Has the Financial Times called the end of ESG? It published an article on 6 June 2022 called ‘How ESG investing came to a reckoning’ and the clickbait tag for it was RIP ESG. This was three years after it launched the FT Moral Money channel.
And dare we say it? Good riddance. Not good riddance to using ESG (environmental, social and governance) factors within an investment process. But good riddance to using ESG as an all-encompassing overly simplistic term which means everything and nothing to investors and commentators.
ESG has become a byword for everything that fits under the responsible investment umbrella. By this we mean the different approaches investors might utilise in pursuing a responsible investment strategy. These are some of the issues that we think have contributed to the ‘ESG is over’ narrative.
‘ESG funds’ and ‘ESG companies’
There is no such thing as an ESG fund or an ESG company, just as there is no such thing as the perfect company: all will take different approaches so cannot be directly compared. There is no perfect company – you are always going to have to weigh up the different elements of the ESG triangle of environment, social and governance factors.
Being clear about the approach taken
Because everything seems to have been lumped under ESG there is no delineation between the approaches taken. Investing for impact is very different to investing in a strategy that is focused on voting, engagement and integrating ESG factors within the investment process. If your concerns are about avoiding certain exposures, then you would be seeking a fund or strategy that excludes those areas – in this instance only a strategy which achieves that is going to meet your criteria. End consumers all have their own view about what ‘ESG’ means to them and in the absence of clarity from the investment industry, clearly stating what fund or strategy does what, it becomes massively confusing.
The rise of ‘ESG’ labelled funds
Despite the EU introducing labelling protocols for funds (hello Articles 6,8 and 9) and the UK looking to do something similar, we have seen massive growth in funds including words such as ESG, sustainable or responsible within the title, no doubt as a means to ride the wave of demand for such products. The FCA called this issue out in July 2021, and we have also seen Morningstar remove over 1,000 funds from its European sustainable investment list after reviewing the underlying investment mandates.
‘ESG’ means I will make money / ‘ESG’ stocks underperforming
There has been a significant influx of money into ‘ESG’ labelled funds, and this seems to have been driven to some degree by the view that ESG = ‘good and I won’t lose money. This is a bandwagon I want to be on’. That’s one common myth – incorporating responsible investment within your process does not mean that you are miraculously protected and are never going to lose money.
There is another myth that ‘ESG stocks’ have gone out of favour and that is the end of ESG. We have seen a period of market rotation where growth stocks, which had performed very strongly until recently, have started to lag as value came back into favour. A lot of companies that score well on ESG metrics (see section below on ESG ratings) tend to have growth characteristics, therefore ESG and growth stocks became conflated.
As the very different approaches to responsible investment have all been lumped under the wording ESG, the confusion over what this means, has grown exponentially. For example, how on earth can an ‘ESG fund’ own an oil company? Well, if the fund is focused on stewardship and ESG integration and the manager has a strong track record of engaging with oil companies then yes, it can. However, if this is being marketed as a sustainable fund, that would be a different story. At a recent financial adviser event the panel was asked whether we should sell out of two of the largest renewable companies in the UK - the punchline being that these are BP and Shell. Whether you should divest or engage is a much-debated topic – however under the responsible investment umbrella you can credibly pursue either approach.
We are not saying that ESG data providers are the root of all issues. We take data from multiple ESG data providers; however, we don’t just rely on one for all of it. The reason being is that they all have a particular focus and quite often are providing their qualitative assessment on the underlying company. The main problem with ESG ratings occurs when investment firms use one ESG data providers’ ratings in order to ‘score’ a product based solely on the output from the data provider. We have written about this previously in some length but in summary: 1) data are just data 2) the ratings do not reflect any of the work we do from an engagement or integration perspective and 3) the data set is not perfect or complete.
Recently there have been two high profile instances of asset managers facing regulatory action, owing to their claims of being green not holding up to scrutiny. Part of the issue is that we do not have a clear framework across the investment industry that clearly labels what products / strategies do or do not do from a responsible investment perspective. This is something that the FCA is firmly focused on within its Sustainability Disclosure Requirements (SDR) proposals which hopefully will be helpful in this regard. However, most investors do not just hold UK companies but rather invest globally, therefore a major frustration is that we do not have global frameworks for investors and, most importantly, the companies that they are investing in, to report against. Too often it is apples versus pears.
What can we do to mitigate the ‘ESG’ blancmange?
Using a framework
To try and make this easier for our clients and advisers we have adopted the Investment Association’s responsible investment framework and talk about five distinct categories:
- Stewardship – voting and engagement with the companies and funds that you invest in
- ESG integration – considering ESG factors within your investment process to identify risks and opportunities
- Screening – excluding specific sectors, countries or activities
- Sustainability focus – considering the positive and negative impact of the investments with often a focus on thematic priorities
- Impact – seeking to achieve environmental and social impacts as well as financial returns
This will develop no doubt following the work that the FCA is taking but at least it means we have a clear starting point to define what we are talking about.
Aligning clients’ interests
In April we began collecting our clients’ responsible investment preferences within our regular process of checking that we are meeting their investment needs, from this perspective as well as the other usual considerations. As we have only just started this process, we are not going to make sweeping statements about the end outcome however what it has done is instigate conversations about what type of approach a client wishes to take.
So Goodbye ESG and hello responsible investment.