The exasperating state of ESG

Now, let's discuss that: Will ESG suffer a confidence crisis?

You're right. Investors are increasingly conscious of the social and environmental implications of their financial decisions. As a result, demand for sustainable investment solutions that integrate ESG criteria into decision-making will continue to grow.

Now comes the hard part. Will ESG and responsible investing, as we know it today, be immune from skepticism and scrutiny?

The answer is a very simple: no.

ESG and responsible investing will inevitably face periods of skepticism and scrutiny. The point I am making in this newsletter is that well-intentioned rule-making can inadvertently stifle the ESG and responsible investing movement, hindering the development of more analytical rigour and humility in this area.

Companies doing Good

Our world faces significant social and environmental challenges, and we have a crucial role in addressing them. These challenges present opportunities for everyone—society, businesses, and investors—to make a positive impact. The underlying values of this trend represents a powerful movement that will continue the growth in sustainable economic activities and investment solutions.

Generally, there is assumption that companies whose strategy or business model is based on amplifying positive externalities or eliminating negative externalities will benefit from higher confidence in the sustainability of free cash flow generation, a lower cost of capital, and the potential to increase reinvestment opportunities over time. To demonstrate the durability of their financial performance and the resilience of their business models, companies will improve their corporate stewardship, governance and sustainable policies. The focus on sustainability, risk management, and long-term value creation will continue to drive interest and innovation in this area.

In Europe, ESG fund inflows surged to EUR 233 billion in 2020 from EUR 126 billion the year prior (source: Morningstar, February 2021). The accountancy firm, PwC, in a recent study, made a bold statement:

“Investors are pushing for new ESG products, but demand outstrips supply.”

Investors making money

What is clear (from an applied psychology perspective) is that favourable ESG ratings have a substantial impact on the behaviour of investors; driving positive capital flows. This explains why some asset managers have been willing to adopt "greenwashing" practices in sustainable finance.

I would argue that the problem today is the oversupply of tools and frameworks. The sobering reality is that ESG scores, labels, and narratives confuse investors. The wide divergence in ESG scores across providers raises questions about their reliability and what measures are meaningful.

ESG ratings suffer from insufficient data, perception-driven biases, and measurement discrepancies. Marketing narratives often suggest that ESG-rated equity funds offer two benefits: making a substantial impact and achieving better investment performance. In reality, many ESG-rated equity funds invest in publicly traded companies with fewer negative externalities, rather than driving real-world outcomes (i.e. engagement that drives deeper, systemic changes).

In ESG and sustainable investing, many issues are portrayed as black-and-white, but there are shades of grey. This could lead to a loss of faith during inevitable (short-term) performance downturns and when lofty ESG promises are not met.

Tyre-kicking needed

ESG and sustainable investing is far from a one-size-fits-all landscape. ESG scores and ratings are already under scrutiny. The recent "recalibration" of around 31,000 ESG funds by MSCI Inc. highlights that the rush to launch ESG products may have led to imperfect outcomes. While ESG ratings are unsatisfactory and will face a backlash phase, this could mark an exciting opportunity for a more robust approach to ESG and sustainable investing by corporates and investors.

Just because ESG and sustainable investing will probably go through a backlash phase, that does not mean it is less urgent.

As always, the devil is in the details. Investors need to understand the potential trade-offs between risk, return, sustainability, and impact. For instance, investors cannot rely solely on simple metrics to gauge an asset manager's approach to ESG. Instead, they must invest time and effort in understanding how an asset manager addresses complex ESG challenges and opportunities. I expect asset managers to increasingly support disclosure-based resolutions with their clients.

For business leaders at asset management firms launching ESG investment funds and encouraging fund managers to integrate ESG into their investment approach, it is wise to heed Coach John Wooden’s advice:

“Be quick, but don’t hurry.”

During my time at a US-based asset manager, I often found discussions on ESG integration into our active equity and bond strategies frustratingly slow. This might have been partly due to our predominantly US-based clientele, where the urgency around ESG was not as pronounced as in Europe. Additionally, the higher costs associated with servicing ESG data requirements and providing more detailed client reporting for our European investors could have been other factors.

That said, I truly commend my US-based colleagues for their interest to learn from European investors and regulators, who have long led the charge on ESG and sustainable investing. On a personal note, they sponsored my desire to obtain the CFA Institute’s Certificate in ESG Investing.

Towards Meaningful ESG

So, why is ESG (or sustainable) investing so attractive?

1. It taps into a higher purpose—a belief that we are contributing to a better world or even saving the planet.
2. It reallocates resources toward reducing environmental harm and social inequality.
3. It suggests an optimal risk/return/impact allocation by avoiding ESG-related risks while aiming for sectoral transformation.

While ESG ratings have driven significant capital flows, sophisticated institutional investors and professional fund buyers are increasingly looking beyond the surface. For asset managers, the key value of further integrating ESG into the investment process lies in its potential to create long-term shareholder value. This is achieved by better assessing the interaction between negative and positive ESG externalities, corporate strategy, and the capital allocation decisions made by the management teams of corporates. Consequently, I expect almost all investment strategies to eventually integrate material sustainability factors.

Valuing an investment fund’s ESG credentials remains challenging due to the lack of a universally agreed definition of ESG. The uncomfortable truth is that ESG’s financial performance lagged in 2022, with Article 8 and 9 (SFDR) funds experiencing outflows in 2023, according to Morningstar. Simply ticking regulatory boxes to obtain a sustainability label might restrict active investment managers from delivering the best outcomes for their clients. I'm confident that better ESG measurements will allow for more nuance or questioning. This will happen as more companies approach externalities as a core strategic challenge and provide more accurate and robust disclosure.

Beyond data assurance

The focus of many ESG efforts will have to be driven by outcomes, rather than processes. A good starting point is for investment managers to clarify:

a) How they will deliver on the promise of market or excess returns alongside tangible ESG factors and impact;

b) When they will prioritise long-term ESG and responsible investing authenticity, even if short-term returns will suffer.

The focus must be on honest and transparent communication about: a) the primary objective of an investment strategy (whether it's primary focus is to generate outperformance or achieve a sustainability impact), and b) the strengths and limitations of ESG and sustainable investing, will be crucial for maintaining investor interest and addressing practical concerns.

Historically, ESG investors have leaned towards exclusionary strategies (avoiding certain sectors like energy or utilities) or focusing on high-scoring ESG companies in industries like technology, healthcare, and finance. However, we are now seeing a shift toward ESG momentum—investing in companies showing improvement in their ESG performance rather than just those with high scores.

Active ESG Share - A journey

ESG momentum reflects the positive dynamic change in a company’s ESG characteristics over time, which is expected to influence its financials and share price. For active managers, ESG analysis is a research discipline used to identify transitioning companies before their transformation is fully recognised in the market.

The concept of "Active ESG Share" (introduced in the academic paper The Complex Materiality of ESG Ratings by Martin Cremers et al.) supports the idea of “manager ESG skill” in the active investment industry. The paper found that a higher Active ESG Share might predict better future performance. This could justify asset managers selecting low- or no-ESG-rated stocks, expecting their scores to improve—such as holding Shell Plc due to its increasing investment in renewable energy.

Asset managers with high Active ESG Share will need to justify their decisions more clearly, particularly regarding ESG attribution. The industry must step up with more rigorous return attribution reports and better communication to address concerns of mission drift and greenwashing. Similarly, progress on regulatory standards and data harmonisation is crucial.

For investors, the move towards more tailored ESG/sustainable investment strategies aligned with client preferences is a positive development. In Europe, asset owners are increasingly drawn to thematic and impact strategies, both in private and public markets. These strategies are attractive because they have well-defined outcomes and measure progress towards real-world environmental or social goals.

What should ESG and sustainable investing look like?

Given the industry's fiduciary obligations, we must foster a constructive debate on the ESG and sustainable finance. There will continue to be tensions between risk/returns and impact/sustainability, between political populism and longer-term thinking, and between intention and execution; so do expect more tough conversations ahead.

Disagreements can be challenging, especially when we focus on short-term financial concerns and data inconsistencies. I remain optimistic. Companies, investors, and regulators will continue to look beyond the myths, miscommunication, and mis-selling surrounding ESG and sustainable investing. For instance, financing energy transition or the increased use of carbon-reducing strategies makes sense, but private capital will not resolve all the issues. More companies need to treat ESG initiatives as core business drivers. Government policymakers will continue to drive meaningful change. For instance, entering into force on 5 January 2023, the EU Corporate Sustainability Reporting Directive (CSRD) is expected to advance the scope and quality of corporate sustainability reporting

As an optimist, I expect a more pragmatic, nuanced, and, ultimately useful to investors, approach to ESG and sustainable investing. More corporates are listening and investing in the transition to a sustainable global economy. Investor demand for innovative sustainable investment solutions will remain strong, with growing interest in Impact Private Debt, Carbon Trading, and Energy Transition Commodities. The landscape will remain complex so strong client/asset manager partnerships are needed to reduce the expectation and communication gaps.

Until next time,

Chris Elsmark

April 21st, 2023

Thanks for reading. I'm always pleased to hear your thoughts and feedback. Catch up on past editions of the newsletter?on www.assetcircle.com

Recommended Reading:

Cremers, M et al. 2023. “The Complex Materiality of ESG Ratings: Evidence from Actively Managed ESG Funds”.

PwC, 2022. “Asset and wealth management revolution 2022: Exponential expectations for ESG.”

Important Information | This publication contains general information only. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. And it does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. Before making any decision or taking any action that may affect your business or investments, you should consult a qualified professional advisor.

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