The Parlous State of ESG Investing
As the manager of a European fund that endeavors to invest in companies with strong ESG credentials, it has become increasingly dispiriting to witness the discrediting of this style of investing. Following 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 United States, the Adani scandal in India has added fresh doubt. It has since come to light that the Adani name appeared in more than five hundred so called Article 8 funds, all supposedly promoting environmental, social, and governance goals. These same companies are now being removed from indexes and placed under review amid allegations of fraud and market manipulation.
The ESG SFDR definitions are so imprecise that they allow for a wide range of interpretations. Ask the average investor what promoting environmental, social, and governance goals actually means, and the answer will likely return 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 routinely included in ESG portfolios. So what exactly is ESG?
Where the Framework Falls Short
It seems 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 little more than a box ticking exercise. Conversations with ESG rating agencies reveal that what they have developed is essentially a monitoring system for corporate activity, one that allows companies to claim they track ESG considerations without any real commitment to changing their behavior. The better a company monitors, the higher its score, meaning a large oil company can end up outscoring a small green energy company simply because it has invested more resources into building out reporting systems. Different agencies then apply different, and often questionable, ratings. Combine that with the fact that the largest clients of these rating agencies are the largest global asset managers, and the result is a system primed for greenwashing. The widespread use of best in class methodologies functions as something of a loophole, allowing large asset managers to continue investing in so called sin sectors while still claiming ESG alignment. For very large asset managers, liquidity requirements often force investment into large companies, many of which carry ESG skeletons of one kind or another.
There is also ongoing tension over what the actual role of an investment manager should be. In years past, the view was that the role centered on maximizing risk adjusted returns, or at minimum delivering returns commensurate with a client’s risk tolerance. Risk itself is broadly defined, but adjusting for it generally required that companies be managed conservatively and within the law. Ethical considerations were kept at arm’s length, on the grounds that one person’s ethics are not necessarily another’s. Tobacco offers a useful example. Today it is reasonable to assume that most people accept the medical consensus that tobacco is harmful and can kill. Would a cigar smoking executive of decades past have agreed, and refused to invest in a company like Imperial Tobacco? Probably not. Today the pressing issue is the environment, particularly carbon emissions, yet ESG regulations impose no actual limits on what level of emissions is acceptable, and naturally some industries emit far more than others by their very nature. Best in class methodologies, along with investment strategies focused on ESG improvers, companies slowly cleaning up their practices, allow managers to sidestep the issue entirely.
Global Ambition, Local Consequences
The Adani episode is a useful illustration of a broader pattern playing out well beyond any single company or country. As ESG investing has scaled globally, the gap between stated intentions and on the ground realities has widened, particularly in markets where oversight is inconsistent and enforcement is difficult to verify. This is not a problem confined to emerging economies either, since similar gaps have surfaced among western listed companies as well. The result is a system in which scale and ambition often outpace the ability of investors, or regulators, to confirm that a company’s practices genuinely match its public commitments.
Returning to Adani, this was a very large group with activities spanning commodities, coal mining, utilities, gas, and green energy. Despite claiming adherence to ESG principles and frameworks, there is no reasonable way the average investor would have viewed the group as green. Adani has rejected allegations of financial impropriety, but experience investing in emerging markets, where large energy, industrial, or commercial projects are involved, has shown that unexpected complications tend to surface, and not exclusively within emerging market companies.
So what should an investor do to navigate this minefield? In our European fund, the approach has been to exclude all controversial sectors entirely, returning to the core ethical principles mentioned earlier and implementing them as consistently as possible by avoiding sectors with obvious potential for harm. That means no arms or armaments, no alcohol or tobacco, no gambling, no fossil fuels, no genetically modified products, no pornography, and no pharmaceuticals. This approach will not suit everyone, and in 2022 it came at an opportunity cost to the portfolio, since oil was the only sector to deliver a positive return that year, a sector the fund does not invest in.
The European Securities and Markets Authority recently stated that Articles 8 and 9 are being misinterpreted as proxy ESG labels, which they were never intended to be, and that what is now needed is an EU wide Ecolabel with stricter criteria for minimum green investment. After testing three key EU Ecolabel criteria against roughly three thousand sustainability oriented equity funds, ESMA found that only half a percent of those portfolios actually met the requirements. Regulatory bodies will likely continue to regulate further, at increasing cost to businesses, but this does not appear to be the full solution. What is also needed is greater clarity around what funds will and will not invest in, rather than increasingly complex compliance exercises. ESG funds might consider publishing every investment they hold in an easily accessible format, allowing individual investors to review the full makeup of a fund rather than just its top ten holdings, which remains standard practice. This would shift more responsibility onto the buyer, in the spirit of caveat emptor. At the same time, companies that market products under ESG or sustainable labels without adequate justification need to be held accountable, and fined where necessary. To that extent, minimum thresholds and clearer labeling may still serve a useful purpose.
