uh, objecting to sexual harassment policies at the company. So I think that's one element where , uh, there's general conses consensus among both investors , uh, society at large, and employees that big tech can do better. And, and I mentioned employees 'cause I , I think they are an incredibly important constituency in all of this. Uh, you know, it's , it's no surprise that the big tech companies are engaged in an all out war for talent. And I think the , the notion that big companies can ignore the , the , the wishes of a their very powerful employee base is long gone. So I think many people will, will be familiar with , um, an issue at , at , at Spotify where , uh, initially Neil Young , uh, the singer wanted to , to pull his , um, his catalog from Spotify objection to , uh, what he, he , uh, complained was, was disinformation on Covid from the Joe Rogan Show. And so this led to some very serious backlash from , uh, employees. And , uh, finally resulted in, in Daniel Eck , the , the CEO of Spotify , uh, releasing much more information on, on Spotify's , uh, policy towards , uh, disinformation and content moderation in, in a town hall. Um, and again, this was , uh, this was very much in response to the notion that employees who obviously are an incredibly important part of Spotify's success were unhappy with the way company was dealing with this issue. So it's just , um, further proof I think that, you know, these, these s issues , uh, may be hard to quantify , um, but they're certainly having an effect on the way , uh, employees think about the companies they work for and how managements are being forced to react. Right?

Speaker 2: 24:00

So some of the stuff you talk about, to me in my mind, it highlights that there's this kind of a balance , uh, a fine line almost between, you know, at the , at the one extreme you have people being critical, you know, and perhaps rightly so of , of some of these platforms for not having moderated content enough. But if you swing too far the other direction, you, you run the risk of creating, you know, in essence a kind of social credit score , uh, for people where, you know, if you get, if , if you've got, you know, if Twitter and Facebook and and uh, so forth are policing the content on their platforms too heavily, you could in essence have people being cut off from the public square. I mean, even though these are not , you know, and it's a tricky issue 'cause they're not government companies and so, you know, all , all the stuff about, you know , first Amendment rights. So that really only applies to, to actions taken by governments to censor speech. If a private company, you know, they have no obligation to allow anybody out to their platform, but in , in the same way you could argue, well, you know, an electric company doesn't have an obligation to sell you electricity if they don't like you. Well, that's why we regulate them so that they do actually have to sell you electricity. You know, the question is have , have these platforms become, in essence almost like a public utility where if you are taken off of them for expressing views that the managements of those companies don't like, you know, have they in effect , you know, cut off your ability to function in, in today's society. And, you know, the extreme version of this that we're always told to look out for is what's happened in China where, you know, like if you don't pay your bills, and it's , it's not , it's less political there , I think, but it's like if you're, you know , if you haven't paid your bills, like maybe you won't be allowed to buy a train ticket to go travel, that kind of thing, you know, and , and suddenly your , uh, you know, your ability to kind of live your life normally is, is impacted by things you may have said or something. Uh, do you see that as a big risk? Uh, and , and what , you know, are companies worried about that or,

Speaker 3: 25:56

I think companies are definitely worried about that. Um, I think these companies are very conscious of the fact that they are being put in the position of , um, occasionally being the, the arbiter of, of public speech, which I, I think is an , uh, incredibly uncomfortable position for them . So I think there's the , the broad question of , um, you know, free speech and content moderation for, for example, which I think is , is very tricky. I think, again, from a a kind of narrow business perspective, these companies are having to tread very cautiously. So if they are , uh, creative platforms, for example, they thrive, I think, on having a multitude of , um, views and opinions and different types of creators on their platform . And so if they are seen as being, I think, overly stringent on moderating content , uh, that just makes them a less attractive platform for , um, the creators. And so it , it really does set up a very interesting question , um, for them in terms of, of being palatable in terms of the content that they host, but also still being supportive of a wide range of viewpoints , um, but different types of creativity. So I , I think that that really strikes to the , the heart of, of what they do, which why many of them are , are wrestling with these questions so furiously.

Speaker 2: 27:22

Okay. Well, the , the , you know, the name of this podcast is actively speaking and , uh, we're , you know , we talk about issues of interest to active managers and , and their clients. One of the issues that I think , uh, gets out of discussion in , in this regard , uh, regarding ESG is, you know, the index companies like Vanguard and BlackRock , uh, are quite large now. You know, there's been a lot of money moved into, passive has moved into passive funds over the years. And , uh, so they own in many cases, you know , significant chunks of, of many publicly traded companies. Um , what would you say to an investor who's considering whether to, you know, invest actively or passively if, if they're concerned about ESG issues and want to have , uh, managements that's gonna , are going to engage or, you know, manage investment managements that is going to engage with companies , uh, you know, what , is there a difference in , in how active versus passive managers are behaving?

Speaker 3: 28:19

And I, you know, I I certainly think , uh, some of these, these large , uh, passive , uh, firms are, are taking a different approach , uh, simply because they have a , a different business model. Um, I will say from the , the standpoint of an active manager , um, we do believe very strongly in the value of engagement. Um, and being a smaller , uh, active manager, I think allows our ESG team to work very closely with our investment team to really try and understand their viewpoint on these companies rather than making deliberations , uh, in a silo or, you know, at a great distance from, from the investment team. And I think that's really important because as listeners will probably have , have figured out , um, these are very complicated issues, you know, a a a template approach doesn't really make a lot of sense sometimes. I think you really have to dig into the, the individual details of these companies , um, and really try to approach these as we like to say in our ESG team , uh, with rigor and nuance. And so I think this is a , a real area where active managers can differentiate themselves by really integrating their ESG views , uh, no matter how complicated those views may be into their investment analysis and deciding where these things may be material, and , uh, actually having the confidence to take a differentiated approach from , uh, other players in the market.

Speaker 2: 29:50

Yes , it's, it's hard to figure out what the motivation actually for a passive , uh, manager is in engaging with a company. They're , you know, the , the nature of what they do is they're sort of required to own everything in an index regardless of how the company's behaving. And , uh, you know, they, what's the incentive to them to engage with the company and , and argue for different business practices, whereas the active manager is doing it because they think it will help the company's performance over the long term .

Speaker 3: 30:16

Right, exactly.

Speaker 2: 30:18

Well, Remy , that's , this has been very , uh, interesting educational. I, I certainly learned a lot. Uh , I wanna thank you again for joining me.

Speaker 3: 30:25

Thanks for having me, Steve. This was terrific.

Speaker 2: 30:28

And , uh, the listeners, if you've enjoyed , uh, our podcast, please uh, give us a , a rating on whatever our platform you get this podcast from. Uh, leave us a good review if , if you're so in kind , and , uh, we'll be back with another episode soon. Thanks.

Speaker 1: 30:44

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Speaker 4: 31:00

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