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ESG: another acronym to throw around?

From the desk of John Arnesen,

Consulting Lead, Pierpoint Financial

securities lending securities lending esg responsible investing
ESG is inextricably linked to securities lending

For those of you who subscribe to our daily news stories, you will appreciate that I try and pick articles that you typically have not come across in the endless stream of information you have to digest every day. In my reading, looking for stories of interest, the sector written about more than almost any other is Environmental, Social and Governance, ESG related articles. Often referred to as 'responsible investing' or 'sustainable investing', it all falls under the same umbrella. So, why is the press so prolific in its coverage and why are asset allocations that fall under this umbrella, accelerating year-on-year and, as the chart below predicts, expected to continue their upward trajectory?

I think it boils down to a simple premise. It is the right thing to do. There is something inherent in human nature to try and do good, and while we may fail over and over again, the desire to be ethical, to be accommodating, to avoid conflict, not to pollute nor abuse our fellow human beings is a primary tenant of human nature. To reflect these principles in investing seems like a logical extension of personally held principles, but why is the explosion in ESG- related products happening now?

Actually, it isn't that new. Avoiding investing in companies involved in the slave trade dates back to the 18th century, more often than not driven by religious beliefs. In fact, any boycott of a product or producing country is a clear expression of either the E, S, or G and encourages others to think similarly. Think of South Africa in the 1970s and '80s and how the groundswell of public opinion over apartheid led companies to divest from South Africa which, one could argue, had a successful outcome.

As to why ESG is becoming mainstream investing and accelerating, it seems to be driven by us as employees, as consumers and, as savers. Perhaps faced with overwhelming data that human output is having a detrimental effect on the climate, we have turned from expressing concern over the environment to taking action. This is driving not only climate initiatives but all aspects of society, and it has become essential to investors that deeply held principles are reflected in the investment choices they make. What I have struggled with in all of this is how do you interpret the available data, is there enough of it and isn't the drive towards standardisation counter to the concept of a principles-based approach? After all, isn't it your principles you want reflecting in investment choices, rather than someone else's?

However, the more I read about ESG, the more I find a common theme running through the discourse, which is the need for standardisation of ESG ratings. There is no shortage of bodies that categorise what the E, S and G should contain but there are no 'rules' as to whether an investment passes muster as it is about as subjective a decision as you can get. For example, should you discriminate between an energy stock with great returns but one that has no emission reduction targets and is disinterested in providing further information and a similar company that has an aggressive plan to be carbon neutral by 2030 and links executive compensation to that goal? Alternatively, should you avoid the energy sector altogether? What about a tobacco producer? On the face of it, probably an easy decision to exclude, but what about one that has plans to transition from tobacco to large-scale cannabis grown for medical use only?

Standardisation, it appears, is what market participants are crying out for and I accept that to measure something, you need to start somewhere, with a tool to do it, and asset managers are under increasing pressure to report to investors how ESG-compliant or 'green' their managed funds are. Regulators are keen to get in on the act. The FCA is considering independent governance committees on methods used to report on firms' ESG activities, and the UK government is very concerned with exposure to climate-risk related investments that could materially affect valuations, so the Department of Work and Pensions is mandating ESG reporting by UK pension schemes. Trustees beware. The shift to mandatory from non-mandatory reporting is as a result of little effort being made to report over the past year with only 2% of trustees making changes to investments and, according to a survey, 38% believing the requirement is nothing more than a box-ticking exercise. I find this quite shocking because such an approach makes a mockery of the goal that ESG investing is trying to reach. However, when a task becomes a regulated requirement, the path of least resistance typically prevails. For trustees to really understand the E S and G of companies, on which data will they rely and who will be providing it? Some part of the chain, be it the companies themselves, the asset managers or a third party will require more significant resources and analytics to provide the necessary output.

Getting some consistency with the overwhelming proliferation of ways in which sustainability risks are disclosed may be championed by the International Organization of Securities Commissions (IOSCO) which recognises that the sheer number of frameworks available to companies makes it difficult to define what a sustainable finance product actually is. IOSCO is planning a task force to take on the monumental effort to take and 'translate' the different standards globally into something more standardised and transparent. An ambitious task indeed.

While I firmly believe in investing with ESG at the forefront of decision-making, not all voices are convinced by the outperformance claims which are made with frequency. The FT in late October published an article making the point that to claim better risk-adjusted returns from ESG investing has insufficient evidence supporting it because the time horizon on which such claims are made is too short and therefore the claims inconclusive. The argument I found more compelling is that if the aim is to divest from 'bad' companies or those involved in unpalatable industries, it will cheapen their share prices, which may lead to them outperforming their more 'virtuous' portfolios over time. Tobacco stocks have been shunned in recent years by a more health-conscious public, but they consistently outperform the S&P 500 and pay very high dividends. Philip Morris aims to generate 30% of sales from smoke-free products by 2025. Principles vs return is a point that has to be considered.

Another article which did tickle me somewhat recently was a report on the pet-food production industry and that it doesn't have a great track record on the sustainability front. So, for you dog owners, the next time Rover is naughty, remind him he isn't very ESG compliant and that a plant-based diet could be on his horizon.

In the meantime, is ESG simply another acronym? It is more than that: it represents a massive change in our thinking and expectations on how, why and where we spend and invest our money.

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