Perspective

The Five Tensions Facing ESG Providers

This article was first published in theFTAdviser.

The explosive growth of environmental, social and governance investing in the past few years is creating tensions that could make life more complicated for money managers and investors alike.

For decades, investors who were passionate about certain causes mobilised around the idea of 'socially responsible' investing, in the hope of using their financial might to help bring about changes they believed were worthwhile.

But in the past few years, as the inevitability of climate change has shaken business and government leaders around the world, investors have been piling into ESG portfolios at a breakneck speed. A record $350bn (£247.6bn) flowed into ESG funds in 2020, according to Morningstar.

In theory, putting money into climate-friendly companies and moving away from carbon-intensive industries seems like a 'can’t miss' solution. ESG investing, like socially responsible investing before it, suggests a world of 'good' and 'bad' in which good people invest only in the good things and are rewarded with good returns while clearly harmful industries like, say, tobacco suffer.

But climate is not tobacco. Companies that might seem bad today because of their carbon emissions might also be essential cogs in the global economy (energy producers or airlines for example), and could be on their way to a more sustainable future. Casting them aside now could be counterproductive or even foolish.

The wide range of ESG issues, the variety of circumstances that different companies face and responses they make, and the simplifications and biases inherent in the metrics as well as in investors’ minds, all make the reality of ESG investing much more complex than the feel-good messaging around it suggests.

There are five inherent tensions that providers of ESG products and investors need to be mindful of.

1. Difficult trade-offs

Even the best sustainability approaches involve grey areas in which the pursuit of one goal could compromise another. Sometimes there are tensions between the E or S agendas: the Financial Times reported last December, for example, thatfor electric vehicles in Europe had been held up by environmentalists’ concerns over sand lizards on the site. Likewise, nuclear power offers the zero carbon emissions energy the world desperately needs, but also brings concerns about waste.

Sometimes the tensions are between the S and G. In February the Financial Times reported on the “dark secret” of sustainability: that ESG investment favours tech companies that often minimise their tax liabilities. In any tax system that seeks to penalise undesirable behaviours and reward desirable ones, acting in a more desirable way will, by design, save tax – but the extreme tax position of the big tech companies, combined with their heavy weighting in ESG indices, creates an unintended social consequence.

2. Balancing inclusion and exclusion

Increasingly, the goals that people seek through socially responsible or ESG investing cannot be achieved by divestitures alone. In ESG there is not one clear-cut set of categories to divest from and another to invest in. In total, there are 17 sustainable development goals defined by the UN, focusing more on any one of them would shape a different set of investment priorities. Adding to the complexity, different ESG scoring systems weigh goals differently. The simple letter grades (B+ and so on) from Refinitiv, for example, belie a complex set of weighted synthesis of more than 500 company-level measures they seek to collect, with a sub-set of 186 driving the overall process. Investors with particular interests will need to unpack this sort of synthesis and apply their own weights in order to pursue their own goals.

3. Brown now, but olive tomorrow

In the climate change context, what many investors want is to own clean, green assets. But the reality of the climate change challenge is that most of the action, and investment opportunity, is in the transition from brown to green, which means owning assets in various shades of olive. Investing to convert brown assets to olive, or dark olive to light olive, is often where investors can have most impact, whereas cleaning the portfolio by divesting does not decarbonise anything.

Striking the right balance is not always easy. This approach means engaging with businesses and investing in assets from which many would rather disassociate. The placement of pro-climate-action directors on the board of ExxonMobil in May was a result of climate-concerned investors choosing to invest in and engage with ExxonMobil, not divest.

The approach means judging companies on their future plans, not just their current performance. A high-emitting business with a bold transition plan in a hard-to-abate sector might be one of the most deserving investments.

The challenge is in how such a business shows up in ESG scores, the appetite of investors to own them in the short term, and the reputation they may earn from doing so.

One prominent company, for example, has a strong stance of engaging with challenging business to improve their performance on both E and S factors. Yet this stance has attracted the attention of activists concerned that the bank is currently lending to brown and olive businesses at an early stage of their transitions.

A related complication: the false precision of the reporting requirements for asset managers and investors, which can reinforce wrong actions. The general approach of many is to focus on achieving ever-improving ESG scores. But the only way to achieve that in the accepted time frame is to swap 'bad' companies for 'good' ones in portfolios, which runs counter to the brown-to-green concept.

4. Geographic variation

Some markets are more or less climate conscious than others, adding complexity to global money managers’ ESG programmes.

The Nordic market, for example, has a low tolerance for what investors there see as bad companies. In some cases, asset managers’ only option is to sell the offending company, which removes the ability to engage and improve. And if the asset manager were to engage, they would be put at a competitive disadvantage because that is not what most clients want.

5. Unpredictable returns

ESG investing is easier to sell and to do when there is no trade-off between financial returns and ESG impact. ESG outperformance has been empirically true in recent times. As funds flowed into ESG stocks, the tech giants that are overweight in those indices soared, and the oil majors were revalued. During 2020 the exponentially growing market capitalisation of renewable energy company NextEra Energy, for example, rose to match the declining market capitalisation of ExxonMobil.

But that relationship is not axiomatic any more than the notion that emerging market indices should outperform because those markets are growing faster. It depends on what is priced in at any given time. Over the first five months of 2021, investments in ExxonMobil have far outperformed NextEra as oil prices have recovered.

Over the long term, ESG funds have been able to pursue their non-financial objectives without compromising financial returns.

From its beginning in September 2007 through to April 2021, the MSCI ACWI ESG Leaders Index has delivered a gross return of 7.4 per cent per year, compared with 6.7 per cent for the MSCI ACWI benchmark.

But the rosy assumption of a win-win, with virtue being rewarded financially, is not a given. Most investors, like most consumers, want their sustainability to be delivered penalty-free.

With all these tensions to resolve, some may end up disappointed.