The very real limits of ESG integration
What does successful ESG integration look like? Does it look different for different investors? And does it go far enough? The Chartered Financial Analysts (CFA) Institute will feature a debate on these questions at its forthcoming European conference.
I will look at each of these questions in turn but before I do it is critical to understand the background and context for the ESG debate. There are four parts to this. First, that ignoring ESG red flags is risky. Second, that high ESG rankings can signal financial outperformance. Third, that existing capital allocation is not aligned with a sustainable world, and hence needs to change. Fourth, that because most capital allocation happens within firms, investors as owners can and should influence this through stewardship.
Now back to those questions. At an operational level, ESG integration merely means the explicit consideration of ESG factors in investment decisions and portfolio construction. It does not specify what weight to assign to them, which of the three to prioritise, or which qualitative and quantitative measures of the three to consider.
Just because asset managers consider ESG measures in investment decisions, it does not mean they give them much weight. It is perfectly plausible, though unlikely, for an asset manager to say they have integrated ESG fully, without altering a single investment decision they make.
Two fully integrated asset managers may make different investment decisions, for example, even when using the same ESG and financial metrics, and having identical portfolios. Evidence is, that when near term financial and ESG indicators point in different directions, the financials win even if they only hold for the short term.
A second problem is which of E, S or G to prioritise, and how to weigh them. For example, what to do with a firm that ranks highly on awareness of environmental risks or contribution to tackling them but that has poor governance? Tesla comes to mind here. How does an asset manager weigh these against each other?
A third problem is the variable quality of the panoply of ESG tools, datasets, rankings and metrics out in the market today. Some contradict each other, others seek to compare apples to oranges and still others seek to quantify things that are in essence unquantifiable.
Even well intentioned and competent users of these can end up with investment decisions that look dramatically different, despite having fully ‘integrated’ ESG. Moreover, pre-existing biases or scepticism can colour an asset manager’s choice of data and tools, so they confirm these beliefs rather than provide the most rigorous approach and analysis.
There is no real benchmark for what ESG integration means in practice. Even with the best of intentions, changes to investment decisions after integrating ESG will be highly variable and may not be material in most cases. Our research at Re-Define shows that the real difference in how asset managers allocate capital before and after they have signed up to PRI or one of the other alphabet soup of principles in the responsible, ESG and sustainable investment domain is significantly less than 1%.
Let us address the next question. How different would ESG integration look for different investors? As an extreme example, ESG integration would look very different for a day trader and a sovereign wealth fund designed for sharing wealth across generations. At risk of overgeneralising, it is fair to say that larger more long-term investors should have a more rigorous approach to ESG integration than smaller investors with a shorter horizon.
To see why, let us look at each four points we considered for context. First, ESG risks are more likely to manifest in the longer term, so are more relevant to investors with a longer-term horizon. Another important consideration is that negative externalities, which can be ignored by small short-term investors become internal for large long-term investors. Profitable emissions of carbon or excessive use of antibiotics or aggressive tax avoidance by one of your portfolio companies will undermine others.
Second, the secular trends, such as the progress in renewables, which ESG indicators can proxy, will also throw up more profitable opportunities in the long term. Similarly, better performance governance can signal a superior ability to identify and adapt to these secular trends.
Third, a large and long-term investor can only thrive if the world itself is sustainable, so such investors have a vested interest in allocating capital to make this happen. It is entirely possible for a small hedge fund to generate outsized financial returns even if the world is going to pot, but not for a large universal investor such as Norway’s trillion dollar fund.
Fourth, such reallocation is not enough, and investors need to perform strong stewardship of the companies they own to make sure that internal allocation of capital and business strategies are aligned with a sustainable world.
Here again the evidence is rather disappointing. Yes, large long-term investors do invest more in ESG and stewardship, but nothing like what they need to. The percentage of manpower or financial resources devoted to these even by giants such as NBIM and BlackRock are disappointingly small, despite recent increases.
Let us now address the last question. Is ESG integration enough?
The listed markets that capture more than 80% of invested assets are backward looking by construction. ESG strategies limited to these clearly do not do enough to achieve a sustainable world. Integrating them into illiquid private equity, real estate, infrastructure and other alternatives clearly go further in striving towards sustainability. Going beyond ESG integration into investing heavily in stewardship to drive corporate decisions in a more sustainable direction can potentially have a much larger impact on allocating capital to get to a sustainable world.
But if asset managers are serious about sustainability, there is little choice but to proactively allocate capital to drive that outcome. Investors have a collective responsibility for that. This will require a huge change in how capital is allocated, and will show up as a 20–30% change from status quo, not the less than 1% so far that we have seen with ESG integration and its ilk. And with the stewardship function becoming as important as the investment function, not the poor country cousin it is at present.