ESG: The New Standard for "Best-in-Class"?

ESG: The New Standard for "Best-in-Class"?

There's growing evidence that companies who integrate societal concerns about the workplace, environment and corporate governance into their operations may have a competitive advantage and improved growth potential.

For years, ESG (Environmental, Social and Governance) strategies have helped investors pursue their financial objectives in a way that's consistent with their beliefs and values.

However, environmental, social and governance concerns have now emerged as important business issues for many companies and industries.  What's driving this convergence between investor concerns and corporate goals? Factors include:

  • Growing pressure to reduce greenhouse gas emissions and increase energy efficiency in operations and products.
  • Globalization of the world’s major economies and resulting changes in the priorities of workforces as well as consumers.
  • Increasing world population, growing prosperity and consumption among some segments of society, and the associated demand for goods and services.
  • Expanding demands for goods and services on a limited natural resource base, and the resulting pressure to improve resource productivity.
  • Better and more widely available information on the environmental and social impact of development on local communities and economies.
  • Ever-increasing public and, consequently, governmental concerns about quality-of-life factors such as air and water quality, equity in the workplace, work-life balance, and human rights.

A new framework

We believe these trends are reshaping the competitive landscape in many industries and are transforming seemingly non-financial, ESG issues from relatively minor factors in corporate decision-making into factors that are integral to competitiveness in the 21st century.

It's our view that the companies likely to benefit from these trends will be those whose leadership, values and corporate culture enable them to go beyond regulatory compliance and derive strategic value from their workplace, community and environmental initiatives.

We associate the degree to which companies acknowledge and respond to the ESG factors that emerge within their operating arena as indicative of their level of “awareness.” Measuring this awareness is an imprecise exercise. Its analysis by asset managers is relatively new and still evolving.

At ClearBridge, we frame our efforts around a “Best-in- Class” methodology which aims to evaluate a company’s capacity to manage the ESG drivers of business performance by analyzing corporate policies, management systems and practices, and a company’s track record in these areas. Key indicators we use include:

  • Workforce demographics and productivity, including recruitment and retention, training and development, work-life arrangements, occupational safety, employee and union relations, and global supply chain monitoring.
  • Environmental indicators, including climatic, ecological and health impacts, strategic product advantages, innovation, and natural resource usage
  • Community involvement, including engagement, transparency, stewardship (human rights, conservation, etc.), volunteerism, and strategic giving.
  • Corporate governance, including management structure, board composition, governance guidelines, transparency and disclosure.

As one might expect, each sector of the economy (e.g., technology, energy, retail) is likely to face a different range of issues, given the different business environments in which they operate. Recognizing this, our sector analysts and portfolio managers selectively emphasize those particular issues that we believe are most relevant to a company’s performance.

For example, work force issues are generally critical success factors to technology and pharmaceutical companies because they operate in a creative environment -- that is, their value depends on the innovation and intellect of their work force.

On the other hand, environmental and community issues may be of particular interest when evaluating natural resource companies -- because their business requires securing a license to operate and extract resources through logging, drilling, etc.

Potential for value creation

Virtually every company has some positive characteristics and some negative ones with regard to environmental, social and governance practices. We, as investment managers, must weigh the strengths against the challenges for each company and compare their performance with other companies in their sector to determine those that are on the leading edge and those that are lagging behind.

These comparisons inform the internal ESG ratings our analysts assign to companies in their coverage universe. These determinations are made through our direct dialogue with management, proprietary sector analysis and third-party research, as well as publicly available information from industry and trade organizations, government agencies, public interest groups and other sources. New issues emerge from time to time and the importance of some issues may change as a result of legislation, shifts in consumer values and other socioeconomic conditions. Therefore, ESG integration is a continuous process.

Key implications

We believe that an integrated approach to fundamental research, stock selection and portfolio construction enables us to identify top-quality corporate management teams that are better positioned to create strong, competitive advantages for their companies and stay on the leading edge of their industries. In turn, that selectivity can aid us in achieving our long-term portfolio goals of providing competitive, risk-adjusted returns.

In addition, we believe an integrated approach to ESG investment provides an opportunity to interact with companies on these issues and equip leading-edge companies with the economic leverage to advance these issues across their entire value chain. Given our position as one of the largest shareholders in many of our portfolio companies, we believe the implications of sustainable investing could significantly promote recognition of best practices in the market.

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