ESG Scepticism
The last few weeks have seen an increasingly intense debate around ESG. As ESG Advisors, we believe it is our responsibility to provide clarity to the market and guide our clients and stakeholders on what ESG can mean for them. In this article, we aim to bridge the increasing divide by explaining in clear terms what ESG is and is not. We look forward to continue an active dialogue and contributing towards making this space more transparent and impactful.
Christina Rehnberg, Senior Associate
Over the past year there have been numerous critiques of ESG and the Responsible Investment industry. Many of them excellent and highlighting the challenges that the ESG movement faces. The criticism has fuelled a debate and often successfully exposed those who use the ESG trend as a mere misleading marketing exercise.As with anything, this space does require scrutiny and disagreement is necessary for a healthy debate and driving ESG and responsible investment forward. At the same time though, there is also incredible misuse of the ESG term by those who claim to expose ESG fakes. As an ESG advisor, my eyes twitch when I read stories about individuals finding a fossil fuel company in an “ESG fund”, or people being shocked when “ESG funds” do not focus on impact. Of course, at the core is the problem of misleading marketing practices and funds claiming to have an impact that they do not have. I am writing to all of you, please can we all start using the term “ESG” responsibly? ESG criticism seems to often center around exposing "ESG funds" by pointing out that they invest in companies that are defined by them as “unsustainable”, or firms that have a high ESG score but then are involved in something "unsustainable". I keep finding myself coming back to the same point: what everyone should know is that there is a difference between “how E, S, and G issues affect an investment/company” versus “how an investment/company affects E, S, and G”. And it seems to me that many sceptics believe ESG is purely about the latter. This is the point
ESG is not the same as impact. ESG is not an objective assessment of the sustainability of a firm or country. ESG literally means “Environmental, Social, and Governance” not a specific investment objective or set of values. Responsible investment itself is a spectrum and does not always specifically aim for impact, while E, S, and G information is used by investors in numerous different ways to help build an opinion on an investment or to inform stewardship activities. “ESG funds” (there actually is no such thing) use this additional information to help identify investment risks and opportunities (i.e. how ESG issues may impact their investments), or to help drive change in firms who are performing poorly on ESG-related matters, or to build impact investing strategies, or to align their investments with ethical beliefs by ensuring no involvement in particular industries or companies – or a combination of these. Therefore, the one criticising “ESG funds” should first fully understand the nuances of the responsible investment spectrum and then look at how the manager describes the incorporation of ESG information and what this is solving for. If there are inconsistencies between the ESG policy/statements and what is happening on a daily basis or what is reported on – this is cause for concern. But if the way the fund uses ESG information does not align with an outsider’s view of ‘sustainability’ or ‘ethics’, this is hardly greenwashing and rather comes to the core of subjectivity in ESG, sustainability, and investing itself. On the topic of what ESG is and is not, there was an article recently about “The ESG Mirage” in Bloomberg stating that “MSCI, the largest ESG rating company, doesn’t even try to measure the impact of a corporation on the world”. In MSCI’s methodology, they do not claim to measure impact and their website states that the ESG Rating is “designed to measure a company’s resilience to long-term, industry material ESG risks”. This is not the same as the impact of the firm on the external environment – rather it measures how the external environment impacts the firm. MSCI’s ESG ratings have always been about the ESG risk exposure and how well companies are managing this – not about quantifying the impact of the company on society or the environment. MSCI does have impact metrics and this is a different product offering from the ESG Ratings. Similarly, there are data providers out there who specifically focus on impact (see for example Clarity AI and Richmond Global Sciences), while others focus on material risks and opportunities, sentiment, or specific ESG themes. ESG data providers should be held accountable for misleading marketing practices and should provide transparency around what their products do and do not measure. But similarly, those using the products should understand the spectrum of responsible investing and the numerous use cases for different types of ESG information.Let me give you an example for thought
Consider an investment manager looking at investing in firms located in a water scarce region. The manager can look at how the water scarcity in the region and water management practices may impact the future value of each firm, investigate the exposure to water-related regulation and controversies, and assess how the water scarcity might change over the lifetime of the investment (impact on the investment). She might want to focus on evaluating how and by how much the firms’ practices impact the water scarcity in the region and the communities in which each of them operates (impact of the investment). If the investment manager has the opportunity to take ownership stakes in the firms, among other things, she might want to look at those who are water intensive to help them improve efficiencies, thereby reducing risks and drive long-term value. She might also decide that she does not want to be involved in companies that may contribute negatively to water scarcity, and thereby exclude poor performers completely. If she has the ability to short firms, she might want to consider shorting poor performers based on the conviction that they will be driven out of the market. Or, she might decide that she doesn’t want to profit from those firms at all, and also excludes them from the short book. What happens if she cannot take an ownership stake, and instead provides credit to these firms? She might decide that the water management aspect is not a significant enough downside risk that influences the ability of the borrower to repay its debt, and therefore goes ahead with the debt position despite the water issue. Or, she might include water-related improvement targets in the loan terms or even link the interest rate to water-related KPIs (which would need to be clearly defined). What happens if she is trading the price difference between the equity and debt of the firm? She would want to understand how water related risks and opportunities impact the movements between these two, if at all. What if she is trading the sovereign debt of the country that this region is in? Or the currency? Does water scarcity in a region have the potential to impact the exchange rate? If so, how, and by how much?As you can see, the information about the water related aspects of the region and the firms can be used in numerous different ways depending on the investment thesis. And we haven’t even discussed what KPIs to use, mentioned any other traditional financial factors, or even other E, S, and G issues that may be relevant for the investment in question.Clearly, ESG cannot be applied in the same way across all funds, and it would be ridiculous to expect that ESG is a one-size-fits-all whereby you can criticize a fund as “ESG or not” purely based on the holdings of the portfolio.What to do?
To move onwards and build on what the debate has highlighted, it is of incredible importance that asset managers clearly explain why they believe ESG is important for their investment and ownership activity, how ESG information is used on a daily basis as well as evidencing what the outcome of this process has been through reporting. Similarly, ESG information is not as easily applicable across all asset classes and investment strategies, and therefore it is important to discuss current limitations and future ambitions with timebound targets.In response to the confusion and to provide more transparency, regulators have also started stepping in. A welcome development is the Sustainable Finance Disclosure Regulation in the EU, whereby fund managers are required to explain how ESG information is used in the investment process. There is still some confusion around how the disclosure and reporting requirements apply in practice across different investment strategies (particularly hedge funds). But I believe that regulatory developments like these should be supportive of providing clarity for all stakeholders.Outside of the regulatory developments, we should all do our homework and call out those who are actually greenwashing and claiming to do something that they are not instead of policing funds against our own subjective beliefs on what should or should not exist in an “ESG fund”. In the end, there is no such thing as an “ESG fund”.I have tried to explain these nuances as clearly and concisely as possible, which is hard given how multi-faceted ESG actually is. I would love to hear your take on the matter and if you disagree. Hopefully we can drive the financial system towards solving the biggest issues that humanity faces together – ESG can play a role here, but impact investing more so.Get in touch at info@northpeakadvisory.com if you would like to discuss this in more depth. We have also written about the topic of ESG data and ESG skills, which you can read about in our Insights section. NorthPeak also offers online ESG training modules to support and build your teams ESG understanding and knowledge.