ESG: Toward a Sustainable Approach to Investing

Sustainability may be a long-term megatrend, but investors face plenty of short-term challenges, says Patrick Ghali, Managing Partner, Sussex Partners, in the first part of a new series.

With the introduction by Europe in March of this year of the Sustainable Finance Disclosure Regulation (SFDR), it should be clear by now that ESG considerations will be an integral part of any investment strategy going forward. The reasons for this are manifold, ranging from the necessity to create a more sustainable and fairer future, to prudent financial risk management (such as consideration of regulatory risk and orphaned assets), as well as nascent alpha opportunities resulting from new markets being created (such as carbon credits). The EU, for example, has committed €470 billion to developing hydrogen alone over the next 30 years, so there can be no doubt that this is now a long-term megatrend, rather than a short-term theme.

Just as manifold though are the potential pitfalls of ESG investing. Firstly, there are no clear industry standards when it comes to measuring ESG factors, and different managers apply varying and individualistic standards and metrics to their investments, many of which don’t withstand proper scrutiny. Greenwashing, as a result, is widespread.

Under scrutiny

With even the largest managers coming under global scrutiny for the integrity of their sustainable investing credentials, the challenge for smaller managers is all the greater. While some managers apply unsophisticated and obvious basic filters to avoid specific exposures, others analyse their investments choices at a much more granular level to try and understand the factors and broader ramifications of each factor in detail.

These variances in approach make it extremely difficult to understand the actual impact of ESG filters at a portfolio level. It also means that investors need to spend additional time and resources learning each manager’s specific processes and approaches, rather than being able to depend on a standard set of globally accepted and reliable ESG measures. The additional burden that this imparts on investors is not to be underestimated and means that they need to become experts in assessing ESG factors themselves, which given the lack of industry standards becomes somewhat of a circular problem as different investors undoubtedly will have diverse approaches to this issue.

Due to the complexities this creates, many investors have chosen to partner with specialist firms to shortcut the learning process. These firms act as independent guides and validators, helping to support and shape investors’ ESG frameworks. But while this seems to be the best possible option at present, it doesn’t solve the fundamental problem of a lack of universally adopted industry standards.

In the absence of standards, and while the industry and governments work towards a solution, being able to clearly and logically back up whatever approach an investor chooses will be key. While many consultants in this space apply their own proprietary blend of factors, these need to be able to withstand scrutiny and be clearly measurable, to allow ongoing and meaningful reporting to end-investors. Overly simplistic and high-level filters no longer are fit for purpose.

Bringing ESG into sharper focus

A second challenge confronting investors is which ESG factors to focus on in the first place. ESG is a broad church, a catch-all phrase that encompasses a multitude of different possibilities and lacks specificity. To achieve some degree of manageability here, investors may want to consider the UN’s 17 Sustainable Development Goals (SDGs). The SDGs allow investors to evaluate and tailor their investments with a much sharper focus than possible with the nebulous classification of simply ESG. The SDG categories enable investors to identify specialist managers in narrower niches, such as life under water, climate action, or affordable and clean energy, so true impact can be better measured.

Liquidity and timeframe of holdings is another challenge. Different investors will have individual liquidity requirements for their overall portfolios and, unsurprisingly, ESG and SDG options are now available across the full liquidity spectrum, from multi-year lock-up private equity to daily liquidity UCITS strategies. We estimate that the universe of UCITS funds that classify themselves as ESG/SDG now entails approximately 100 managers, mainly in some derivation of equity strategies with the majority of these having been launched by managers in Europe.

For the time being, there seems to be more focus on ESG/SDG in Europe where SDFR regulations[1] required all funds marketed into the EU under AIFMD to update their prospectuses by 10 March 2021 to declare their ESG status and whether they are Article 8, 9 or “other” types of funds, with potential adverse tax implications for funds classified as “other” being a distinct future possibility.

But whilst Europe has historically led the shift to responsible investing, Asia is catching up with Europe. Today, a number of Chinese mangers have not only created credible ESG programs but have been able to demonstrate clear alpha attributable specifically from applying ESG/SDG criteria to their investments with a strong focus on the environment and related technologies. Similarly, Japanese activist managers have been able to successfully generate higher returns by focusing on the ‘S’ part of ESG. There is little doubt that as managers in Asia continue to demonstrate added value from ESG, other peers in the region will follow in their footsteps.

Overwhelmingly active?

This leads to another very current debate as to whether ESG and SDG aims are best achieved via an active or a passive investment approach. Intuitively, it would make sense that active management is better suited. NATIXIS, a leading French wealth and asset manager, in a 2017 report, estimated that index investing equated to economies on track for a 4.5 -5 temperature increase, far from the 1.5 goal that has been set by global governments. The rapidly changing regulatory environment, which can lead to entire business models no longer being feasible (such as further extraction of carbon reserves being disallowed), rapid changes in investor/consumer sentiment relating to certain sectors and companies (especially in the age of Reddit), and the creation of brand new markets (think green and blue carbon credits), all indicate that an active approach should be better suited to navigating an investment environment where ESG considerations are fore. So perhaps ESG/SDG considerations will herald a new golden age for active managers.

We will drill down into each of these themes is subsequent commentary for ESG Investor and hope to provide readers with ideas on how to best approach this topic, to raise some questions investors should consider before and while investing, and to point out some of the inherent pitfalls.

[1] Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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