Understanding the challenges to ESG investing

The first is fear.

While fears and concerns over climate change can act as a motivators, they can also be inhibitors when it comes to investing in ESG.

Eugene Krishnan, chief financial officer of US digital health organisation Jaan Health’s view is that some may be feeling pressure to do everything all at once, and that may mean losing out financially. Such fears, he says, may prevent them from investing.

Investing well is how you should think about this.Stuart Dunbar, Baillie Gifford

This problem is addressed by Stuart Dunbar, partner at investment company Baillie Gifford. 

Dunbar admits that while some people worry about a conflict between ESG and returns – namely that returns will be compromised in the interests of sustainability – or perhaps a conflict between environmental and social factors, this not the case.

Far from it, he says. “The misconception that incorporating ESG factors into investor decision-making puts income at risk is wholly wrong.

“So too, is the idea that this is a completely separate topic to investing well. Investing well is how you should think about this. It’s a positive thing, rather than a negative.”

He continues: “I don’t actually see a conflict of interests between the E and the S and the G.

“In the long run, companies that don’t behave responsibly or to a responsible degree, who are poorly governed, who don’t have responsible policies in place, those are the companies that stand to be much more challenged anyway.” 

Metric misapplication

Greenwashing is also a threat of course, and this is very much masking the value of ESG and its ability to have maximum impact. 

Part of this is the unintended consequence of misapplied, and misleading metric analysis, which makes it hard for investors and advisers to understand ESG ratings. 

For example, Flora Wang, director, sustainable investing at Fidelity International, says when it comes to metrics it is clear that “a single, data-driven ESG rating cannot (and should not) try to be everything at once”. 

As a minimum, she says there needs to be two distinct ratings: one to reflect a company’s positive impact and another for its negative externalities.

Consumer stress under the cost of living crisis is currently a major inhibitor in the challenge for ESG.Dunbar

“Attempting to capture both in one score dilutes the informational value of the final rating – as the positives and negatives inevitably cancel each other out, resulting in a rating that fails to represent either and can’t be relied upon to guide capital allocation decisions,” she says.

Wang suggests that the ESG rating could focus on the negative impact a company has and use another system, such as the UN’s Sustainable Development Goals framework, to assess its positive business activities, such as products designed to tackle climate change.

She says: “Taken together, both ratings give a clearer picture of where its impact lies and can help with capital allocation.” 

There are also technical reasons why current ESG ratings don’t fully capture a company’s level of sustainability.

Therefore, she feels that “current quantitative ESG ratings are designed in a way that frequently exposes them to being misunderstood or misapplied, and one system may rate a firm entirely differently to another”.

Regulation and consumer choice

While there is plenty of scope for metric analysis improvement and greater accuracy to aid genuine reporting, there is also a lot to be said for where we are with regulation and consumer pressure, and the limits around these at the moment. 

Dunbar believes that, through a combination of regulatory pressure and consumer pressure, a company’s behaviours are going to be revealed through disclosure and social media, which empowers consumers to make their own choices, to buy goods and services or not.

However, consumer stress under the cost of living crisis is currently a major inhibitor in the challenge for ESG to flourish in near future. 

Dunbar feels that ultimately this is about all ESG pieces of the jigsaw fitting together. “Governments have to prioritise the social elements, before the environmental can be taken care of effectively,” he proposes. 

The challenge is, “are consumers going to make (a sustainable) choice? If you are confronted with a cost of living crisis, or if you live in a part of the world that is not as wealthy, can you afford to pay a little more for more sustainably sourced food?” 

Global responsibility

But without social change, there will be less environmental change.

Dunbar says: “The environmental part [seems] the most consequential and pressing, but we need to contemplate that if the social (elements) aren’t in place for people to care about the environment, then it is unlikely that their behaviours will moderate in a way that we can successfully impact environmental change.” 

Dunbar advocates for taking more global responsibility.

He says: “If you look at COP26, I think on balance it probably was successful in that there are commitments being made that have put it front of mind, and companies can drive it more internationally than governments can.”

Integrating ESG into the investment process isn’t so much a destination as a journey.Flora Wang, Fidelity

But he says one of the failings of COP26 was that for emerging economies, the social building blocks would have to be in place before the environmental challenges can be tackled.

He warns that if people are worrying about (where they will live) and how they will look after their kids, then the carbon-led building out of an economy that people have in the west will be limited.

For investors, this will force them to think about all aspects of ESG – not just the environment – and how their money can be invested in a way that helps to put all the building blocks in place, in the right order.

Another discussion that advisers will need to have with their clients, especially when considering global sustainable investments.

Challenges for governments:  

For Ashley Hamilton Claxton, head of sustainability at Royal London Asset Management, it takes governments, industry and consumers collaborating together to turn the world sustainably. 

But Dunbar takes a cautious – if practical – approach. 

“Can you get elected as a politician if you are going to fund billions of pounds of renewable power infrastructure in emerging countries?” he asks.

That said, he believes governments are stepping up regulation to create greater transparency and accountability to investors, who have the ultimate say.

He calls this ‘outsourcing’ of responsibility to the industry.

He explains that regulation, disclosures and transparency means his company can make informed choices about where to invest, or where a potential organisation is on their ESG journey.  

While there is still a lot of voluntary disclosure – and it is up to investment managers and advisers how much store to set by this – Dunbar feels that some level of monitoring and compulsion is needed. For this reason, education is also vital.

Dunbar adds: “We can [reach] young people who are passionate about the environment and social issues, but can you educate adults if they don’t care in the first place?”

This is why he believes ESG threats and implications have to become even more visible, and for the industry as a whole to make progress in helping people to understand the nature of the challenges before this can be translated into day-to-day decisions.

Wang adds: “Integrating ESG into the investment process isn’t so much a destination as a journey – one that gets better as more people undertake it.”