January 31st 2023
Generic marketing and tough markets may have damaged confidence, but enhanced ESG reporting will further focus capital on societal outcomes.
Turbulent times in markets have led some to claim “Mission Unaccomplished” on the merits of ESG investing. It is fashionable, perhaps even fair, to call foul on a movement that seemingly heralded the dawn of a golden age of investing proffering both to solve societal ills along with sustained above index returns, if all based on fairly short-lived experience. As ever, within the hubris hyped by considerable investment marketing spend lay the root of our folly.
With hindsight it is easy to see how good intentions and naïve use of a ESG data sometimes skewed portfolio positioning biased towards the headline elements of the environmental ‘E’ of the ESG ranking system – resulting in portfolios that were, say, overweight momentum-driven technology stocks and underweight the energy sector – and which then suffered the sobering market consequences as energy prices soared, the tanks rolled into Ukraine and inflation returned with a vengeance during 2022.
Hopefully few investors are so fickle than to draw conclusions based on such a short-term time frame. But it does beg the question as to whether all investment managers had sufficiently considered and explained the implications of the sector, style and factor biases resulting from their stated ESG approach.
This is not to challenge the relevance of negative or positive selection to align to an investor’s societal priorities, ethics, values or religious beliefs. Rather this finds fault with a simplistic approach reliant upon high level ESG rankings that often hide a multitude of conflicting corporate behaviours underneath.
But our greater failing was surely to define ESG an outcome and therefore to think of it an investment strategy in its own right. After all, the ESG acronym emerged as a collective term of convenience to describe a fundamental research process; namely an expanding set of issues and measures covering a multitude of stakeholder outcomes. Investing in a strategy labelled “ESG” is itself no more insightful than putting money into a fund with “financial metrics” or “accounting” in its title and expecting an improved outcome.
The sheriffs are belatedly riding into town to clean up the mess in Dodge.
Some justice is being exacted against investment firms that have brandished superlative environmental credentials in promotion of products or services while purposefully obscuring an unequal practice across the wider asset base that they manage, or finance. The modern crime of green-washing is also well cited by evangelists with a social cause to promote.
As relevant are regulatory efforts to reform the investment marketing regime to better codify and signpost the explicit focus of investment products, thereby calling time on the meaningless ESG tag as an objective.
This is welcome as it should better help end investors to align assets to their own preferred societal priorities, rather than being shoe-horned into the one-size-fits-all ESG clog hitherto offered by many managers.
Better classification of sustainability sub-sectors will nurture a more thematically defined investment landscape; we already see many products articulated around narrower objectives – promoting environmental objectives such as lower Green House Gas (GHG) emissions versus an index, alignment towards the Paris Climate objectives, or more efficient water usage, for example. Classification rules could therefore support the emergence of other important thematics such as improved biodiversity outcomes, individual Social Development Goal initiatives or the promotion of social justice, gender equality and those aiming to benefit exploited or underrepresented groups.
In a more societally conscious age, genuine consumer choice is welcome.
Much has also been written on the shortcomings of corporate ESG data, particularly concerning the errors and omissions inhibiting accurate company comparisons across timelines, geographies, sectors, company size or across the public/private ownership divide.
Such criticism is often justified not least as so much of the data is backwards looking as well as being very expensive. But the immense budget spend on such data sets shows that many investment firms extract valuable insights, and it also illustrates how ESG factors are already embedded within institutional research at large. Constructive moaning around data shortcomings further encourages improvement but also underpins concerted supervisory initiatives to enhance corporate transparency, accountability and therefore to promote responsible corporate behaviour.
In October 2021 the UK Government signalled its intent to adopt the internationally recognised TCFD protocol for monitoring GHG emissions as the foundation for its investment signalling within its Green Taxonomy, leaning into sustainability accounting standards as codified by the ISSB. This follows the EU spearheading of its own corporate reporting taxonomy that already requires all investment products to be classified through its Sustainable Finance Disclosure Regime (SFDR).
Some frustration surrounds the wholesale focus thus far on carbon emissions to the exclusion of other environmental or societal concerns. Be that as it may, the EU has implied an intent to incorporate wider social issues over time while the UK has been more explicit in highlighting water use and marine impact, the circular economy, pollution prevention and protection of ecosystems as explicit taxonomy reporting objectives.
Since ESG is an evolving set of evaluative measures, albeit those seeking to put a monetary value on many externalities and a company’s operational impact upon various stakeholders, so ESG data has immense utility to help investors determine managerial acumen, strategic intent and potential financial liabilities. These intuitively direct an investor’s attention towards longer term outcomes, sustained or otherwise. Combined with more explicit regulations requiring companies to report on various outcomes, such as water utilisation and ecosystem degradation, so we will see more reliance on such ESG data over time not less.
Hopefully end investors will also witness an improved qualitative use of this information by their investment managers alongside better articulation of how products with more specific ESG objectives might fare under different market conditions.
Accepting that damage is easily done where lazily employed so it remains entirely wrong to call time on ESG as an activity within investing. Quite the opposite. ESG 1.0 may be down, but version 2.0 is not far behind.