50 shades of green

What’s not black and white, but grey all over? Answer: ESG investing.

This might seem a strange assertion for a responsible investing advocate to make. Surely, I should be extolling the unbridled virtues of the discipline, particularly in the wake of recent high-profile criticisms of it? To do so would be disingenuous, however. Let me explain.

Part of the reason Tariq Fancy’s¹ brutal, but to my mind overly simplistic, critique of responsible investing gained so much attention was that elements of what he said are true. The other, more worrying, reason is that we have completely lost our collective sense of nuance. Instead, we seem to crave crude answers to complex problems: ESG is either good or bad; finance equally so. Such a lack of sophistication in reasoning has serious implications.

A series of examples reveal the contradictions and inconsistencies that a simple – un-nuanced – ESG lens finds hard to reconcile.

When E and S collide

Let’s take the recent strong performance of ESG investments. Firstly, while it is true that many responsible investment strategies have outperformed their broader benchmarks, this is largely confined to renewable and environmentally tilted stocks. Where it has applied to broader portfolios, large weightings towards tech companies tend to be found.

It is here where environmental factors start to collide with social ones, which are notoriously hard to define and measure. For example, tech companies pay little tax, particularly in jurisdictions where their activities have a large impact. As a recent Financial Times article pointed out, a greater contribution to government coffers could be used to fund socially useful areas like education, healthcare, social care, and other critical public goods.² Big Tech has also come under heavy criticism for its role in undermining democracy, amplifying hate speech and exacerbating mental health issues.

Of course, the opposite can also be argued – think of the Arab Spring and increased connectivity and social connection globally. As I said, things are rarely black and white.

To further illustrate the point, the World Benchmarking Alliance recently published a performance update on its Automotive Benchmark, which tracks the progress of 30 of the biggest companies in the sector in meeting the goals of the Paris Agreement. When they compared it with the Corporate Human Rights Benchmark, it revealed “almost no correlation could be found between a company’s relative performance on either benchmark, suggesting an alarming disconnect between actions on climate and human rights issues”.³

It is no wonder that benchmark and rating confusion exists: depending on the relative weightings providers apply to certain factors, the results will be different. A recent comparison of MSCI and ISS ESG datasets for companies’ controversy scores found only 11 companies overlapped.

Figure 1: Overlap between MSCI and ISS controversy scores

Source: MSCI, ISS, Aviva Investors, as of March 8, 2021

The authors of a paper entitled Aggregate Confusion: The Divergence of ESG Ratings⁴ argue that to help rectify matters, “companies should work with rating agencies to establish open and transparent disclosure standards and ensure that the data is publicly accessible”.

Voice and exit

Then you have the issue of divestment.

Understandably, many people do not want to hold ‘dirty’ assets like fossil-fuel companies or high carbon-emitting buildings on ethical grounds. However, even this seemingly clear-cut moral decision is not straightforward. Firstly, it assumes you can solve a demand issue simply by cutting supply. I wonder how many of the same people who balk at the idea of holding a fossil-fuel company, or so-called brown stocks, have also tried to eradicate their own demand for polluting products?

I understand the power of signalling, but there is also the question of voice and exit, as economist Albert Hirschman highlighted. Divesting equates to losing your voice. If you stay invested in a company and continue to wield the credible threat of divestment while speaking up on key resolutions at shareholder meetings, you will arguably make more of a difference than if you simply walk away. You do have to be prepared to walk away if your demands and expectations for change are not met, though – recognising when an engagement programme has failed. Otherwise, your threat will be hollow.

Furthermore, are all energy stocks equally bad? Could some of them not be transformed into major players within the green energy revolution? Of course, there are challenges to this line of thought, such as siloed thinking and operations, bureaucracy, domain-specific expertise, joint-venture structures and pressure to pay out dividends (which provide income for investors and retirees, by the way). But it is interesting to note that, in the US at least, energy firms are key innovators, producing more and significantly higher-quality green patents than other industries.⁵

Renewable waste

A supposedly more impact-driven way of clearing your conscience is simply to invest in clean technologies and renewable energy. Or is it?

Electric batteries rely on mining cobalt, lithium and nickel, among other rare-earth materials. Supply chain and human rights issues abound, with China controlling significant amounts of these crucial mineral supply chains. Furthermore, the mining of lithium in Chile has prompted legal fights over water in the Atacama and 70 per cent of cobalt is mined in the Democratic Republic of Congo, a country with an extremely bad track record when it comes to corruption and labour standards.⁶

With demand for these minerals set to soar, such issues are unlikely to go away. There is also the issue of waste which, being a relatively nascent industry, the renewable sector has yet to face up to. Wind turbines, solar panels and electric batteries all must be disposed of or recycled somehow – with the latter two containing particularly toxic metals like lead and cadmium. In the case of the former, the US will reportedly have more than 720,000 tonnes of wind turbine blades to dispose of over the next 20 years.⁷

Until it costs less to extract these elements from renewable wastage than to dump them in landfill and mine fresh raw materials from the ground, we will still have an issue. While I have confidence that the circular economy will be mobilised to tackle these issues, the current state of play proves again the need for nuanced thinking.

A ‘just’ transition

Next is the notion of a ‘just’ transition. While the hope is many developing nations can simply ‘leapfrog’ dirtier forms of energy as their economies and societies develop, is it really fair for developed nations to preach to developing countries about the moral and scientific dangers in using fossil-fuel-based economic expansion? The hypocrisy is clear: we have already ridden that wave, extracted (most of) the progress (and resources) required, only to have seen the light and turned over a new – greener – leaf.

This is why we recently helped fund an oil refinery in the Ivory Coast. It is also why we acknowledge some countries have deeper social issues and will need to rely on ‘brown energy bridges’ for some time. Only when you have food in your belly, a roof over your head and a feeling of security can you start to consider wider societal and environmental issues. 

In reality, ESG cannot be reduced to simple binary arguments. It encompasses such a wide array of meanings and activities that to try and do so is foolhardy.

Macro stewardship

For those of you still wondering which parts of Mr Fancy’s critique are true, it is his call for greater government and policy intervention. In investing terms, this equates to what we call ‘macro stewardship’ – which is another way of saying ‘market reform’. But by anchoring it in the language of stewardship, our wish is to tether it more closely to the core principles of ESG investing.

Threats – or rather market failures – like inequality, climate change and environmental degradation cannot be solved by micro-level nudges alone (which, though worthy endeavours, impact investing and screening amount to). And while full ESG integration and engagement go a step further, they still fall short. As stewards of other people’s money and given the growing number of net-zero commitments, we have a fiduciary duty of care to do more: to use our knowledge, influence and our clients’ voice to push for systems-level change.

Navigating this ethical minefield in simple client fact-finding exercises, as laid out in the MiFID directive, is a start. Legal and industry standard definitions, alongside regulatory efforts like the EU’s Green and Social taxonomies and the Sustainable Finance Disclosure Regulation, are also welcome. But as the level of comfort and sophistication grows, far more will be necessary to truly capture clients’ preferences.

Language can be frustratingly malleable. Completely harmonising meanings in the minds of investors is desirable, but simply not possible. And while we must continue to better define the ESG landscape, it does mean that trust and faith in investment brands will be crucial in dealing with ESG in all its nuanced glory.

The truth is that it is extremely hard to neatly package up morals and then sell them on coherently and transparently. Mr Fancy, of all people, should know this.