As the manager of a European fund that endeavors to invest in companies with strong ESG credentials, I find it increasingly dispiriting to witness the discrediting of this style of investing. Following on from the downgrading of Blackrock, Amundi and various other funds from SFDR Article 9 status to Article 8, and the politicization of ESG between the so called ‘progressive’ and conservative wings in the USA, we now have the Adani scandal in India and the discovery that the Adani name appeared in more than 500 so-called Article 8 funds that are supposed to ‘promote’ environmental, social and governance goals. We now find these companies are getting removed from indexes and placed under review amid allegations of fraud and market manipulation.
The ESG SFDR definitions are so imprecise as to allow a range of different interpretations. Ask the man on the Clapham omnibus what he thinks promoting environmental, social and governance goals means and he might reasonably go back to basic, commonly accepted ethical principles: Do not pollute, do not kill, do not harm, do not steal, and yet companies flouting all of these are being included in ESG portfolios. So what exactly is ESG?
It seems to us that in its original intent, ESG was meant to encourage ethical investing, but in the process of developing a bureaucratic regulatory framework, it has become a box ticking exercise. It is evident from our various discussions with the ESG rating agencies, that what they have developed is a monitoring system for companies’ activities, which has allowed companies to say they monitor for ESG considerations, but without any commitment to clean up their act. The better the company monitors, the better the scoring is, so that it is quite possible for a large oil company to end up with a higher ESG score than a small green energy company, simply because the larger company has invested more dollars in putting in place the various systems. The different agencies then apply different and often questionable ratings. Add in the fact that the largest clients of these rating agencies are the largest global asset managers, and it is a recipe for ‘greenwashing’. The widespread use of ‘best in class’ methodologies is a ‘get out of jail free’ card for the large asset managers to continue investing in so-called ‘sin sectors’. Despite many claims that they adhere to ESG, the reality is that if you are very large asset manager you are almost forced, for reasons of liquidity, down the route of investing in very large companies, many of which will have ESG skeletons in the closet of one sort or another.
There is also ongoing tension as to what the role of an investment manager actually is. In days gone by the view was that it was to maximize risk adjusted investment returns, or at least to deliver returns commensurate with any client’s specific risk tolerance. ‘Risk’ is itself a subject of wide definition, but adjusting for risk generally included a requirement that companies should be managed in a financially conservative way, and within the law. Ethical considerations were kept at arms length on the grounds that one man’s ethics were not another’s. Take tobacco for instance. Today it is reasonable to assume that the majority accept the medical conclusion that tobacco is bad for you and can kill. Would the cigar or cigarette smoking PM of yesteryear have thought the same and refused to invest in Imperial Tobacco or the like? Probably not. Today the hot topic is the environment, and in particular carbon emissions. But the ESG regulations do not actually put any limits on what is acceptable in terms of emissions, and of course, some industries emit much more than others by their very nature. The ‘best in class’ methodologies help managers dodge the issue. So do investment strategies focused on ESG ‘improvers’, i.e. companies that are slowly cleaning up their acts.
But returning to Adani, this was a very large group with activities in commodities, coal mining, utilities, gas as well as green energy, and although they claimed adherence to ESG principles and frameworks, there is no way the man on the Clapham omnibus would have viewed them as ‘green’. Adani has rejected allegations of financial impropriety, but as investors, it has become apparent to us over many years that in emerging countries where large energy, industrial or commercial projects are involved, ‘stuff happens’, and not just within emerging market companies either, but in western quoted companies as well.
So what do you do as an investor to navigate this minefield? In our European fund we just take the view we will exclude all controversial sectors, so we go back to the core ethical principles mentioned above, and try to implement them as best we can by avoiding sectors with obvious potential to harm. Ergo: no arms or armaments, no alcohol or tobacco, no gambling, no fossil fuels, no genetically modified products, no pornography, no pharmaceuticals. This may not be to everyone’s taste and indeed in 2022 it was an opportunity cost to the portfolio, since the only sector delivering a positive return was the oil sector, which the fund does not invest in.
The European Securities and Markets Authority (ESMA) recently came out with a statement that Articles 8 and 9 are being misinterpreted as proxy ESG labels, which they were never intended to be, and what is now needed is an EU wide Ecolabel with stricter criteria on minimum green investments. Having tested three key EU Ecolabel criteria on roughly 3,000 sustainability oriented equity funds ESMA found that only 0.5% of the portfolios lived up to the requirements. The regulatory bodies will do what they do, regulate more and more, at an increasing cost to businesses. But it seems to us this is not the whole answer. What is also needed is more clarity on what funds will and will not invest in, rather than more complex box ticking exercises. To that end ESG funds might wish to publish in an easily accessible manner, every investment that they make, so individual investors, if they are so minded, can go into their websites and check out what the companies in any particular fund actually do, and not just the top 10, which is more normal practice. Then more of the responsibility could be placed on the buyer, i.e. ‘caveat emptor’. But of course, companies who market their products with ESG/ Sustainable labels, without adequate justification, also need to be held to account and, if necessary, fined. To that extent minimum thresholds and labeling may be useful.