The perception of ESG investing has changed since its zenith last year. Accusations of greenwashing are increasingly an occupational hazard for asset managers with fines, regulatory scrutiny and even police raids becoming pitfalls for those accused of transgressing the bounds of acceptable claims.
ESG has also become a pejorative term in some political circles, with woke capitalism – whatever that might be – apparently the epicentre of our current economic ills and ESG the root cause of the energy crisis. It is now fashionable to be an ESG sceptic.
How far we have come in that time. Then, the wave of enthusiasm for ESG encouraged inflated claims for its positive influence on investment returns and corporate profitability. “Win-win” was a an oft-quoted maxim for the still inconsistently defined application of ESG into investing practice. The real world has struggled to live up to those claims.
Most notable was the surge of inflows into ESG- and sustainable-labelled funds, many of which had been hastily rebadged or freshly deemed Article 8 or 9 compliant under the ever-evolving EU Sustainable Taxonomy.
Growing client demand galvanised enthusiasm for ESG, something that is now being tested by the war in the Ukraine, rising inflation and the first hint of outflows. Even surging support for shareholder resolutions on climate change last year has tapered off, with some of the largest investors appearing to hit reverse in the face of political polarisation on the energy transition.
Understanding incentives
The fractious debate on ESG is making it increasingly harder for investors to balance fiduciary duty and the increasing social obligations being placed on it, while avoiding accusations of greenwashing. The dropping of the social pillar of the EU Taxonomy underscores the difficulty of defining best practice. Adding in elevated inflation, monetary tightening and geopolitical tension to the mix just highlights the challenges facing investment managers, whose main purpose remains to make their clients money.
Increased scepticism towards ESG should be no surprise. Many of the criticisms levelled at ESG investing, such as inconsistent data quality, poor definitions, and no evidence of a permanent ESG performance premium, have validity.
What the sceptics miss, however, is that the rise in interest in the environmental consequences and the social impact of our economic and business models, and how they are governed, is not about specific corporate outcomes, but about the system as whole. There is no such thing as a sustainable company without a sustainable economic system. A net zero company (or even portfolio) is a meaningless concept unless the global economy achieves net zero. Indeed, being a sustainable leader or net zero-aligned may come at a cost if the system is not incentivised to reward leadership. Understanding incentives in a system are essential to understand how it operates and price inflation is a powerful force in changing behaviour.
Active stewardship
Parallel to the rising awareness of environmental and social issues in investing has been the increased emphasis on active stewardship. While the regulatory focus has been on stamping out greenwashing by investment managers, are we about to see engagement-washing as the next area of interest?
Corporate engagement has been a mainstay of good investment practice for decades, and was undertaken historically to improve corporate effectiveness through encouraging better governance and stronger capital allocation discipline to enhance the profitability of underperforming enterprises.
In recent years, however, engagement has become seen as a cornerstone of ESG, with most stewardship reports focusing on claims of improved social or environmental outcomes, rather than better financial performance. Some have even erroneously tried to position engagement as the only authentic way to implement ESG.
The seeming detachment of modern-day engagement from better financial outcomes for shareholders is just one missing element. There is also the challenge of demonstrating actual ESG-aligned outcomes from individual engagements when so much seems to revolve around letter writing with limited, if any, follow-up. The use of “unique” when describing engagement activities is always a cause for concern when so many investment firms now put engagement at the heart of their ESG approach. The increasing obligation to engage is in danger of rendering it a tick-box exercise.
Companies are getting wise to this trend and are learning to be engagement-friendly; if the goal is simply more disclosure, then it is an easy game to play. As anyone who has been involved in corporate change can attest, it is no trivial exercise and usually takes years of hard work to achieve. Good engagement, therefore, should never be a volume game nor a transitory exercise. Instead, it should focus on effectiveness within the bounds of practical reality and recognise the barriers to changed without direct intervention by governments.
Beyond narrowing the focus to opportunities with the potential for real change that support better shareholder outcomes, system-level engagement is an emerging way to transform the stewardship paradigm. System-level thinking is needed to fully understand the interplay between the myriad forces reshaping our world and recalibrating economic opportunities and defining emergent risks. It also helps investors understand where best they can influence the system to achieve the better social and environmental outcomes they are targeting.
Greater engagement with policymakers and regulators will be warranted for some activities to ensure the right incentives are created. For other objectives, engagement further down the value-chain may achieve greater impact, either with solution providers or even private companies, social enterprises or academia. Engagement will need to embrace the complexity of our natural, social and economic systems. This will require working collaboratively across a wide range of points of influence to achieve the necessary tipping points needed, especially for the most complex areas, such as biodiversity and climate. While this offers a vision of delivering more effective shifts in our system, it must come with a recognition that investors alone cannot solve every ill of our world.
