ESG, Environmentalism, Responsible Investing, Sustainability, and the myriad of associated acronyms, which are only increasing after the COP26 UN International Climate Conference, can make it complicated to understand the ESG landscape. It can be useful to look at the bigger picture, and in doing so one is led to the conclusion that despite the complex and systemic nature of solving the many challenges within ESG, the tectonic plates are shifting to ensure that in 2021 ESG has become mainstream.
The global goals that ESG are supporting are set out neatly by the UN’s Sustainable Development Goals, known as the SDG’s (pictured above). Whilst each is clear, the linkage, and conflict, between many of them is not apparent. These are evident when say child labour keeps a family from poverty, where too rapidly pursuing climate agendas leads to mass poverty, etc.
The systemic nature of the environmental challenges we face requires all the stakeholders to work together to achieve the same goals, in particular the key targets of the Paris Agreement and the related challenges in the environmental social and governance space. As an investment advisor, we help investors to structure, manage and control their investments. From our perspective the challenge is to determine how, or indeed if, a client should be aligned to the SDGs and how these should be integrated in a practical and cost-effective manner, within a primary mandate expressed in terms of conventional investment objectives and risk controls.
Unsurprisingly, within the ESG investment approach, there is considerable focus on climate, simply because this is the biggest and most immediate problem. While fund managers have been, and continue to be criticised for facilitating investment into fossil fuel-based investments, the truth on the ground is that, as an industry, they have made huge strides in the past 3 years to incorporate ESG principles into specific products. In doing so, they demonstrate their deep thinking about how to identify the emerging innovations that will support the transition from a brown to a green economy and how to avoid the resulting risks. The industry is well ahead of the regulators in this regard.
We are currently rarely seeing any fund manager presentations in which ESG is not just part of the PR but, ostensibly, part of the process.
While many managers originally dipped their toes in the ESG water with product that was presented, almost diffidently as esoteric, most now have firm-wide sustainable investment approaches, realising that the risks and opportunities will apply to their entire portfolios. We are increasingly seeing major investment managers presenting the sustainable investment approach as their default position.
This is underpinned by the increasing number of fund managers who are signatories of the UN Principles for Responsible Investment (PRI), which are now approaching over 4,300 with $121 Trillion in assets under management. At COP26, an even more ambitious coalition of global financial institutions have joined the Glasgow Financial Alliance for Net Zero (GFANZ) which commits financial institutions with over $130 trillion of private capital to accelerating the decarbonisation of the economy. Fund managers are at the heart of the initiative, with existing networks coming together.
Fund managers who are active stock pickers are also digging deeper into the net zero commitments made by companies they hold, raising expectations that through formal engagement they can encourage transition to improved alignment. The jury remains out.
In general, regulators have been behind the curve. Companies are innovating and providing investment opportunities well ahead of the regulatory environment. Investment risks from stranded assets will be evident when the regulators catch up.
Forward thinking companies are pushing the regulators to create a level playing field when they compete against companies who pollute and extract with no regulation or cost.
While the regulators have taken some first steps, membership organisations are leading the charge. In addition, to the PRI and GFANZ (which support financial institutions), non-governmental organisations have developed to support consistent reporting (SASB and TCFD have now combined into ISSD, aspiring to a common global reporting basis.)
The most advanced regulator is the EU with its EU Taxonomy, which sets out to define what ESG is. The Guernsey Green Fund regime has also led the way, as has Channel Island-based The International Stock Exchange with its TISE Sustainable market segment and becoming a Partner Exchange of the United Nation’s Sustainable Stock Exchanges.
But the problem is that these approaches are not consistent with one another or internationally, and it is questionable to what extent they have teeth.
Investor surveys demonstrate that there is a clear appetite for doing good with their investments. When asked recently if they want to make a positive impact with their investments, over 71% of investors replied yes, surprisingly only skewed slightly towards Millennials. When asked if they want their investments to match their personal values, even more, 81% said yes, again skewed towards younger generations.
Professional investors are defining a clearer role for ESG in addressing organisational and societal goals, along with key financial objectives.
It is interesting to note that asset owners are nevertheless still some way behind, with demand not keeping up with the range of products on offer. Explanations for low ESG related portfolio take up include “Clients have not raised this” and “too much risk of intergenerational disputes”. There are also concerns about the impact on investment returns or approaches that curiously treat ESG like a diversification strategy by allocating 5-20% to the area. Our approach as investment advisors is that investors are either in or out. We believe that owners are catching up as they increasingly realise that there are significant risks to investment returns and reputations in not properly addressing ESG. It is no longer a tick box exercise to feel good. Moreover, there is a risk of missing out on investment opportunity in a time of major disruption and exposure to exogenous factors that are as yet difficult to discern (carbon tax, orphan assets, waste and plastic taxes).
Perhaps the largest drag to acceptance of ESG investment principles, has been the belief that by constraining your investment environment, investment performance will suffer. This used to be true but there is increasing evidence that, looking forward, this is no longer the case and having an ESG component will be positive simply because of the weight of money. As with any investment opportunity there is a risk of over-paying but this should not be conflated with the investment being ESG.
There is also a growing awareness of the concept of impact, in terms of how much an individual company’s activities are supporting the goals of the SDGs, but this is proving difficult to measure with a lack of consistency in approaches. We fully anticipate, in a relatively short time frame, that these issues will be resolved and that annual returns will be presented to include financial and non-financial elements.
As the ESG ecosystem evolves, momentum in the system will be with those players that link all the elements together. As investment advisors, we help the client define their requirements within a flexible Sustainable Investment Framework. ESG is the default position, from which you have to opt out. The approach ensures you have a proper conversation about ESG investing at the outset. The range of fund manager approaches to the topic are then taken into consideration as an essential part of a diversified portfolio structure.
For these reasons, our view is that ESG is not a passing fashion, 2021 has seen it become mainstream.
In its almost existential complexity, it presents opportunities and risks, with the challenge moving forward, for professional service providers, is how to articulate these to your clients and provide a practical framework within which they can be managed.
as published in Business Brief, December 2021