Environmental, social and governance (ESG) is a hot topic, with decarbonisation the latest big buzz word as the world figures out a way of reducing carbon emissions in a global economy up until now dominated by hydrocarbons. And all within the space of just ten to 30 years.
According to a Global Sustainable Investment Alliance report, sustainable investments have surged 34% to more than US$30tn since 2016 and BlackRock, the world’s largest asset manager, now predicts that ESG exchange-traded funds (ETFs) assets will hit US$400bn by 2028.
But there’s a problem. A sustainable investment strategy is only as good as the data you feed into it. At the inaugural Big Call: ESG Investors Forum in November 2019, which I hosted, Gianfranco Gianfrate, professor of finance at EDHEC Business School, spoke of inconsistencies arising from the number of ESG data providers – he noted that there are around 200. “Because there are so many data providers [with such varying scores], investors are able to find one that rates the sustainability of a company, even if the others do not. It is like having no ESG ratings at all,” Gianfrate told delegates.
One oft-cited example is that of the two biggest providers, MSCI and Sustainalytics, which have a correlation of just 0.5 on their ESG data scores. US investment firm Research Affiliates has dug deeper into this and come up with a concrete example of different data firms using their own, incompatible, subjective criteria to score businesses.
According a paper by Feifei Li and Ari Polychronopoulos, respectively head of investment strategy, and partner, product management at Research Affiliates, in the period from July 2010 to June 2018, two notable ESG portfolios had a performance dispersion of 70 basis points per year in Europe and 130 basis points a year in the US, translating into a cumulative performance difference of over 10% and 24% respectively.
Unsurprisingly, this has sparked a storm of complaints about greenwashing, especially as most of this data is based on self-reported numbers issued by the companies being tracked. Greenwashing is a pejorative term used to describe companies self-reporting sustainability data, which makes them seem impressive on ESG criteria but belies a very different reality.
Arguably, one of the most notable critics has been SCM Direct, which has accused many ethical strategies of widespread misclassification and misselling, in a November 2019 report. SCM Direct finds several ESG products, including the Legal & General Future World ESG UK Index Fund and the Vanguard SRI European Stock Fund, had significant amounts of exposure to companies in tobacco, gambling and alcohol industries.
But it’s not just SCM that is critical. At the Big Call forum, Matt Brennan, head of passive portfolios at AJ Bell, said that ESG ratings are effectively “black boxes with little disclosed on how they are calculated”. And Peter Sleep, senior portfolio manager at 7IM, shares these concerns, arguing that “many companies are greenwashing their funds to make them commercially attractive without putting in much resource or changing their own behaviour”.
“Many companies are greenwashing their funds to make them commercially attractive without changing their own behaviour”
A cynic might go even further and suggest that this push to ESG is just about getting ahead of new regulations – and there is some evidence for this. State Street recently published a report called Into the mainstream: ESG at the tipping point, which surveyed investors at over 300 institutions. It finds 52% of European investors cited getting ahead of regulation as the key reason for adopting ESG. Mitigating risks was a close second, but it’s impossible not to conclude that a bevy of new rules might be a motivating factor.
The UN’s Sustainable Development Goals are certainly informing some responsible investors, but one senses a more immediate interest in two climate benchmarks: the EU Climate Transition Benchmark and the EU Paris-Aligned Benchmark. In June 2019 for instance, the EU Commission introduced new disclosure requirements related to sustainable investments. The regulation was implemented around three pillars: the elimination of greenwashing, regulatory neutrality and a level playing field for all investors.
But the really big debate here is less the growing but small pool of ethical funds, more the wider investment sector. Put simply, isn’t climate change such a big issue that it impacts all fundamental analysis of a stock or bond? That’s certainly the guiding spirit behind a paper published by MSCI, Principles of sustainable investing, which calls for research analysts to incorporate ESG considerations into their fundamental company analysis.
In a 2015 TED Talk by London Business School’s professor of finance, Alex Edmans, he suggests that company boards need to be much more ambitious than just worrying about the downside risks of climate change, and the core focus on profitability is misguided. Businesses need to think about their overall wider societal responsibilities that include their employees. His analysis finds that companies with high employee satisfaction, measured by inclusion in the list of the Fortune 100 Best Companies to Work For in America, outperformed their peers by 2–3% per year between 1984 and 2009.
Research from FactorResearch shows an over-emphasis on climate risks might detract from returns. The author of the research, Nicolas Rabener, analysed a time series of returns for US-quoted ETFs with an ESG twist. Once he equal-weighted those returns, he found that his index of US ESG ETFs slightly underperformed, ie, passive index tracker funds with an avowed ESG mission underperformed most major benchmarks since 2005. He also found that these ESG-friendly funds traded at a slightly more expensive valuation than the US stock market, and had a structural overweight in technology and underweight in energy stocks. Rabener believes this could be a deadly cocktail – additional costs to pay for all that data, a reduced investment universe and structural sector bias.
Yet, one could argue that on a forward-looking basis, perhaps these numbers on past returns might end up being irrelevant. If the former Bank of England governor Mark Carney is right and many listed companies end up with stranded assets or uneconomic cost bases (aviation perhaps), maybe the only way of mitigating risk is to exclude the wrong stocks and the wrong sectors?
An alternative approach is to be more inclusive, and focus only on those businesses that can make a positive difference, say by cutting carbon emissions or even taking carbon out of the atmosphere. This inclusive, impact led approach to decarbonisation might end up being more effective than an exclusionary approach but might require a focus on earlier stage businesses that might be held by private equity investors.
Views expressed in this opinion piece are those of the author alone and do not necessarily represent the views of the CISI.
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David Stevenson is the Adventurous Investor columnist for the weekend Financial Times. He also writes for Money Week, Investment Week and the Investors Chronicle.