I examine the great variety of definitions and consider the various initiatives to standardise descriptions – EU, IFRS, CFA
Are managers real converts?
Conversion on the road to sustainability
Many companies are busy announcing their conversion to the ESG religion. So, bad guys have revelations on the road to Damascus and turn into St Paul. St Paul became a good guy at great personal cost, since he was ultimately martyred under Nero. For boards of companies, it is easy to announce a 20 year strategic conversion but harder to carry it out. Martyrdom for failure to carry out the intention will not be a regulatory requirement – and anyway by the time the reckoning comes current boards will probably all be well retired on handsome pensions. Here we examine some of the issues and dilemmas of the kind that St Paul may have had to explain in his mission to convert the heathen.
Many investors still don’t believe in ESG
The most frequently cited reason for not investing ethically was perceived lower returns and many investors don’t appear to care either whether ESG outperforms or not. A UK-based YouGov survey quoted in a UK Sustainable Investment and Finance Association publication indicates that
“only 9% of the public think it’s important to invest money ethically, and 84%are willing to accept investing in something that was unethical or countered their beliefs”
Many studies, for example the report from an authoritative source like Morningstar, suggest that over the long term, say over ten years, ESG oriented funds have out-performed their non-ESG competitors. However there is limited data on sustainable funds’ long-term performance due to the relatively short track records of many strategies and huge variety in ESG approaches. In the shorter term, relative returns shift depending on market conditions. For example more recent performance numbers may have been distorted in ESG funds’ favour by underweighting in poorly performing oil and gas stocks and overweighting in the ‘clean’ FAANGs (the tech giants).
Even if they do believe in ESG, how is the ordinary retail investor to decide?
The green fog around ESG (Environmental, Social and Governance) funds gets ever denser. As the International Organisation for Securities Organisations (IOSCO) noted in a 2019 Report there are three key problem areas:
1. “Multiple and diverse sustainability frameworks and standards
2. Lack of common definitions of sustainable activities
3. Greenwashing and other investor protection challenges”
Or in other words: there is no single globally-accepted ESG or sustainability framework; there are no consistent globally-accepted definitions, and – humans being humans – some are exploiting these weaknesses and investors may suspect that a lot of the hype is just marketing guff.
So what’s new?
“Well run companies, which provide honest products and services that customers need and want; act responsibly and accountably towards stakeholders and society in general; treat employees fairly, pay them properly and develop their skills; and have the foresight to understand and adapt to economic and technological change, are more likely to continue to trade profitably in the long term for the benefit of their shareholders. None of them are perfect but they meet most of the criteria. Such companies have always provided the best returns over the long term.”
If that’s ESG we are all for it.
Internationally accepted standards are on the way
These should be able to answer two of IOSCO’s problems – diverse sustainability frameworks and lack of common definitions – and consequently help convince investors that they are not just being enticed by the third problem – greenwashing.
There are several much-needed initiatives that may bring clarity to confused investors.
The EU is having a go. The Sustainable Finance Disclosure Regulation (‘SFDR’) was “enacted to address the twin objectives of increasing transparency of sustainability-related disclosures and to increase comparability of disclosures for end investors”. And in February 2021 the Regulatory Technical Standard (‘RTS’) that describes how to implement the SFDR.
Well, on the upside, the three European financial regulators are jointly setting a single set of standards which are consistent. On the downside, as they acknowledge, one size does not fit all. And the resulting pre-contractual disclosure template – which only relates to fund investments – at four pages is double the length of a UCITS key investor information document. And the work that lies behind this disclosure is massive – phew! – take a look at Annex 1 of the RTS – 23 pages.
The IFRS Foundation has decided to take the next step on an IFRS that will contain headline principles for sustainable reporting and is engaged in extensive consultation with a view to producing a definitive proposal in time for the United Nations Climate Change Conference COP26 in November 2021.
The CFA Institute’s report on Sustainability in Investment Management published in December 2020 had the headline conclusion that :
“Sustainable investing involves balancing financial and extra-financial considerations, balancing the short term and long term to ensure that short-term goals do not compromise long-term goals, and balancing stakeholder interests and seeking fair outcomes for all.”
The Institute will be producing a standard on disclosure later this year.
Why is it difficult for fund management firms to explain what ESG means?
The initiatives for global standards are all seriousstuff and will be needed. But they are lengthy and technical And, although they may differ slightly, at least they will be authoritative and objective. But what investors want explained in simple terms is whether a particular fund’s objective meets their criteria and what it invests in.
Investors need facts to decide whether that fund meets their own definition of ‘sustainable’, or ‘responsible’. They may wish to emphasise one factor – environmental, social or governance – over another for example. Surely the simplest way for an investor to know if a fund is not just greenwashed is by clarity as to the criteria used by its fund manager to determine whether or not an investment qualifies for inclusion in the portfolio.
Is it easy for fund managers to set and apply ESG criteria?
Even when standards are in place there will still be a need for additional judgement. There are many dilemmas – is a repentant BP going to use its enormous cashflow to invest in green energy generation, as its purchase of big blocks of seabed to erect wind turbines may indicate? Then it may become in ten years’ time one of the largest generators of green energy. If so, at half its share price of 3 years ago it may be a steal. So simply selling it because it is brown may be no more than an unnecessary and value-reducing knee-jerk reaction. Is Toyota going to be a green hero by announcing it scars will all be electric by2030,thusbecomingthe‘volkswagen’ of affordable electric vehicles for those who can’t afford Teslas? At a p/e of 12x it’s a darned sight better value than Tesla at a p/e of over1000x. And is nuclear green or not? Some say yes and some say no. But tell investors what you think.
So will the new converts please come clean and tell us what they actually do
Why not? No virtue signalling, please. Why was St Paul one of the most successful promoters of an idea in history? Because he interpreted the teachings of Christ for ordinary people and explained them clearly and simply. Perhaps something like this.
“Selection of this fund’s investments prioritises companies that have
Minimal or reducing adverse environmental impact – or a positive environmental impact and/or
Decent and inclusive treatment of all stakeholders and/or
Ethical and responsible governance and management and/or
Companies must meet criteria established by:
[cite standard] for environmental impact
[cite standard] for treatment of stakeholders
[cite standard] for governance
to be eligible for investment.”
Job done in less than four pages ????
All about investment funds 