Should We Ask Investment Advice from Al Gore?

Ma. Amora Manabat, CFA

The CFA Institute’s brand of fiduciary duty is demanding more and more from us intellectually. First, we find that the 250 hours we spend yearly going through CFA exam material brings us up merely to the basics of taking care of other people’s money. Even after successfully completing the program, at the very least, accountants felt they needed more finance, economists felt they needed more accounting, and almost everybody thought they needed to beef up quantitative skills. Then there’s the ubiquitous section on ethics that induces one to think about taking a law degree.

Now the CFA Institute encourages analysts to consider environmental, social and governance (ESG) issues. The level 3 curriculum already includes readings on governance, premised on the obvious notion that good management enhances the company’s value. A few weeks back the CFA Centre for Financial Market Integrity published its manual for investors on ESG factors, providing guidance on how to think about the impact of environmental and social issues in company valuations.

That the CFA Institute is pushing thorough consideration of ESG issues implies that sustainability management has been largely ignored in the past. With the plethora of factors that have to be considered in determining a company’s worth, long-term factors such as the environment and social situation are simply assumed away. Not surprisingly, long-term investors like the pension and endowment funds were the first to realize that they need to take these issues more seriously.

Investors with short-term horizons in the United States eventually also took notice. The high level of activism in the United States made these long-term considerations affect short-term company performance. For example, the emissions of coal-fired power plants, per se, would not affect financial performance. However, success of environmental lobbyists in legislating high emission fines will compromise the financial viability of coal-fired plants.

Some investors draw up negative lists on ESG matters by prohibiting investments on, for example, coal power, firms that employ underage workers, and so on. The screening acts to limit the risks that result from bad practices. More recently, ESG issues are being viewed also as value-enhancers, that is, good practices create greater value. Accordingly, some investors incorporate ESG issues in their analysis within a risk-return framework. The latter approach requires more analysis but seems more practical than the first, as it avoids the absolutism of negative lists. However, quantifying the contribution of sustainability management to risks and returns continues to be an analytical challenge. Analysts are likely to already face significant roadblocks in looking for information on energy use and gas emissions - linking this information to profitability might already require a leap of faith.

In some cases environmental and social issues directly affect firm valuation, like how rising sea levels will depress the price of coastal real estate. But mostly, the impact of these issues depends on the changes they cause in the firm’s reputation, and the legislative, regulatory, legal setting in which the firm operates. As such, the extent of these issues’ impact on company value depends on the society’s level of concern for the issues. In Nepal, for example, it would be impossible to ignore labor issues. And in Bhutan, damage to the environment would be unacceptable.

We therefore beg the question, do ESG issues affect company valuations in societies that do not think they are important? How much damage will the use of child labor cause if the society in which the company operates is tolerant of working children? There could be some effect if the company sells to another country with stricter labor standards, as in the case of Nike manufacturing in Viet Nam and selling to the United States. The increase in trade linkages and transnational operations could cause some convergence in the level of awareness of ESG issues. But the speed of such convergence is not yet known. While societal priorities and values are formed through long periods of time, technology and globalization have made exporting them easier. The best approach is still good old fashioned rigorous analysis – it is better to ask the ESG questions, than ignore them.

Most interestingly, Al Gore is the chairman of Generation Investment Management ("GIM"), an investment firm that believes that pursuing sustainability confers an investment advantage. GIM currently has over $1 billion under management and claims that its returns are well above their benchmarks[1].

[1] http://stockpickr.com/port/Al-Gore-Generation-Investment-Management/