To restore trust in ESG, we need to be much clearer on its limitations as well as its strengths, argues Mirza Baig.

Read this article to understand:

  • Why it’s time for a more honest and objective appraisal of ESG
  • Why the ‘performance promise’ has emerged as the biggest misrepresentation of what ESG can do
  • How ESG enriches the investment process

Environmental, social and governance (ESG) investing has experienced an unprecedented boom in recent years, portrayed in some quarters as a silver bullet for almost every challenge within financial markets, economies and societies.

Perhaps its zenith came during the COVID-19 pandemic, where the relative outperformance of companies seen to be doing the right thing by their employees and society was heralded as a watershed moment. Flows into ESG-badged funds skyrocketed. Seemingly everyone wanted to jump on the bandwagon.

The honeymoon period couldn’t last. Russia’s invasion of Ukraine has exposed the fragility of energy security in many countries. Inflation has surged to multi-decade highs, central banks have aggressively hiked interest rates to counter it, growth forecasts have been slashed and sentiment among investors, consumers and businesses has sunk.

Add in growing accusations of greenwashing, and a new narrative around ESG has formed. Rather than a saviour, ESG has been painted as a primary threat to economic growth – or, at best, a dangerous distraction.

This is symptomatic of an alarming trend where public discourse is being hijacked by the agendas of the extreme right and left. To help guard against ESG being misused or abandoned, we need to revisit, in an honest and objective manner, what it can and can’t do.

What ESG can’t do

‘Good ESG’ companies will not always outperform

The ‘performance promise’ is arguably the most damaging and dangerous misrepresentation of ESG. To disentangle this misnomer, we need to clarify two key issues.

  1. ESG is not an objective science. The umbrella of ESG is a complex set of a multitude of factors, from board composition to supply-chain resilience, and from political lobbying to environmental management. It covers the full spectrum of leadership, strategy, operations, products and services, and stakeholder management.

    No company has achieved perfection against every or any metric, and it is unreasonable to believe there will be one in the future that does. Companies may excel in some areas and struggle in others.

    The ESG credentials of a company are essentially a judgement of the factors an observer considers to be most important, on a relative and absolute basis. It is natural that ESG scores for the same entity vary, and some investors form a positive ESG view while others are more negative. Homogeneity of thought does not exist in any form of investing, nor is it desirable. This is not a flaw of ESG: it is simply the reality of business and investing.
  2. ESG indicators are important but not the whole story. A company may be considered a high-quality ESG name that may contribute towards a portfolio’s performance. However, the company’s overall outperformance or underperformance will be a consequence of many fundamental investment considerations, such as balance sheet strength, product quality, competitive differentiators, demand dynamics or macroeconomic drivers.

    ESG was never designed to operate as a standalone investment and valuation framework. Its value is inextricably linked to the robustness of the fundamental investment process it is embedded within.

ESG is not a single, all-encompassing investment strategy

Over the years, and particularly recently, the types of activities lumped under the aegis of ESG has expanded significantly. These include ethical exclusions, ESG integration approaches, proxy voting, engagement, net-zero ambitions and innovations in product strategies, such as thematic and impact funds.

ESG integration is about delivering enhanced investment returns

Each of these activities is distinct, with specific, defined objectives and client outcomes in mind. While impact funds target specific sustainability outcomes, ESG integration is about delivering enhanced investment returns. Accordingly, while impact funds may shun all fossil fuels, ESG integrated funds may increase their exposure to natural gas based on an assessment of future market dynamics, including its role over the short-to-medium term as a transition fuel. Effective ESG fund labelling is a positive step but more needs to be done to clarify what is intended by each strand of ESG activity and evidence outcomes.

The term ESG was coined to simplify communication. If the term itself is adding to the confusion, it is the suitability of the acronym that needs to be reassessed, not the underlying practices.

ESG investing alone cannot remediate sustainability-linked market failures

ESG can help identify mispriced risks and opportunities and direct capital towards companies that have more sustainable business models. However, certain systemic risks are the result of fundamental gaps in the regulatory environment, which means mispriced assets may remain in perpetuity until the gaps are addressed.

The most pressing example is the absence of a robust carbon price to fully capture the cost of emissions. Based on the existing regulatory environment, ‘mispriced’ high-emitting assets are in fact being rationally priced by the market over a short-to-medium term investment horizon. Consequently, actions to decarbonise portfolios at the pace required to align with net-zero pathways may result in material risks to financial performance, creating inherent conflict between the long-term sustainability of portfolios and near-term investment targets.

Decarbonising economies is a multi-generational, multi-stakeholder endeavour that will not be fixed by climate-aware investors in isolation. Investors have a responsibility to proactively advocate for sustainable regulatory reform (what we call macro stewardship).1 However, it is governments and regulators that must act to tackle market failures, which in turn will cascade back into adjustments to business models, valuations and allocations.

What ESG can do

ESG enriches the investment process

ESG factors without question can and do have a material impact on the success and failure of businesses. Diverse and engaged boards make better strategic decisions. Robust governance systems better protect investor rights and returns. Employee welfare impacts operational efficiency. Responsible supplier systems create more resilient supply chains. Effective environmental management minimises liabilities.

While ESG does not tell the whole story of a business, it does complete it. Investors need to get better at identifying which ESG factors are genuinely material for different sectors and regions. However, disregarding ESG considerations altogether would be a dereliction of fiduciary responsibilities.

ESG encourages longer-term investment thinking

There is general acceptance that portfolio-level investment time horizons are often misaligned with the savings and retirement needs of beneficiaries. This has triggered various policy and regulatory actions, including the implementation of the European Shareholder Rights Directive.

The inclusion of ESG factors can serve as a powerful and positive catalyst for change

Overhauling the time horizon of the entire investment ecosystem will require a multi-pronged strategy encompassing each stakeholder along the investment value chain. Against this backdrop, the inclusion of ESG factors can serve as a powerful and positive catalyst for change. 

As markets react (often overreact) to quarterly earnings and economic data, ESG considerations can help contextualise and reframe investment theses around longer-term value drivers and risks. These include analysis of megatrends shaping industries, supply chains, demographics and consumer behaviour, coupled with bottom-up, long-term projections of corporate transformations.

This approach is needed to identify the winners of tomorrow rather than fixating on today. Stripping investment processes of ESG considerations would be a retrograde step. 

ESG helps drive positive change in issuers

Investors’ ability to deliver value does not stop at asset allocation and security selection. ESG, in the form of voting and engagement, enables investors to hold management and boards accountable for performance, while directly influencing the sustainability of business models and strategy, capital allocation and the quality and effectiveness of risk management.

ESG enables investors to hold management and boards accountable for performance

In cases where issuers are non-responsive to investor pressure, this is far from wasted energy. In fact, it provides important insight into the culture and prospects of a business. Asset managers that fail to effectively utilise, or are blocked from using, their voice and stewardship rights are depriving clients of a critical tool in generating risk-adjusted long-term returns. 

ESG helps clients align investments with their sustainability preferences

Asset management is a service industry, with managers acting as agents for their clients. Their role is to inform, provide solutions and deliver on agreed objectives.

ESG agendas are not imposed unwittingly upon clients. Rather, an asset manager’s ESG principles, such as firmwide sector exclusions, net-zero ambitions and commitments to human rights, allow clients to determine whether those values align or conflict with their own. This is becoming an increasingly important consideration for manager selection. 

Asset managers are also responsible for designing products and solutions that cater for the full spectrum of client needs. This will include traditional strategies with a sole focus on delivering investment returns against fixed risk parameters, and solutions that look to capitalise on specific sustainability themes or deliver ‘real world’ sustainability outcomes.

Any attempt to artificially impose a scaling back of the range of sustainability, thematic and impact funds will result in less client choice and an increase in latent demand – in essence, the antithesis of free-market capitalism. 

Stay in your lane!

The benefits of ESG are too important to allow the current political debate to dictate and possibly derail the entire agenda.

Dismissing ESG will result in less-informed and poorer investment decisions, shorter-term thinking

Dismissing ESG will result in less-informed and poorer investment decisions, shorter-term thinking, diminished corporate accountability and investor influence, weaker transparency and less choice for clients. 

However, we must be much clearer on definitions and in specifying exactly how and where ESG adds value, while being bold enough to recognise, communicate and operate within its natural limitations.

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