Long ReadJun 22 2022

Does ESG have a future?

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Does ESG have a future?
(Dreamstime)

The term ESG has become a “catch-all” used to describe a wide variety of investment outcomes and is not helpful for clients, says Mirza Baig, global head of ESG investments at Aviva Investors.

But if the term ESG is so widely used as to be meaningless, and as both HSBC and Deutsche Bank get into hot water over their responses to ESG, how can a client ever have a diversified exposure?

Despite the strong inflows and performance of ESG-related mandates over the past three years, the latest data from the Investment Association indicates ESG mandates account for less than 6 per cent of the total assets under management of the UK open-ended funds universe. 

However, the direction of travel seems to be clear, as that 6 per cent represents a tripling of market share in around five years. 

But one of the major challenges is that many companies comply with only one of the aspects of E, S, or G, rather than all at once.

Whenever a new innovation in the finance world becomes trendy, typically, it evolves so quickly that it becomes problematic.Vikash Gupta, Var Capital

For example, Tesla’s contribution to the environmental cause is unquestioned, but with a chief executive who runs several other companies and is using his Tesla shares to raise debt to buy Twitter, it is possible it would fail on governance grounds. 

Similarly, while solar panels are undoubtedly a popular and valuable contributor to the portfolios of those whose priority is climate change, most solar panels are made with a component called polysilicon, where 90 per cent of the world’s supply of this is in the Uighur region of China where international organisations have highlighted human rights abuses, meaning some solar panel producers may not meet the social S criteria in ESG. 

So, does ESG have a future in its current iteration? 

Evolution of ESG

Adviser and indeed media professionals in our industry have been deluged with content from fund houses about new launches of ESG products, complete with tales about the rich heritage of the particular business in ESG investing, despite it being a relatively nascent asset class. 

The term ESG is in itself an evolution from the original 'ethical investing' concept, which focused on simply excluding companies that did harm and so was very subjective.

ESG was supposed to provide more clarity while also creating bespoke definitions around ethical sustainable and impact funds. But that created new challenges, as many companies correspond to some but not all of the criteria.

But for Vikash Gupta, chief executive of Var Capital, the evolution has happened too quickly and this is creating issues, as many clients may be seeking exposure to ESG as it was, while seeing an evolution into new areas, which may be confusing the issue and taking it away from the core of ESG as understood by many clients. 

He says: "ESG has evolved from an area of wanting to do ‘better’, led by the conscientious, to a world of risk management and a reputation, recruitment and investment tool for corporate boards. Whenever a new innovation in the finance world becomes trendy, typically, it evolves so quickly that it becomes problematic.

"Now, we’re seeing problems around ESG emerge, particularly with many organisations greenwashing – that is, paying lip service to it, rather than actually putting in real action to do better."

I had a look at three different reports and environmental dominates all of them, to the extent that the social is often just a few lines.Steve Kenny, Square Mile

Gupta adds: "As businesses now face increasing scrutiny and scepticism over their tick-box approach to their ESG initiatives, how will this impact the wider ESG sector? Will investments now have to be more durable, and will ESG investments now need to actively strengthen and do what they claim to do? How will this be measured?"

Baig says even the term ESG "has not been helpful" for investors, as it is too generalised. 

He says: “The issue is that the range of options available to investors are far subtler than the name suggests. One can have an ethical fund, that is a fund which excludes certain investments, or one can have thematic funds.

"We have an environment fund, for example, and we have a social fund, and of course there are investments in the environment fund that wouldn’t make it into the social fund and vice versa. And we would not call either of those funds impact funds, as that is a different category again.”

He feels the lack of subtlety is disadvantaging the reputation of ESG as a whole. 

He says that right now, while flows remain positive into ESG sectors, “the pace of increase has slowed just as market performance has”, but he says he believes that the present underperformance of ESG-related equities is the result of cyclical factors in markets, namely the decline of growth stocks relative to value stocks, and the majority of the equities that would typically qualify as ESG compliant are growth stocks, particularly in areas such as renewable energy and emerging technology.

Thematic approach

Steve Kenny, commercial director at consultancy Square Mile, says the investment industry places a lot of focus on the E (environmental) in ESG, as this “is the one that is fashionable now, but it is also the one that is easier to explain. 

"It's a bit more difficult to explain or measure the S (social), and to be honest, most companies have been doing the G (governance) for years, and because they view that as normal, they aren’t very good at highlighting it, so all of the focus has been on the E.

"I had a look at three different reports [earlier] and environmental dominates all of them, to the extent that the social is often just a few lines. ESG in Europe right now is just environmental, but we are starting to see the launch of thematic funds.”

Tom Sparke, investment director at discretionary fund house GDIM, says: “I think some parameters need to be set – will the fund strive for the best in E, S and G, or accept that some negative aspects are a natural by-product of change?

"Examples such as mining for the natural resources essential for electric vehicles or the positive impact of Tesla being overshadowed by its poor governance are just two of a plethora of issues that ESG allocators must face.”

I think that the future may be for more focused funds.Tom Sparke, GDIM

Thematic funds would likely focus on a particular ESG theme, for example, social inclusion, and are not aspiring to be catch-all funds.

Baig views thematic approaches as individual “solutions” to suit different clients, and says that new thematic ESG funds will be launched by Aviva Investors in response to client demand. 

His company offers both a dedicated environment fund and a dedicated social fund, and while both are marketed as ESG funds, “we would never expect two such funds to have completely the same holdings, but we think thematic is going to be important in the years to come”. 

Kenny says that while thematic funds are launching, he thinks they will be in addition to, rather than instead of, generalist ESG funds. 

In contrast, Sparke says thematic funds may be the future of ESG. He says: "I do think that the future may be for more focused funds, to deal with certain issues. I think that a low-carbon-focused fund or a socially responsible fund could make more of an impact than a fund that is broadly skirting all of these issues."

Lisa Beauvilain, global head of sustainability at Impax Asset Management, says one has to start from the premise that “there is no perfect company”, and focus on whether companies are moving in the right direction on each of the issues, something which may involve clients making short-term compromises, but the nature and extent of these compromises may also challenge each individual client's perception of what they are investing in and why. 

Regulation

The Sustainable Finance Disclosure Regulation, and whatever comes from the UK, are an attempt to provide a framework along the lines advocated by Sparke, with a fund classified by its level of intent around ESG. 

Hugh Cuthbert, fund manager at SVM, says a more generalist approach to ESG may be more appropriate for most clients, but the present SFDR system of regulation, which classifies ESG funds according to certain criteria, is unhelpful for those seeking to have a broad ESG exposure.

He does not regard an ESG fund being a catch-all as a problem, as he thinks all fund managers that are doing a good job for investors need to be using ESG criteria as part of their investment process. 

He says that classifying funds makes it harder for such generalists to operate, as they drive clients towards the more niche products, even if this is not the most suitable outcome for them.

David Thorpe is special projects editor of FTAdviser