Concern about climate change is rising around the world. On the streets, in the media, in parliaments, among central bankers, citizens and investors. With public awareness having reached a tipping point, sustainable investment is on everyone’s lips and has moved from niche to mainstream, from the feel-good fringes to the center of business decision-making. Unfortunately, greenwashing is rising too!
There has never been a better time to talk about and act on sustainable investing. Recent regulatory and policy developments, such as the EU Action Plan on financing sustainable growth and the related legislative proposals, have led to greater awareness among financial market players and the investor community alike. Bank of America estimates that based on demographics, a massive $20 trillion will flow into ESG funds over the next two decades: That’s equivalent to the current size of the S&P 500.
This “demand tsunami” is accelerating the metamorphosis of portfolio management community. It’s becoming increasingly difficult to analyze assets without Environmental (E), Social (S) and Governance (G) considerations. Balance sheets, bottom-line earnings and business case analysis should all include an assessment of intangible assets (e.g. reputation, brand and intellectual property) but also ESG metrics. Financial metrics are not enough anymore.
By impacting the cost of capital of company, integration of ESG considerations helps to drive our world in the right direction.
The financial industry’s transformation is driven by conviction but clearly also by opportunity. Whatever the reason, the great take-away is that financial markets are creating a self-reinforcing mechanism. By impacting the cost of capital of company, integration of ESG considerations helps to drive our world in the right direction.
But we also need to be realistic. Greenwashing1 is endemic, with many companies exaggerating their environmental (or social) progress and marketing of their products. This is true for the industrial world as well as for the financial world.
At first, any investor in sustainable financial product should know that ESG ratings remain ambiguous. The accurate measurement of environmental and social impact is an evolving concept with reporting standards still in their early days. According to MIT researchers2, the correlation among ESG ratings was on average 0.61 (implying that assigned ratings differ quite greatly between rating agencies), which compares to 0.99 for traditional credit ratings. Clearly, data quality is a top priority for any portfolio manager. How can one manage risk and spot opportunities, if you are not able to measure those with some accuracy? As well as providing empirical confirmations about ESG rating discrepancies, the same research paper also diagnostics the sources of divergences. The main ones are identified as the fact that different agencies have differing scopes of measurement and they assign differing weights to these attributes. This clearly demonstrates the need for more open and transparent disclosure standards as a way to improve the accuracy of ESG ratings.
Sustainable portfolio management doesn’t mean concentrating capital in a handful of behemoth companies which have the best ESG attributes.
Moreover, sustainable investment should not be perceived as a panacea to avoid controversies. Sustainable portfolio management doesn’t mean concentrating capital in a handful of behemoth companies which have the best ESG attributes. Rather, the industry should combine its ambition to deliver competitive performance with ESG considerations. This goal is better served by identifying the leaders and disruptors of tomorrow, while using an additional lens in the analysis of the company – one which assesses the sustainability of their business cases and action plans.
In essence, every investor needs to understand that financial market analysis has never been an exact science and will never be an exact science. There is no spreadsheet or martingale that can guarantee your investment will be fine.
Shareholders and asset owners demand actions from the companies they invest in, for instance the alignment to Paris Climate agreement. Citizens, pressure groups and activists are clearly stepping up, requesting the immediate end to investment in controversial activities. Financial flows are probably more timid, driving a phasing out of some activities related to, for instance, carbon emissions. Banks, asset managers and regulators are moving and taking steps to navigate climate change mitigation and adaptation measures, while activists are requesting a bold revolution. Sustainable finance promotes evolution not revolution. The direction is the same, but let’s face it, the speed is not exactly in sync.
Asset owners are pressurizing managers to put money where their mouths are. Walking the talk is a priority. In that sense, the talk needs to be optimistic and humble as they embark on a journey of learning by doing. Managing client expectations and being transparent on ESG should be crucial for any conscientious portfolio manager. Expecting portfolio managers to avoid controversies sounds like requesting a free lunch, or in today’s financial context, expecting a risk-free investment with an appealing and guaranteed return. In essence a wishful thinking perspective.
According to the Financial Times, proxy voting by investors and engagement related to the environment are now as frequent as governance related votes in the USA. A sustainable roadmap is becoming a prerequisite for firms, as is optimism (and ambition). Firms that have equipped themselves with these have already taken a step in the right direction.
Sustainable finance is not a panacea, neither an exclusive solution, just a tool inside the transition toolbox.
While civil disobedience and ‘extinction rebellion’ have been and still are game changers for raising awareness, the irreversible transition towards sustainable finance, while conformist, should help to control the blood pressure of those who consider financial markets as the lifeblood of economic systems. Sustainable finance is not a panacea, neither an exclusive solution, just a tool inside the transition toolbox.
1 From greenwash, defined by Cambridge dictionary as « to make people believe that your company is doing more to protect the environment than it really is.