For or against? Partisan or not? A fad or real?? Caricature is fashionable and ESG is unfortunately no exception. What’s more, data and measurement challenges, vested interests, politics, and marketing further obscure the reality. We believe that much of the current debate over ESG, sustainability and responsible investing stems from a fundamental misunderstanding about how we call on finance to address the environmental and societal challenges we face: expectations are often idealist and short term focused, where sustainable finance is simply about mitigating risks and capturing long term opportunities.
ESG is information, not an investment style
ESG is not an investment approach. It is not yet quantifiable like Growth, or Value, or Index investing styles, and it may never be. ESG is about information. It is about incorporating data into securities analysis, risk management, and portfolio construction. It is about Environmental, Social, and Governance issues which are not being priced in, that is, externalities (or true costs) and even internalities like tobacco, not reflected in the valuation of the equity and credit. Some of these are more ethical, moral, or cultural in nature, while some consider long-term economic development and what may be required for that economic development to be sustainable and inclusive.
Hence, ESG Investing is an umbrella concept that means different things to different people. It can range from an investment strategy which excludes companies based on religious or cultural considerations (e.g. excluding alcohol, tobacco …), to explicitly seeking to finance the energy transition of a chemical company or supporting specific charity projects like inclusive education and sheltered housing.
What is ESG not? ESG is not a partisan opinion
ESG is about the analysis of presumed extra/non-financial factors which may affect the value of an investment. As it deems them financially material, Sustainable and Responsible Investing considers many of those aspects by pricing in, or ‘internalizing’ these critical externalities. The ESG information is incorporated into equity and credit valuation, risk modelling and portfolio construction to 1) identify and reduce sustainability risks, 2) to understand and capture sustainability-related opportunities and 3) toassess and mitigate negative repercussions for the environment and society. No more, no less.
From that, who rules over the credibility of sustainability claims? Who determines whether these assertions are fair, or are misleading and exaggerated? Against whose standards or reference framework do we assess these claims? Are we considering the complexity of what is at stake and the many science-based initiatives and trajectories (read transition)? Or is it interpretation based on patchy data and self-assessed disclosures of data collectors?
At the moment, the answer to ‘who sets the rules’ remains incomplete. We have recently seen strong progress, particularly in Europe where the EU Commission has lead the way. Yet, the regulator has not yet fully defined environmental objectives or criteria and needs to clarify how we should finance the energy transition and its social impact. Other ‘rules’ are set by associations such as NGOs, or lobby groups, which support some specific environmental, social or economic cause without reference to the broader context or the unanticipated consequences.
Very often, the latter are value judgements. In this regard, we are all right and wrong at the same time. In the end, the financial industry is a steward of capital. We need to acknowledge that it operates in an interim or transition phase today. And yes, greenwashing erodes trust in sustainable finance, however, silo thinking or setting the bar unrealistically high for investments does not advance the cause of sustainability. It could even slow or reverse the much-needed steering of capital flows to finance a more sustainable and inclusive economy. So, the challenge is to set strict enough investment definitions for ‘sustainability’ and ‘impact’, and yet not to set the bar so high that we detract from the end goal of transitioning to a more inclusive and sustainable economy. Demanding perfection of corporates and investors gives no incentive for improvement.
“We will be relentless in our pursuit for perfection. We won’t ever be perfect – but in the process we will achieve greatness”Vince Thomas Lombardi, famous American Football Coach
Difficult to measure? … yet rooted in fact
Real sustainable impact is very hard to capture, and even harder to prove due to the lack of reliable data. Measurement, while improving, remains an area of contention. It is further complicated by the fact that some of the objectives lie decades in the future.
A sustainable economy? It is not a question of where we want to be in 10, 20 years. More importantly, it is a matter of how we are going to get there. In the short term, it is a balancing act that requires ambition and courage, and the acknowledgement that it is going to be a bumpy and imperfect journey. Some difficult and expensive choices need to be made by policy makers, regulators, and financial actors. But in all those challenges lies the opportunity of creating sustainable economic growth. Sustainability considers the complexity of many ecosystems and its stakeholders, the dynamic and the connectedness among them. ESG, Sustainable and/or Responsible (or any other related acronym) investing, is about that. It is rooted in the principles of sound corporate governance and business. Each of these elements is based on facts, data, and science, with all its imperfections.
As a consequence, regulation and society are changing, with very different requirements and expectations of what role companies and investors play. Whether rapid or slow, energy transition is clearly underway, disrupting business models with clear social implications for employees, customers, and the public.
These are all real risks. Just because we cannot measure them accurately or consistently does not mean we can wish them away. At some point they will affect our investments. That is precisely what sustainable and responsible investors should do, consider the risks and the opportunities that arise.
Pay as you go
Isn’t it ironic that it took a war in Ukraine for European governments and society to grasp the urgency and the need of energy transition? The actions of one authoritarian leader did more than a $100/tonne carbon price to propel Europe into massively upscaling its Green deal. It won’t be enough, and it will come at an incredible cost.
He who incurs the costs, should pay the costs.
Sustainable and responsible investing, with all its flavours and its colours of green and grey, is about intentionally incorporating the issues faced by our society into the decision making process, even if those issues lie decades into the future, and are not yet priced by markets or taxed by governments. In the end, it is for governments and society to create an environment for capital to flow to best meet the needs and challenges.
The nature of the externalities is that the beneficiaries are not paying the full costs. Therefore, are governments doing their job? Are they efficiently regulating the environmental and social (mis)behaviours of corporates, investors and end-consumers? Should they be pricing in these externalities created by corporations, for example through the oft-mooted carbon tax? We doubt that current regulation in Europe, the UK and the US will allow the financial industry and all its stakeholders to sort it out.
This is the misconception about ESG, and about Sustainable and Responsible Investing. Very often, sustainable and responsible investors go beyond today’s bottom line and consider the long-term impact of our investment activities – and the cost of externalities which someone will have to pay in the future. Measuring that impact and assessing whether it is sustainable enough remains a judgement call. In some sense, it is a matter of drawing the line.
Ethically, the sustainability conversation should consider all stakeholders. But in terms of the profitability of a company or an investment, it might be argued that the costs of considering some stakeholders are so long-term, or difficult to quantify, that they are not being properly weighted in our hard calculations.
Tail risks are long-term – until the moment they hit your portfolio
For all issues encompassed by this loaded phrase, ESG, how can we possibly analyse the performance difference when most of the impact will occur over the next few decades? The sustainability risk landscape is becoming more complex and interconnected. There is a tension between short term and long-term sustainability. At some point, externalities become so expensive that they must be paid for by some stakeholder(s). The cost of these externalities, whether environmental, social, or some combination of the two, as well as the opportunities that arise from the changing society, become substantially more important to the long-term investor.
Our Candriam ESG Convictions
ESG is a broad concept. We must all be clear and transparent about our definitions, and continue to improve standards. Again, demanding perfection leaves no room for improvement. We are all part of the ecosystem – the ecosystem of our natural environment, and of our interconnected societies. It has taken quite a long time. The climate change argument has now moved on from ‘Is it real?’. We now have scientific evidence that it is real, and the damage is already expensive. The argument now is how do we deal with it, and who pays.
The actions we take and the capital we deploy must not create new externalities. What about human rights? The shareholder should profit from the manufacturing of solar panels and its other benefits, but the shareholder should not profit from using child labour to produce them. We believe the energy transition will benefit everyone as the climate threat is reduced. We must ensure that it is a fair, and just, transition. Jobs will be lost. Jobs will be created. We can balance these changes so interconnected stakeholders can share the benefits.
At Candriam it has been, and remains, our conviction that companies which embrace sustainability-related opportunities and challenges in combination with financial opportunities and challenges are the most likely to generate shareholder value.
So we shall we lead the music!