Free version: ESG must be split in two

Playing its part in battling the global cost of living crisis, The Financial Times has kindly allowed my op-ed on September 2, 2022 to leap the paywall and be read for free. My thanks to the editors.

Stuart Kirk: ESG must be split in two

If we do not disentangle the industry’s dual meanings, it will not progress

The writer is a former head of responsible investment at HSBC Asset Management and previous editor of Lex

Many are surprised by the recent ESG backlash. Not me. Popular money-spinners draw enemies and worthiness is rarely a shield. Even Mother Teresa copped it now and then.?The timing is right too. War, inflation and wobbly markets have pushed ESG down the agenda. Booming energy and sagging tech shares have left it vulnerable. Where were the dissenters before, you might ask??

Still, it is welcome that questioning ESG is now tolerated. Too late for some. I’ve received hundreds of messages since my infamous Moral Money speech from others thrown under an electric bus for putting their hands up.?I’m pro-ESG, as it happens. But I have long argued it has an existential defect. Fix this and ESG can thrive.

The flaw is that ESG has carried two meanings from birth. Regulators have never bothered disentangling them, so the whole industry speaks and behaves at cross purposes.?One meaning is how portfolio managers, analysts and data companies have understood ESG investing for years. That is: “taking environmental, social and governance issues into account when trying to assess the potential risk-adjusted returns of an asset.” Most funds are ESG on this basis. Weather, corporate culture or poor governance always influence valuations to some degree.

But this approach is very different to investing in “ethical” or “green” or “sustainable” assets. And this second meaning is how most people think of ESG — trying to do the right thing with their money. They prefer a company that doesn’t burn coal, eschews nepotism and has diverse senior executives.?Two completely different meanings then. One considers E, S and G as inputs into an investment process, the other as outputs — or goals — to maximise. This conflict leads to myriad misunderstandings.?

In an ESG-input world, for example, it is OK to own a polluting Japanese manufacturer with terrible governance if these risks are considered less material than other drivers of returns. Ditto if they are already discounted in the share price. But try telling that to a Dutch pension trustee with an ESG-output focus.

Or consider greenwashing. There is no such thing in an ESG-input context, because sustainability is not the point. You can accuse a fund manager of not considering these inputs to the degree they say they do. But that is just a process issue. Have German regulators ever stormed an office because a value manager bought too many growth stocks? No.

Likewise it is unfair to accuse ESG-output funds of greenwashing. That is because there is no agreed measure for “green”. New fund passports in Europe supposedly tell investors what percentage of a portfolio’s assets are sustainable. But everyone has calculated this differently. Is an oil company always “unsustainable”? What if 30 per cent of its revenues are from renewables? What about 60 per cent??

Fund reporting is also a nonsense when ESG has two meanings. Asset managers are constantly asked to show that their ESG portfolios have a better average ESG score than the index. But for funds where ESG is just an input, any score without reference to valuation is meaningless. After a huge sell-off in stocks with bad ESG ratings, you probably want loads of them if they’re cheap enough.

As for ESG-output funds, their reports have the wrong numbers anyway. Almost all portfolios are still measured against input indices, such as MSCI, even if holdings are chosen on an output basis. Very few clients I met in my previous role understood this — and yet these reports are the basis by which funds are chosen.

The only solution to these problems is to split ESG in two. A designated range of ESG-input funds would dissolve the most common complaints. Of course they underperform sometimes; all active management does. As for Elon Musk’s moaning about inconsistent scores? It’s no different for earnings forecasts.

None of the above applies to ESG-output funds, however. Here the industry must be honest about the trade-off between returns and “doing good”. And it cannot be left to index providers to rate “goodness”. Investors can disagree whether a future carbon tax will hurt car company profits, but everyone should have the same emissions numbers. Standardised scores are a regulatory priority.

A bright future for both forms of ESG is possible if each makes sense on its own terms. Keep conflating the two, however, and large areas of the ESG landscape will not make sense, nor can the necessary debate occur for the industry to advance.