In the wake of coronavirus, ESG investing has been growing tremendously.
In fact, it is estimated that the overall ESG assets total to $30 trillion.
According to a recent study by Deloitte, ESG-mandated assets in the United States could grow almost three times as fast as non-ESG mandated assets, making up half of all professionally managed investments by 2025.
Undoubtedly, this is a good thing. Right?
After all, the fact that ESGs are on the rise only shows that people’s consciousness is awakening and that there’s a demand for transparency and accountability.
But equally, as ESGs are growing in size, there’s a growing concern over greenwashing raised at the same time. Thing is, when the growth is fast and markets are booming, greenwashing tends to end the picture one way or another. And ESG, unfortunately, is no exception.
What is ESG?
The history of ESG goes back to socially responsible investing (SRI): an idea established about 200 years ago when the Methodist movement protested against investing in unethical companies: the ones that made weapons, tobacco, or used slavery, for example.
Since then, ESG has evolved and gained more sophisticated angles. It is now more than just “not investing in unethical companies”: it aims to positively contribute to the environmental, societal, and governmental practices done by the company (while generating a financial return from investing in it, of course).
It is important to understand that ESG is not philanthropy nor is it a trade-off with returns. ESG aims to bring both: returns and a better future for all stakeholders, from workers to the environment.
So if it all sounds so great, what’s the twist?
One word: greenwashing.
The history of sustainability
A bit more than ten years ago, sustainability was a topic managed not by sustainability departments (which hardly existed back then), but by corporate communications.
In fact, it didn’t have anything to do with business operations or the entire company strategy. Back then, sustainability was referring to philanthropy rather than to strategic decisions, and, more often than not, was manifested as a mere, nice stamp on top of an annual report. Nothing more.
Today, it is far from that.
Today, you will find very few CEO presentations or strategy papers that don’t mention sustainability and, in at least some way or form, discuss climate change, safety, racial diversity or gender equality.
Sustainability has become the core of all strategic work done by corporations.
Not only does the world need more sustainable companies, but also consumers. It is not sufficient to leave the “saving of the planet Earth” to the Patagonias of the world.
If the company wants to succeed, sustainability needs to be taken seriously.
The investment world is lagging behind
Unfortunately, this is not the case when it comes to the investment industry.
More often than not, ESG is essentially a stamp of a good will rather than a genuine proof of actions.
It is used to market traditional funds, to add a nice coating on top of the cake, but it’s when you dig deeper that you realize that the fund might include a big portion of traditional investments that don’t actually put sustainability as a top strategic priority. Or how do you see if an ESG-branded fund includes aviation or traditional energy companies? After all, people presumably want to see ESG-branded funds do good for the environment — not promote polluting lifestyles.
ESG is not only used by the fund managers, but also by different scoring agencies that aim to support investors in their challenge to choose more sustainable investments. Scoring agencies utilise different scoring methods and processes to analyse investments and to rate their performance. Sounds solid, although the details are often misleading.
This is also echoed by Steven Maijoor, chair of the European Securities and Markets Authority (ESMA), who says:
“The lack of clarity on the methodologies underpinning ESG scoring mechanisms and their diversity does not contribute to enabling investors to effectively compare investments which are marketed as sustainable, thus contributing to the risk of greenwashing.”
Also, in many cases these ratings are given far too much weight when the actual performance or strategic focus is not analyzed at all. To put it bluntly, it is easy to calculate a portfolio that gives you a high rating based on a specific metric, but understanding that company's strategy, performance and ambition level requires hands on work which ratings cannot do.
In addition, different rating agencies put emphasis on different things which results in interesting situations when a same company can get a different rating depending on the agency.
Financial Times recently made a good comparison about Tesla where one rating agency gave a relatively high score to the company while another one dropped it to the bottom 10%. The reason being that the first agency values environmental performance while the other one puts a higher emphasis on workers’ rights.
So at the end of the day, which score is correct? Impossible to say.
This example shows that, depending on the rating, good companies may look worse than they are, and bad companies may look better depending on the rating or indicator used. It is thus up to consumers to know the background or have the patience to investigate the scoring metrics, the challenge being here that such information is hardly accessible and rarely available. And yes, fund managers should be able to explain the analysis behind, but that is not always the case.
EU is working on it
As always, when there’s a challenge, there’s an answer from the EU.
This applies to ESG as well.
The EU's proposal, "Taxonomy Regulation", intends to create an EU-wide taxonomy on environmental sustainability and to give a common language and framework to identify which activities or instruments may be categorised as environmentally sustainable. Although the focus is on environmental issues, it includes comments to social issues as well, such as inequality in its wider form (gender, racial, religion, etc), social cohesion and human capital.
The proposal is a good start and definitely something that is needed. However, as with all major proposals, it is a challenge to cover all aspects in a sufficient detail, in a way that it would also cover all the needed issues.
In addition, the implementation lacks power: the new taxonomy is not mandatory when making investment decisions, which means that allocating finances is free from regulation. However, investment banks offering sustainable products must disclose objectives of the fund and methodologies used, as well as provide an assessment of the overall sustainability-related impact of the financial product.
Have we lost all hope?
Sustainable investing needs to face the same challenge that took place with the corporations approximately ten years ago. It is time to move on from the rating-based world to a real world where actions matter more than ratings or indicators. Investors themselves need to go out there, get their hands dirty, and understand what is really happening instead of relying on an “approval rating” prepared by some other agencies or institutions.
Is this doable? Yes and no.
Currently, fund managers and investors see sustainability and strategic ESG still as a job that must be doable via excels or service providers. Risk mitigation and easy-to-use solutions are being utilised as most of the investors don't see sustainability as their core job (or even a job that needs to be done by themselves).
We need experts. Urgently. Sustainability is not a buzzword: it is there to stay. Now more than ever, the investment world needs to change the mindset, put sustainability at a strategic core, and hire (and nurture) experts that know how to tell glitter from gold.