The ESG Bubble
Without a doubt, sustainable investment is a key lever to promote the change of business paradigm. However, it is increasingly important to have transparency so that these investment flows are truly destined for sustainable assets. Along these lines, we believe that European taxonomy will bring clarity and allow investors to focus their efforts on those investments that truly address social and environmental problems.
We share with you the article written by Kenneth P. Tucker where he speaks very graphically about this ESG bubble and the importance of the alignment between investment flows, the commitment of companies, together with citizen action and a more urgent and aggressive government policy to change the mentality and rules of the system.
Article “A Trillion Dollar Fantasy”, by Kenneth P. Tucker
The National Oceanic and Atmospheric Administration Observatory in Mauna Loa, Hawaii, reported that carbon dioxide levels in the atmosphere had reached 419 parts per million, the highest levels recorded in more than 4 million years.
That same day, BlackRock, the world's largest asset manager, announced another milestone: it had raised $1.25 billion for its investment fund for the United States carbon transition. The largest exchange-traded fund in history. The fund is a reflection of what the CEO of BlackRock, Larry Fink, communicates to his clients: “we don't see the company as a passive observer” when it comes to combating climate change.
Seeing the world's largest asset manager acting as a social and environmental agent should be a reason for optimism. Instead, it represents a kind of Kabuki game in five acts, according to Kenneth P. Pucker.
• Act I: Companies realize their responsibility to address growing social and environmental challenges.
• Act II: The academic class begins to research on the subject.
• Act III: Rating agencies, consultants and other financial institutions are rushing to create environmental, social and governance (ESG) products, highlighting the opportunity for companies and investors to achieve superior financial performance and social and environmental impact. A win-win circle.
• Act IV: Investors are slowly recognizing that ESG investing, as currently practiced, is unlikely to lead to a higher financial return and, for the most part, they are not concerned about the planet's impact.
• Act V: Wake up to the opportunities and limits of investment to address growing social and environmental challenges.
Where are we right now? We are in the intermission after the third act. As ESG investment has accelerated, the planet has experienced the hottest two decades on record, Antarctica has melted, income inequality in the United States has skyrocketed, and species have been disappearing at a rate never seen before for millennia. The Dow Jones Industrial is reaching new highs and asset managers are charging high fees to oversee an increasingly popular new investment category: ESG investing.
This is what is wrong. Investors are finally getting serious about ESG investing. But, as is currently practiced, most ESG investments have little or no social or environmental impact.
Companies wake up
Timberland, a footwear and apparel company that was then worth billions of dollars, was at the forefront of a cohort of companies committed to society and the environment. The company expanded one of the first corporate social responsibility (CSR) reports in 2002, paid employees for 40 hours of community service and installed renewable energy in its distribution center and corporate headquarters. Timberland believed that companies had a role to play in addressing growing social and environmental challenges.
Despite Timberland's incipient efforts, at the time the prevailing trend in business, academia and Wall Street was that Corporate Social Responsibility was, at best, a distraction.
Undeterred, the first practitioners of Business Sustainability received the support of a growing group of NGOs and consultants eager to help companies define and report on their social and environmental impact.
In 1997, the Global Reporting Initiative (GRI) with the support of the United Nations Environment Programme to create the first comprehensive framework for sustainability reporting. “In the early 2000s, there was a belief that sustainability disclosure was the missing ingredient,” says Ralph Thurm, former director of operations at GRI. “Data would allow consumers and investors to pressure companies to become more sustainable, providing benefits to people and the planet.”
Over time, Wall Street's vision of social and environmental issues shifted from enmity to indifference.
Investigations begin
A 2012 study began to change investor sentiment. This collaborative study between academics from Harvard and London business schools examined 90 “twin” companies, each in the same industry (for example, Walmart and Kmart Corp.), one classified as “high sustainability” and the other as “low sustainability”.
During the first six years, the stock price movements of high-sustainability and low-sustainability companies were almost identical. However, when compared over an 18-year period, the authors found that highly sustainable companies outperformed low-sustainability companies by an average of 480 basis points.
How the research fostered a marketing blitz
Armed with these studies, the Wall Street sales engine was launched. Goldman Sachs and BlackRock made acquisitions and new hires to support the launch of new ESG investment products, and research by Morgan Stanley and other companies “helped allay concerns that investors have to sacrifice returns to do good,” as The Wall Street Journal wrote in 2016. Investment firms collectively went from denying sustainability to becoming fierce advocates for it.
It's hard to overstate the change in cash flows generated by this narrative of mutual benefit. Just five years ago, the term ESG investment was still fairly new. Now, according to the Global Sustainable Investment Alliance (GSIA), one out of every three dollars invested globally is invested in ESG assets. Over the past two years, contributions to ESG funds have been almost double those of other stocks.
The unknown size of the market is a warning sign
There is no common definition or legal framework for ESG assets. According to the Financial Times, “ESG is, in many ways, a bank's marketing dream, precisely because it's so vaguely defined.”
Without security barriers, asset managers can build ESG-branded portfolios any way they want.
Regulators, particularly in Europe where ESG has a longer history, understand that this cannot continue unchecked. In Brussels, the European Union is working towards a taxonomy that governs what can be traded as a sustainable asset or ESG.
In the United States, the Securities and Exchange Commission has created a working group on climate and ESG, and the CFA Institute is drafting a new set of standards for asset managers. Meanwhile, greenwashing in the asset management industry continues unabated.
ESG ratings and investment are not designed to promote environmental and social impact.
Sustainability reports did not present systemic challenges. ESG investing, as currently practiced, won't either.
Wake up: There is evidence that finance can be a source of positive environmental change
Beyond the ESG game, there is good news. Pressure from investors and citizens has led more than 1,000 companies to commit to science-based objectives to deliver environmental results to protect the planet. Both companies and countries have recently accelerated their commitments to net-zero carbon goals. Japan and the EU have committed to becoming net zero emissions by 2050 and China by 2060.
At the same time, drastic reductions in the prices of renewable energy and batteries make it uneconomical to add new fossil fuel capacity in most parts of the world. Government support for technologies such as hydrogen energy, regenerative agriculture and plastic recycling, and a more broadly shared urgency to address environmental disruption, is driving the flow of capital toward climate technology solutions such as batteries and clean cement and steel. This is producing exciting and transformative solutions in fields including renewable energy, biobased materials and transport.
Investors and shareholders are also demonstrating that finance can be a source of positive social and environmental impact.
The three questions ESG investors should ask themselves
Until these tools are widely adopted, investors seeking an ESG impact should ask asset managers three simple questions to determine the likelihood that a fund is designed to generate positive environmental and social outcomes:
1. What percentage of your fund is dedicated to environmental or social solutions?
2. How do you measure environmental and social impact?
3. How do you evaluate the fund manager's performance?
The answers to these questions will make it possible to differentiate grain from straw and distinguish funds traded by ESG from funds committed to ESG.
The private sector will need to be an increasingly active and authentic partner in addressing social and environmental challenges. However, governments and policies must lead these challenges.
To do so, new rules are required, including carbon and water prices that reflect social costs, clean electricity mandates, commitments to remove internal combustion engine vehicles from roads, taxes on corporations and individuals that are fair and enforceable, and incentives for new solutions for sectors that are difficult to decarbonize.
The funding of the EU's Green New Deal linked to the environmental progress of each country is a model to imitate, while the reintegration of the United States into the global community by making aggressive commitments to electrify and decarbonize is good news. This is how the bursting of the ESG bubble took place.
So is investor preference for ESG assets and efforts to standardize sustainability reporting and regulate ESG investing. That said, don't expect these changes to adequately address social and environmental issues. That work must also come from citizen action and from a more urgent and aggressive coordinated government policy to change the mentality and rules of the system.
Source: Kenneth P. Pucker, Institutional Investor “The Trillion Dollar Fantasy”
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