After an extensive research and due diligence process, during the 1st quarter of 2021, GYL Financial Synergies made our environmental, social and governance (“ESG”) model portfolio platform available to our private clients. These model portfolios only invest in managers that integrate ESG research into their investment process. ESG represents a set of metrics and factors for examining corporate sustainability. Alongside the megatrend of slowing globalization are further environmental and social challenges such as climate change, resource scarcity and rising inequality.1 Our research suggests that incorporating dedicated exposure to megatrends within this challenging investment landscape, such as the transition to an eco-efficient economy, could represent an opportunity to capture a diversified source of returns. Subsequently, in August 2022, we added a thematic sleeve with a focus on environmental markets to ESG model portfolios at a 60% equity allocation and higher. This new addition represents an opportunity to revisit the nuances of sustainability-oriented investing. There are three broad meanings of the term “sustainable” or “sustainability” – the general systems theory definition of sustainable, sustainable development as defined by the United Nations, and socio-ecological sustainability as a distinct worldview. These definitions of sustainability provide the greatest conceptual utility as interrelated and complimentary ideas with different scopes.
Any discussion of sustainability has two components, the operation of a system, and the objective of that system. To paraphrase the system’s theorist Donella H. Meadows, a system is an interconnected set of elements coherently organized in a way that achieves a function or goal.2 Sustainable then, may be broadly defined as the “generic property of an often-complex system to continuously produce a desired output.”3 For the investor, the primary systems of interest are companies, sectors, and economies. ESG investing seeks to mitigate downside risk of permanent capital loss or seek opportunities for competitive advantage through corporate sustainability. In traditional actively managed investing, portfolio managers base investment decisions on the analysis of corporate balance sheets. Corporations create these documents utilizing Generally Accepted Accounting Principles (“GAAP”) to convey objective and comparable financial data.4 The domestic universality of GAAP means that investors can systematically evaluate and compare the valuation and finances of any company in the United States. Federal securities law also requires that most publicly listed corporations in the United States issue annual 10-K reports, which includes an overview of the business, and any material risks it faces.5 The SEC defines a material risk as any risk “to which reasonable investors would attach importance in making investment or voting decisions.”6 ESG reporting frameworks, such as those published by the Sustainable Accounting Standards Board, seek to provide a similarly objective analysis of nontraditional factors which research indicates can create or destroy value for shareholders or stakeholders7. Depending on an investor’s scope, one might only consider risks and opportunities which impact the corporate balance sheet, or one might consider “dual materiality,” factors impacting employees, customers, and society more broadly.8 Corporate sustainability ratings, or ESG ratings, are produced by separate entities from the reporting frameworks and tend to focus on financial materiality and quality of disclosure.9 As such, ESG ratings should always be interpreted as a metric regarding the exposure to, management of, and disclosure of nontraditional risks to corporate sustainability, not the company’s impact on broader social and environmental problems.10 While these can be and often are correlated, they are not identical. ESG analysis offers a financial benefit as far as it can reveal risks and opportunities previously unexamined and unpriced by the market. Similarly, ESG analysis carries the risk that an investor might place too much emphasis on nontraditional issues. The consideration of corporate sustainability should, in theory, lead indirectly to broader benefits, but such benefits are neither guaranteed nor are they the main objective.
The widely accepted definition of sustainability, or sustainable development, originates in the 1987 report Our Common Future by the United Nations World Commission on Environment and Development. Both the commission and the report are colloquially termed the “Brundtland” commission, after the chairman, Gro Harlem Brundtland. The Brundtland Commission defined sustainability as “meeting the needs of the present without compromising the ability of future generations to meet their own needs.”11 Here, the scope of the system sustained represents human society, and the objective represents economic growth. The Brundtland definition combines the concepts of intergenerational equity, resource stewardship, and the precautionary principle of environmental impact. The commission recognized environmental and social limits but argues that improved technology and social organization can allow for “a new era of economic growth” wherein “sustainable development is not a fixed state of harmony, but rather a process of change.”12 In 2015, the United Nations released the Sustainable Development Goals (“SDGs”), a collection of 17 initiatives, such as reducing poverty and combating climate change, which build from the Brundtland Commission’s definition of sustainable development. The United Nations intend the SDGs to promote economic growth while simultaneously conserving and nurturing limited resources. The United Nations present these goals as a co-equal and unified vision of a better future but acknowledge the underlying potential for conflicts between goals. For instance, in discussing a global energy and resource transition, the United Nations emphasize the need to take “fully into account the specific needs and conditions of developing countries” and minimize “the possible adverse impacts on their development [from such a transition] in a manner that protects the poor and the affected communities.”13 As such, the most constructive view of the SDGs necessitates cost-benefit analysis to optimally generate collective and equitable growth. Due to stakeholder diversity, the SDGs engender compromise over ideological purity, although in practice narrow voices are often the loudest.
The SDGs have become a common language across the private and public sector in communicating environmental and social endeavors, and the financial services industry is no exception. The SDGs allow investors a framework to analyze whether an investment aligns or misaligns with commonly shared goals. For instance, product involvement screens are useful tools to decide whether to include or exclude certain companies in a portfolio. A sustainable development investor might choose to exclude tobacco companies from his or her portfolio, as the sale of tobacco undermines SDG #4 Good Health and Wellbeing. Alternatively, the same investor might seek higher exposure to renewable energy and cleaner fossil fuels to advance SDG #7, Affordable and Clean Energy. The investment case for aligning with the SDGs arises from the scope of the problem and the opportunities – the Organization for Economic Development estimates that globally, there is an annual $3.7 trillion deficit between current investments towards the SDGs and the required amount estimated to achieve the goals by 2030.14
The third definition of sustainability, which we might term socio-ecological sustainability, builds upon the concepts of the systems definition of sustainable and the United Nations definition of sustainable development. However, unlike the two previous definitions, sustainability represents a distinct worldview. In his book, Flourishing: A Frank Discussion about Sustainability, the retired industrial ecologist and MIT professor emeritus John Ehrenfeld adeptly articulates sustainability as flourishing, or the aim that “humans and other life will flourish on the Earth [for as long as possible].15” The socio-ecological view of sustainability argues that human society, post-industrial revolution, has focused on economic growth as the barometer of social progress. However, in doing so, has conflated the pursuit of material development with individual and societal well-being, and that while correlated, they are not the same.16 Furthermore, it argues that the anthropocentric views of industrialized society often fail to consider the moral value and needs of nonhuman life forms.17 As such, sustainability presents a different vision: all life falls within its scope, it is simultaneously dynamic and of indefinite duration, and selects well-being, rather than development, as its guiding priority. The socio-ecological view of sustainability argues that the industrial worldview contains a fundamental flaw in the presence of biophysical and social limits, and produces undesirable “side-effects,” which are in fact systematic maladies.18 According to this perspective, problems such as climate change are not technical challenges to be solved with technological solutions, but rather symptoms of the same root cause, an economic model predicated on unlimited growth. Advocates of this viewpoint argue that sustainability does not reject corporate sustainability and sustainable development but characterizes them as “eco-efficiency.”19 These are the steps necessary to provide industrialized society sufficient time to undergo a revolution in its value systems. For instance, a low-carbon economy based on a limited supply of rare metals for electric vehicles and solar panels, without robust recycling systems in place, would merely shift the economy’s source of unsustainability. Sustainability will require innovative economic models, not just innovative technology.
Understanding the differences between the terms sustainable, sustainable development, and sustainability enables clearer discussion about wealth management’s role in addressing environmental and social issues. Furthermore, it helps set reasonable expectations for an ESG-integrated portfolio. Finding competitive investments that reflect authentic applications of each definition of sustainability represents a challenging endeavor. We designed our ESG model portfolio platform to help our clients meet their financial goals with diversified, broad market investments. As such, our first focus within the ESG models remains identifying managers who meet our requirements and consider corporate sustainability as a material factor in their investment process. However, on occasion, we can expand our ambitions to align with broader sustainability themes. Our new thematic sleeve within the ESG models includes investments in alternative energy, energy management and efficiency, clean and efficient transportation, sustainable food and forests, water infrastructure, circular economy, digital infrastructure, and environmental services. The sleeve contains high-quality companies with durable competitive advantages that operate in environmental markets and have top notch environmental, social and governance practices. We believe dedicated exposure to companies addressing these environmental challenges may provide a long-term source of alpha for our clients. If you have an interest in sustainable investing, whether it comes from a desire to mitigate risk, seek long-term development opportunities, or “to do well by doing good” and integrate a small portion of your portfolio with social and ecological themes, ask your GYL advisor about our ESG model portfolios.
1 Mercer: Themes and Opportunities 2022
2 Thinking in Systems, Meadows, 2008
3 Flourishing: A Frank Discussion About Sustainability, Ehrenfeld & Hoffman, 2013
4 A U.S. Imperative: High-Quality, Global Accepted Accounting Standards
5 Investor Bulletin: How to Read a 10-K
6 Modernization of Regulation S-K Items 101, 103, and 105
7 SASB Standards and Other ESG Frameworks
9 What MSCI’s ESG ratings are and are not
11 Report of the World Commission on Environment and Development: Our Common Future
13 Transforming our World: the 2030 Agenda for Sustainable Development
14 Global Outlook on Financing Sustainable Development 2021, OECD
15 Flourishing: A Frank Discussion About Sustainability, Ehrenfeld & Hoffman, 2013
Is What Happened in the UK the “Canary in the Coal Mine” or a Premonition of What Could Happen in the U.S.?next >
Third Quarter 2022 Capital Market Recap1