12 / 11 / 2022
ESG, Like Climate Change Reversal, is Doomed to Fail
Leaders from around the globe are meeting over the next two weeks in Sharm El-Sheikh, Egypt for COP27, the 27th United Nations Climate Change conference. This year we have seen extreme weather events such as the widespread flooding in Pakistan, resulting in a huge humanitarian crisis in the country. A stark reminder of the effects of climate change and the need to reverse it.
The issue is, it seems that our opportunity to reverse climate change has gone. A recent report published by the UN1 suggests the world is still heading for 2.4 degrees celsius of warming, well over the 1.5 degree target agreed at COP21 in Paris in 2015. The globe is already 1.2 degrees hotter. Unless the impossible happens and all energy sources become renewable overnight, going over the 1.5 degrees of warming is inevitable.
Added to this the current geopolitical backdrop with the conflict in Ukraine, the world will be more reliant on fossil fuels in the near term. Energy security and stability in the near term are now the priority.
The asset management and financial services industries play a key role in supporting businesses through the energy transition by providing funding and investment. The problem is, the current framework being pushed to encourage asset managers to consider sustainability as part of investment decisions, commonly known as ESG, is fundamentally flawed.
Treading a Fine Line
ESG stands for Environmental, Social and corporate Governance. There has been an increased emphasis that corporations and investors should take into account these factors when running their businesses or choosing which companies to invest in. This has naturally come from clients of asset managers being more conscious with regard to sustainability, and now there is an additional drive from regulators.
As we all become increasingly conscious of sustainability, naturally there has been growing interest in investment products that invest in companies that impact society positively. It is perfectly understandable that you don’t want your savings to profit from activities that you don’t agree with.
Assets in ESG-type funds grew by 53% in 2021 to USD 2.7 trillion, though ESG funds can cover lots of different strategies whether that is excluding some investments based on ESG factors (such as excluding entire sectors such as tobacco) or funds strategies that only invest in those that rank positively for ESG factors.
What is important is that corporations that are open to investment are transparent about their practices and impacts on sustainability. It is only with clear data that proper investment decisions can be made.
When you look at recent reporting from companies, ESG is often now integral to how companies demonstrate their performance. Let's consider for example mining giant Anglo American. As part of their annual reporting for 2021, they included an 84-page Sustainability Report which covered safety, environmental impact, social measures and detail on female representation in the workforce.
It is obviously fantastic that large corporations are beginning to be more transparent about their practices and the environmental and social impacts, however, there is a fine line between being clear and open about these impacts and simply being an empty marketing exercise or greenwashing.
Things Aren't so Black & White
The Ukraine conflict has raised many questions about how to implement ESG factors in investment decision-making. Before the war, it would be universally agreed that defence firms do not impact society in a positive manner. Nearly all investors would find it difficult from a personal perspective to profit from the sales of arms.
Countries across the globe, particularly in Europe, are increasing defence spending to protect from aggression with the increased geopolitical tensions. When there is such a significant threat to life from another state, it is difficult to argue that protecting people is not beneficial to society.
Even when it comes to energy, where the use of fossil fuels clearly is environmentally damaging, to achieve energy price stability and security in the short term fossil fuels will be necessary. It is a societal need that households have the energy required to keep themselves warm in the winter, that is not arguable.
If funding were to dry up totally for energy companies, that would significantly hamper further oil and gas exploration. This would limit energy supply and further push up prices, which are already at unmanageable levels for most economies and households.
You are seeing this play out with some of the largest asset managers in the world. BlackRock for example who were keen to use their position as the world’s largest asset manager to drive change in the companies they are shareholders of are now looking to vote against shareholder resolutions that look to ban new oil and gas production.
The European Parliament this year has voted to classify natural gas as sustainable whereas previously the political momentum certainly would have been with gas as an energy source not being sustainable at all. Does this mean that gas companies should now be included in funds that focus on sustainable energy sources?
There’s also a danger of slowing down the energy transition if fossil fuel companies are overly punished. These companies have to be on board when it comes to closing down fossil fuels and being fully sustainable, and if their sources are funding are cut then so will investment in the transition.
A Flawed Framework
To determine which companies fall lower on ESG factors than others, firms have begun to create ESG ratings. In a similar way to credit ratings done by firms such as Moody’s or S&P, companies are rated on how they perform when it comes to the different components of ESG.
Companies such as Sustainalytics will rate companies and investors can use these ratings to guide their decisions if they wish to avoid companies that aren’t as sustainable. Very quickly when looking at what they offer, you see the issues with this approach.
Let’s take a look at the Sustainalytics ESG ratings for the company I mentioned earlier, the miner Anglo American:
This is hugely vague. What does it mean to have a “Medium Risk” for all ESG factors? Even when you look at the brochure at what this number represents, there is very little quantitative or qualitative information. Hardly scientific enough to be able to make an informed investment decision.
Also, a lot of information here is very misleading. Anglo American is 8th out of 184 in the whole sector. This looks like it’s doing amazingly, however, as a mining company, there is obviously always going to be an impact on sustainability. Unhelpfully, there is little information on sectors on the whole beyond again vague statements.
Additionally, there is no separation between different factors. All three components of ESG are very different, and can even be conflicting. A company that is a heavy polluter could look a lot better from an overall rating perspective if it performs very well from a social and governance perspective.
When we compare this to credit ratings (although those have many flaws too) it is very clear what they mean. Credit ratings estimate the probability of default or bankruptcy of a company. Increasing probabilities are easier to grasp and the final negative outcome of a bankruptcy, we know exactly the impact on investors.
Here we have no indication of any probability, or what number is high or not, and there is no idea of an impact whether that is on society or simply on the value of an investment in the company.
With increasing regulatory scrutiny, investment firms are having to demonstrate their use of ESG in investment decisions. Many justify their investments by using ESG ratings. As long as these vague ratings tell the story to satisfy the regulator that sustainable goals are being considered, then that is fine in the regulator’s eyes.
This can’t be satisfactory from a sustainability perspective and again we very quickly fall into greenwashing. Investment firms only looking to meet an arbitrary target via some meaningless unscientific ratings so that they can sell their funds to more investors.
The dangers of unsatisfactory ESG analysis are evident from both a sustainability and investment performance point of view. A few years ago online retailer Boohoo was revealed to be paying workers only GBP 3.50 an hour in terrible working conditions in the UK in Leicester.2 The stock fell -50% in value on the news at the time.
The stock was held in many funds advertised as ESG and was rated highly by ESG rating agencies despite what turned out to be a huge social failing on behalf of Boohoo. Not only was there a negative social impact, but this resulted in a significant negative impact on investment too.
You could argue that Boohoo’s lack of transparency with regard to the working conditions of its employees led to positive views of the company and that it was impossible to predict.
I would on the contrary argue that ESG ratings give investors the ability to not consider actual ESG factors and scrutinise the company themselves. As long it has a good ESG rating somewhere, then that could be considered as sufficient.
Negative events as a result of ESG factors cause not only an impact on society but also simply a loss to investors, and that is often forgotten in the ESG and sustainable investing discourse. There are risks to a company’s profitability by those firms not keeping in mind the broader societal impact in the running of the company.
There should be a renewed onus on investors to understand ESG factors and risks of the companies they invest in, and in particular, those with larger shareholdings should use their position to scrutinise the companies’ business practices more closely.
Factoring ESG in Investment Decisions
ESG factors should be a priority in any investment decision. Firstly from a societal perspective, we all want to fund a better society and not profit from exploitation. That includes all kinds of exploitation, whether that is the exploitation of our planet or of people.
Also, it is clear that not considering ESG factors could significantly impact potential investment returns. Although ESG covers a huge spectrum of factors, I believe that ESG analysis (and hopefully ESG rating methodology) should be totally reimagined from what it currently is today.
It should begin, like with credit rating and credit risk analysis, by understanding the potential loss associated with a very negative event. In the credit world, that would be bankruptcy. In the ESG world, this can be many different scenarios, depending on the factors. Below are some examples:
the costs of a cleanup of an oil spill;
the costs of potential fires.
the costs of paying workers fair pay;
the costs of correct working conditions;
the impact on the productivity of a workforce with inadequate benefits.
the legal costs of a money laundering scandal;
the costs of an accounting fraud incident.
A company that is correctly managed from an ESG perspective, the risks of the above kinds of events occurring would be significantly low.
Beyond the probabilistic analysis of individual events, additionally, there are costs associated with meeting regulatory standards and targets which are quantifiable. It is possible to estimate the cost of a company having to be net zero carbon by a certain date and how that would impact a company’s balance sheet and earnings for example.
This provides a much more scientific base to then either create an opinion or assign an ESG rating. Then companies can be compared based on both the likelihood and potential impact of negative events and the costs associated with being in line with regulatory targets.
However, to come back to an earlier point, to be able to carry out such in-depth analysis requires companies to provide the necessary data. To be more transparent. Without sufficient information, it is impossible to correctly judge a company or make a sound investment decision.
The onus of regulation should be first on companies being more transparent with regard to their ESG performance before pressure is put on investors and asset managers to evidence the inclusion of ESG factors in their portfolios.
By putting pressure on investors first without the available data, it forces them into justifying their approach to regulators by using vague disclosures and empty ESG ratings. Ratings that are not truly representative of the ESG risks could see many investors exposed to these risks and investments made in companies that are harmful to society.
The asset management industry is vital to driving the necessary change in society, but without the correct tools, important goals will not be met and disaster becomes an inevitability.