Until the last 10 or 15 years, most ESG strategies sought to add edit to help them find the answer to a simple question. Are the companies we're investing in good or are they bad? By doing this, they could exclude the centers or at least reduce their weight in their portfolio and enjoy a warm glow of moral satisfaction for investing in the good firms. But what they couldn't do is link those values about right and wrong to the source of long-term financial value and a profitable investing. Over the last 10 or 15 years, we've used the rhetoric of materiality and financial impact and sought correlations between old measures designed for another purpose and financial outcomes in places where that relationship is presumed to be strong. After 10 or 15 years of trying, it's time to admit that this approach isn't working. That's why I partnered with Engine No. 1 to develop its total value framework, which we believe is an important step forward at the evolution of ESG data. It's a data-driven approach to investing that puts tangible value on a company's environmental, social, and governance impacts, and then ties those impacts to long-term financial value creation. We've developed the total value framework to address the current deficiencies in ESG data and to help investors generate a lasting impact on corporate behavior and robust long-term financial returns. To that end, we've worked to develop a unique method of measurement that focuses both on the value that companies create or destroy for shareholders as well as stakeholders and the connection between those two groups. Let's start with value for stakeholders. Through the total value framework, we measure the value that companies create or destroy for their stakeholders, for their employees, their customers, their communities, as well as for the natural environment. We try wherever possible to quantify that impact in dollars instead of traditional ESG scores and ranks, which again might as well just be emojis, and are as difficult to incorporate into spreadsheets or algorithms. We use independent sources and estimates to assess the firm level cost of emissions, resource use, waste, social practices, and a host of other ESG factors. Second, value for shareholders. Armed with this new data on stakeholder impacts, we can proceed to measure how the value delivered to stakeholders affects the values then able to deliver to its shareholders. This forces us to examine drivers like potential regulation, changes in customer employee preferences, technological disruptions, and other relevant contributors to a company's risk or growth, factors that link stakeholders to shareholders. For example, we can show that variation in the level of value created or destroyed for stakeholders strongly predict future shifts in the company's financial value, including its revenues, its worker productivity, earnings, net income, market capitalizations, and multiples. Indeed, the association between stakeholder value and these financial outcomes has turned out to be far stronger and more robust than of the correlations observed between the traditional ESG data providers and the same outcomes. Crucially, this frameworks analysis informs investor decisions as well as what asset managers do as owners once they make those investments. Engine No. 1 believes investors can only affect lasting change when they work as active owners. With the total value framework, they come armed with an approach that's rooted in data, connected to value, integrated with their investing process, and focused on change. They also stress the importance of attribution in their view and in mine of understanding the causal factors that drive the connection between stakeholder and shareholder value. By embracing these principles, ESG investing can harness private capital on the scale needed to address systemic challenges like climate change and racial justice. Only then will the potential of ESG funds translate at a better financial returns as well as corporate societal and environmental outcomes. Rather than use a performance ranking based on another set of subjective criteria, the total value framework integrates reliable ESG data into mainstream financial reporting. It attempts to understand and accurately predict how ESG performance affects valuations. We put a dollar value on the uncompensated consequences of production or consumption that impact third parties and aren't reflected in market prices, what are called negative and positive externalities. These include the costs of respiratory illness from burning diesel, the cost of lost biodiversity when forests are cleared for palm oil production. Understanding of these externalities is critical to any approach to measure and quantify ESG impacts. By measuring the financial value of these externalities, in terms of both positive and negative impacts, the total value framework allows much better comparisons between the performance of firms over time and across industries. That leads to better predictions of their impact on future market valuations, which makes it easier to identify the conditions under which ESG performance is likely to be material and the time horizon over which that's going to occur. Perhaps most importantly, the monetization of ESG performance makes it possible to fully integrate ESG factors into mainstream financial analysis and to overcome some of the inadequacies of subjective and biased data. Remedies for the significant negative externalities often involve imposing costs on offending producers or consumers, a process referred to as internalization. This most commonly takes the form of government regulation. Consider for example the Clean Air and Clean Water Acts passed in the US in the 1960s and 1970s. These required polluting businesses to reduce pollution levels and to pay for some of the costs associated with air pollution. Also driving internalization or customer pressure and purchasing decisions, which are often informed by public campaigns from NGOs focused on environmental and social issues. Further internalization comes when a local community sues major corporations for the unlawful dumping of waste or when they demand compensation in damages after high-profile environmental incidence, then companies are hit with associated compensation costs and even punitive damages. Environmental risk on its own can lead to internalization. Witness the disruption to operations, the price volatility in agricultural commodities, and the other costs stemming from droughts, floods, soil erosions, and even pests. Similarly, we believe that firms can create significant positive externalities, which will be rewarded over time as regulators treat them favorably, as employee satisfaction grows, and as customers become more inclined to buy their products. This figure illustrates the relationship between the externalities imposed on stakeholders and the costs internalized by a business. The figure provides an alternative way of looking at the relationship between stakeholder impacts and shareholder value at the firm level. In what we call the current state, the maximization of profits for shareholders is achieved at the expense of workers, customers, suppliers. This leads to a stakeholder backlash and an erosion of shareholder value over time. By shifting to a more positive set of stakeholder relationships, a business can deliver sustainable shareholder returns and stakeholders can benefit as well. By measuring net externalities in addition to shareholder value, Engine No. 1's total value framework captures the positive and negative externalities generated by a company throughout its value chain. As shown in this figure, net externalities are the sum of negative and positive ones. For an unsustainable business, net externalities are negative, stakeholder value will be lower than shareholder value. In the medium term, some of this net externality is likely to be internalized by shareholders, reducing expected shareholder returns, while some may still remain unaccounted for and be what we call here a residual externality. The final bar illustrates the effect on long-term shareholder value, which is reduced by the amount of the externality that is internalized within the study's timeframe. Let's use a concrete example. Exxon Mobil had a specific market capitalization, but it created substantial negative externalities in the form of its GHG emissions, other air pollution, human rights, and community relations, which were negative. It also had positive externalities. It created new patents, new innovation. It offered worker training, it paid wages, it paid taxes, all of which had positive economic and social spillovers. Combining the dollar estimates of these negative and positive externalities together with the market capitalization, we can come to a measure of total value. The next question is how much of the gap between its market cap and the total value will be narrowed or how much of the negative or positive externalities will be internalized by shareholders? In the case of Exxon Mobil, the rapid rise of alternative energy technologies, the threat of government regulation, the salience to its stakeholders of climate risk, and the competitive reactions of many of its peer oil and gas producers, all combined to decrease the time horizon over which shareholders would likely internalize the net externalities. Now, let's look at a positive case. A business that creates net positive value for its stakeholders would expect a higher long-term shareholder value. This is because its net externalities are positive, and a proportion of these may be internalized by shareholders over time as shown in this figure. An example here could be a firm that supports financial inclusion or the communication of market prices at different areas of a province to farmers. While these technologies are valuable to customers, such technologies also create positive benefits for all participants in the market that the company may be able to gain from through leveraging customer loyalty to offer new products and services or securing financial support for governments or civil society organizations. Some research also suggests that employees in such organizations may be willing to work for lower wages or work harder for equal wages, which would also confer financial benefits to the shareholders of such a company.
