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The rush to ESG compliance may hurt its long-term goals

From the desk of John Arnesen

Consulting Lead, Pierpoint Financial

Following my last blog that reviewed an FT commissioned survey of what individuals believed to be effective climate-related actions compared to reality, I thought I would write about the complexities facing investors and issuers and how the speed of change and rush to compliance may produce less than optimal outcomes. Further, to address a subject in the same vein but closer to home, where does and how should securities finance fit into the framework of ESG investing?

It would not be unreasonable to suggest that given the pace of funds flowing into ESG-based investment funds, the 'ESG' could be dropped at some point because it becomes so mainstream that a new term that describes non-qualifying ESG funds is needed. Brown investing, perhaps? The chart below tells a compelling story.

By the end of this year, almost half of institutional money will be invested in an ESG-principled manner. The increase in three years is telling, as is the 567% increase in Impact investing. Those who do not consider ESG factors are certainly trending in the right direction, but at 28%, it still represents a considerable pot of money, but if the downward trajectory holds, by the end of 2025, all fund selectors institutions will have implemented an ESG policy.

Why has the apparent urgency to become all things ESG materialised? I don't buy the hype that it's driven by institutional and retail investors demanding more sustainable products, nor do I think asset managers are altruistically creating funds with an ESG component. I would find it easier to believe if they claimed that they could charge higher fees as their motivation. And yet, these funds are being created at a rapid pace. Could it be motivated by fear of not doing anything and falling foul of environmental activism driving a rush towards sustainability but with somewhat unclear goals?

If asset managers have to juggle a lot of moving parts, corporations have an equally challenging future. Fear of not doing enough in a short timeframe can lead companies into making poor decisions. The pressure of appearing 'greener' than you are, particularly in advertising, has plagued the large energy producers for a while.

Chevron claimed to be 'part of the solution' to climate change but has failed to commit to any measures aligned with the Paris climate agreement. Shell stated it was investing in lower-carbon biofuels and hydrogen-electric vehicle charging, solar and wind power. That should make you warm and fuzzy about them when attending one of their petrol stations unless you learn that they allocated under $3bn in 2020 to their low-carbon business strategies compared to the $17bn in support of their fossil fuel operations. Norway's Equinor said it would grow its renewable capacity tenfold by 2026. Sounds great until you discover that this represents only 4% of its energy output plans.

This 'greenwashing' is pretty much indefensible, but it does provide examples of companies' fear of not being seen to be part of the climate solution and making perhaps truthful but misleading statements as a result. It isn't restricted to advertising.

I came across a 'tell it like it is' blog from an investor website that pointed out that the iShares ESG USA Index (ESGU) has a 2.5% weighting to oil and gas stocks, no different from the weighting in the S&P 500. See chart below. While I won't go as far as the blogger in referring to this as "unashamed bollocks", it begs the question of whether some financial products are designed for a virtue-signalling investor audience.

Source: Bloomberg

This won't be the only example of questionable credentials. The rush to establish sustainability at the corporate and financial product level is likely undermining the care and detail required to ensure a meaningful contribution. We use words like 'transition' and discuss dates such as 2030 and 2050. It seems that this year, 2030 is a date that is taking centre stage, particularly with President Biden's commitment to reduce greenhouse gas pollution by 52% (to 2005 levels) by 2030. While this is highly commendable, and other like-minded nations will follow in kind, the chart below is the stark reality of how energy is consumed in the US.

Seventy-nine percent of energy derives from the same sources that the US wants to transition away from and achieve at least a 52% reduction in 8.5 years. While technology will play a huge role in hitting this goal, is it realistic? The pressure on corporations involved in these industries could easily show up as greenwashing statements or short-term projects to satisfy the climate zeitgeist that does little to make the enormous transition into more sustainable and cleaner energy.

For asset managers and corporations to make meaningful strides in transforming their business models, the availability of standardised data is paramount, both as tools to measure a host of outputs from issuers but equally in the disclosure requirement demand of regulators. With a market increasingly awash with third-party ESG rating capabilities, how does one qualify which to use? Moreover, if consensus can't be reached at the assessment level, how are countries ever going to develop a harmonised taxonomy or, at best, a consensus of how to measure sustainability? Perhaps it's naive to think this is possible given the subjectivity of investors preferences. To quote Professor Bob Eccles of Saïd Business School, "Nobody is ever happy with a standard. It's a giant compromise."

No doubt the debate over standards and accounting will continue, but at least it is a hot topic. The survey depicted below suggests high investor demand to improve what is reported and how.

II think of this as a journey, despite the sense of urgency from all actors, especially regulators. Methods will be tried and tested, disbanded or improved. Arguments will continue, particularly on the environmental side where a self-imposed clock is ticking.

Where does securities finance fit into all of this, if at all? The rush to label products for their ESG or sustainability qualities under SFDR does not allow for more careful consideration of the salient features of securities lending. Rather than hashing out comments on voting rights, which has been covered by many, why not think about how, in the future, it will facilitate the short-selling of greenwashing and poorly rated ESG stocks? I'm sure the former happens today, but we will soon live in a world where investments will be judged by their ESG disclosures and ratings as an additional criterion when assessing a company's health. Securities finance should embrace its relationship with short-selling and demonstrate that in a world that views investing with a more virtuous eye and demands contributions to sustainability, bad actors and those who fail to meet set standards will find themselves on the wrong side of investor sentiment and shorted. The negative debate over short-selling should be turned on its head, and securities lending should claim its position as an enabler for market participants to weed out and punish companies with poor sustainability scores.

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