Three ESG concerns that are justified – and one that isn’t

Make money and do good. Sounds lovely, doesn’t it? This is the role that sustainable or ESG investing is expected to play for investors. The idea that you can invest somewhere, generate great returns and in the process, reduce the ravages of climate change, increase social equity, and make a positive impact on a range of lives.

It’s easy to forget that sustainable investing hasn’t really been around for that long, such is the rapid growth in its popularity. In fact, 46% of investors consciously seek to invest sustainably and 40% of all professionally managed funds in Australia are managed according to sustainable principles (Source: Australian Ethical Investments and Investment Trends).

It’s an investment trend that is set to continue. Bloomberg Intelligence’s ESG 2021 Midyear Outlook reported that global ESG assets under management are likely to surpass $50tr by 2025. Even in a tough market environment, people remain highly conscious of ESG concerns. From an Australian perspective, it’s hard to miss as we swing from bushfires to floods, or read reports on the dire state of the Great Barrier Reef. Or even account for the rising cost of living challenges which are facing millions of Australians and putting many below the poverty line.

That said, it seems to be one of the first areas to fall away in tough times. A recent KPMG CEO survey found that nearly half (45 percent) of CEOs agree that progress on ESG improves corporate financial performance, an increase from 37 percent just a year ago. However, as economic uncertainty continues, half are pausing or reconsidering their existing or planned ESG efforts in the next six months, and 34 percent have already done so.

While the growing popularity of sustainable investing all sounds like great news for investors and the planet, sustainable investing is not exempt from criticism. And in fairness, as a newer investment form, there were always going to be teething issues. With passionate critics and advocates of the form, I decided to take a look at the common criticisms to learn which were justified concerns, and which weren’t.

Criticism: The lack of consistent standards for ESG investing

There is no universal standard for what factors should be included in ESG investing, what measures should be used and how ESG factors should be reported. Rather, there are voluntary guidelines proposed by a range of industry bodies around the world and a range of different measures fund managers can choose to use in analysis.

The closest thing we have to global standards are the UN Principles for Responsible Investing. There are 5241 signatories to it and each is required to report on their activities twice a year. It is not enforced nor are there clear measures for each signatory to adhere to in self-reports.

This has a range of implications:

1. Different companies will report to different ESG standards, particularly because guidelines tend to be voluntary and rely on self-reporting. Accuracy of self-reporting can of course vary.
2. Different fund managers will apply ESG in different ways – some may take an exclusionary approach where all companies that don’t meet their standards are removed, while others may still invest and aim to pressure for change. It can be difficult for investors to accurately compare funds in this way and views on ESG then become personal and subjective according to a fund manager.
3. There is no regulation of ESG standards though companies do have some requirements through associated laws such as anti-slavery reporting. It reduces transparency across the industry.

Is the criticism justified?

In short, yes.

Though times are changing as many industry bodies are pushing for greater clarity. The Australian government is expected to look to set definitions for it in early 2023. Expect a lot of debate over what should be included and what shouldn’t be when it comes to ESG factors, it is a highly subjective area.

Managing it in the meantime?

Natalie Tam, Deputy Head of Australian Equities at abrdn Asset Management, notes that there are some metrics common across all companies, for example carbon emissions, modern slavery, and diversity and inclusion. However, metrics can vary according to industry.

“To address this challenge, we have developed a quantitatively derived ESG house score which uses over 100 internal and external data points to provide a detailed assessment of a company’s ESG health. The score gauges companies on governance and operational factors and helps us assess financially material ESG issues that can affect an investment’s value,” she says.

Investors can consider their own definitions of what constitutes ESG factors and look for investment managers that align to those values. It is also worth understanding how a fund manager practices their ESG investment – do they still include companies which may score low on environmental factors but high on social and governance? If so, do they push for change in a company? And are you comfortable with holding those companies or not.

Criticism: Hypocrisy in the industry and greenwashing

Greenwashing is a major concern for investors looking for sustainability.

Greenwashing is when a company mispresents its green credentials to consumers to gain a benefit. Some examples include when Volkswagen (ETR: VOW3) touted its low emission cars but had in fact been using defect devices to ‘cheat’ on emissions tests. Its cars were in fact emitting 40x the allowable limit for nitrous oxide pollutants. Or Coca-Cola (ASX: CCL) advertising that it was sustainable and eco-friendly because of using recycled plastics in 18 countries despite also being the top plastics polluter in the globe two years running.

A lack of transparency and clear standards can make it difficult for investors to verify claims. It doesn’t help when companies deliberately and knowingly hide evidence either.

In a recent piece for Livewire, Chris Leithner, Managing Director at Leithner & Company pointed out some companies take a vocal and hypocritical stance on ESG issues – while directly benefiting from these problems.

He provides the example of Patagonia which is against petroleum on climate grounds but also continues to use petroleum products like nylon and polyester in its products on the basis they can’t find a suitable light water-resistant alternative. Patagonia also made headlines for its founder’s decision to restructure the company so that all profit is turned to fighting climate issues. Leithner’s research also pointed out that this structure has saved the founder and his family extraordinary taxes. Arguably paying taxes is part of being a responsible global citizen.

Is the criticism justified?

Yes and no.

There are a few ways of looking at this. I hate to say #notallcompanies but just because some companies do the wrong thing doesn’t mean we should write off the entire industry. It does make investing in this space challenging though and investors may need to reconsider how they view their ESG morals.

In a strange way, you could say greenwashing is interesting because it shows that companies want to be seen as green to appeal to consumers. It is unfortunate that rather than actually take the steps to be ‘green’, some mislead consumers.

In the Coca-Cola example though, it is open to personal opinion. Do we argue that Coca-Cola can make some (though not a complete) claim to being green because they are actively transforming their business for the future? Or do we focus on what is happening on the here and now – that they are a major polluter.

Managing it in the meantime?

Tam says it is getting harder for companies to completely greenwash as investors have become more aware of the issues and demanding better disclosures.

“The abrdn Research Institute developed a climate scenario analytics platform. This allows us to run many different climate change scenarios and see the potential uplift or impairment in individual company valuations,” she says.

Australian regulators have also taken an active stance in preventing greenwashing. ASIC offers an information sheet to assist superannuation and investment product issuers in avoiding greenwashing.

“The ASX also recently warned companies against using the market’s disclosure system to make unnecessary or misleading statements that overstate climate and emission reduction achievements,” says Leah Willis, Head of Client Relationships (National) at Australian Ethical.

Criticism: Performance

There’s been a perception for years that investing in ESG means you take a cut in returns and see higher fee structure. Some of the biggest polluters in the world are the most profitable companies. Think BHP (ASX: BHP), James Hardie (ASX: JHX) and ExxonMobil (NYSE: XOM).

Including these companies is a source of debate for many ESG focused investors. For example, these companies may actually score high on social and governance issues and therefore be worthy of inclusion in a strategy. In which case, the strategy still benefits from the performance. Fund managers who take this approach often argue that they have more power to influence change by investing in them rather than ignoring them.

The strategies that choose to exclude them are obviously going to be missing that performance boost. In the case of 2022, that would be an extraordinary boost given the energy crisis.

Is the criticism justified?

Yes – this year…

Across the board, ESG focused investments have had a tough year. Investment Metrics research across 52 products from 45 US based managers found that 78% of ESG products had underperformed the MSCI ACWI Index this year.

But…

The criticism isn’t necessarily justified on a longer-term basis.

The same Investment Metrics research found that 80% of the products had outperformed on a three year basis and were growth-oriented rather than value. This orientation may be more the issue for performance than being “ESG or sustainable”. After all, it’s been a difficult year for growth managers all round.

There’s also the question over whether many such funds have existed long enough for a genuine comparison. If we’re looking at short periods of performance, is that actually the best way to judge? Generally speaking, we should be looking at performance over a range of cycles. You could also argue that the idea of sustainability and ESG is a long term approach too so should we expect short-term payoffs?

With ESG and sustainable issues, we are talking about huge structural shifts that may see our biggest companies today falter in 20 years’ time and up-and-comers take the charge. Perhaps our views on when we expect to see returns and how this is packaged to investors needs to change too.

According to Tam, part of the performance problem for many traditional ESG funds comes down to their use of research and data.

“We take a forward-looking view of ESG risks and opportunities, rather than relying on third-party ESG ratings which are often backward-looking and widely available, so unlikely to be a source of potential alpha. This is also why traditional exclusionary ESG funds have historically not led to alpha generation or outperformance,” she says.

Managing it in the meantime?

It’s worth considering that most academic research has focused on funds that explicitly focus on ESG as their purpose, rather than incorporating an ESG layer within their overall strategy. It sounds like I’m splitting hairs here but there is a difference. Incorporating a layer can be more flexible and more inclusionary than pure focus. It also can be financially beneficial because as Tam points out, ESG factors can have a material impact on share price and company performance.

“As investors, we are not only faced with traditional financial scandals. In fact, in the last several years, the biggest corporate scandals have been ESG-related incidents and disasters. Understanding ESG risks and opportunities alongside other financial metrics drives deeper insights and allows us to make better investment decisions,” she says.

Another factor to ponder is that the performance criticism of ESG funds could also be made more broadly of actively managed funds in general. The Morningstar Active/Passive Barometer found that only 11% of large-cap funds outperformed passive benchmarks over a 10-year period and 40% of all large-cap funds failed in that period too. The best managers and strategies outperform and survive. It seems reasonable to suggest that could equally apply to the ESG space.

Criticism: Sustainable investing doesn’t make a real impact

Advocates of sustainable or ESG investing often focus on the idea of creating positive change through investment. Critics argue that this change is often slow or non-existent and that at the end of the day, investments are focused on shareholder returns rather than world improvement.

Is the criticism justified?

No – opinions here though are subjective.

There’s a few things to unpack.

Realistically, investors invest because they want to make money. Improving the world is a side-benefit they’d like. So, fund managers still need to justify their fees by focusing on offering returns. Is that a negative? Well it depends on the investment strategy. There’s no reason why we can’t see mutual benefits to the environment and to our wallets in certain cases. That said, the unfortunate truth is often as not, our wallets will take priority.

That said, one example you could look at where there is congruence between investors and the environment is in the Australian water fund that Kilter Rural manages with the Nature Partnership. The fund takes the opportunity to ‘donate’ water to wetlands in wet periods where it has excess inventory meaning little cost to investors. Our water management system has redirected the passage of water over time and meant that wetlands don’t receive the drenching they would have in these wet periods in the past. These donations assist in providing that traditional need and help the wetlands survive coming dry periods.

Change can be slow too.

After all, some of the biggest ESG concerns require us to completely transform structures we’ve been dependent on for decades or centuries. Take coal for example. There’s a lot of infrastructure and development to go before we can remove that as an energy source and replace it with more environmentally sustainably sources. There’s also a lot of money to be spent. Do we stop doing something that could have tremendous rewards for us just because it is taking too long?

Managing it in the meantime…

This comes down to how you approach your investments, what you want to achieve and your timings.

While strategies vary, ESG and sustainable investing may be best considered in the realm of long-term investments. Or alternatively, if you are open to taking a more flexible approach, you can look at managers which incorporate a filter but still invest in companies that don’t tick all the boxes with the expectation of future change. This can offer returns as well but it does require being prepared to invest in companies which might not meet your personal values immediately.

For example, Tam points to Pro Medicus (ASX: PME), a stock within the abdrn portfolios.

“In 2020, it had an MSCI ESG rating of B (only one notch up from MSCI’s lowest CCC rating), but after engaging with Pro Medicus team on improving their social and governance factors, we viewed the company as having an improving ESG profile. Over time, this was also recognised by the market with MSCI upgrading the company to BB and then BBB in September 2022,” she says.

Companies are changing – it can be a matter of whether you are prepared to ride out the journey with them.

Conclusion

Sustainable investing is increasing in popularity but it also drives a lot of emotion on both sides of the fence. Though some of the criticisms it garners are justified, you could also argue this isn’t enough to condemn the industry. ESG and sustainable investing is still, to an extent, in its infancy and will continue to evolve. Many fund managers are doing incredible work in this space to incorporate it within their strategies.

There’s also something to be said about planning for the future. The big profits are still coming from traditional structures now, but the trend suggests this won’t always be the case. Investing is not just about the here and now, it’s also about what we want in the future. Investing is about hope (for our wallets) but there’s no reason it can’t be more than this in time.

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