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Commentary

The Investment Case for ESG 2.0

Sondre Myge, Head of ESG at SKAGEN Funds, says investors need to face up to the challenges of responsible stewardship of carbon-intensive assets.

The market is exiting the first iteration of ESG. This has primarily been dominated by avoidance – what not to own – and vague product KPIs with little or no connection to the real economy (think carbon footprints and ESG scores). Having recently travelled in Asia, learning from leading companies on how they are positioning, adapting and preparing for climate change risks, it is clear to me that ESG 2.0 – concerning financial risks and returns over the longer term – will be the name of the game.

Collapsing the binary

There are three key drivers for this change to ESG 2.0.

First, ESG 1.0 provided a very simplified picture of how the world works and how it should look in terms of the green transition. It depicted sustainability as a supply side issue, focused on pressurising companies to reduce the supply of ‘brown’ energy and encouraging them to build ‘greener’ power. Ultimately, it was about bucketing our complex economy into good companies versus bad ones.

The post-Covid reopening brought tightened energy markets, further restricted by Russia’s invasion of Ukraine. It also reminded us of the inherent social function of energy – we started talking about energy security, energy affordability and just transition, with climate change playing an important but secondary role.

The practical complexities of energy markets directly challenged the simplified version provided by ESG 1.0. Building more renewables seems to be the answer, but not on their own in the short term. Wind and solar made up just 25% of globally installed capacity in 2022 and only 12.5% of worldwide production.

Second, there lacks an integrated understanding of ESG factors as they relate to investment risks and returns. The rationale for why green is good and brown is bad from a financial perspective has been flawed – the reality is that any differences are not reflected in the bottom line today.

Wind producers are facing massive short-term challenges, evidenced by recent write offs. Equinor saw its shares plummet following its signal to increase green capex spending on a recent earnings call. Although negative from a long-term sustainability perspective, both are entirely coherent from a short(er) term return standpoint.

ESG was even labelled a factor akin to growth and value, when it was actually growth all along. Herein lies the analytical fallacy; the drive to attribute product contribution to ESG and real-world outcomes at product level, rather than as an enabling force. By now it should be clear that ESG as an input – and output – is firmly an endogenous rather than exogenous factor.

Third is the misuse of ESG data. The expression ‘what gets measured gets managed’ has been the long-running battle drum for producing structured ESG data. The converse, however, is also true; what gets mismeasured gets mismanaged.

The belief that ESG data is inherently similar to financial data and should therefore be structured accordingly is a fallacy, and its use to demonstrate the two dimensions above has understandably caused confusion for clients. For example, carbon intensity is typically disclosed and assessed on a revenue basis but this can be misleading or manipulated – assessment on a production basis is harder to calculate but provides a more tangible insight into actual carbon performance.

The result is that ESG 1.0 sounds out of tune and the latest Morningstar review of sustainable strategies, which showed that funds globally suffered net quarterly outflows for the first time on record in the fourth quarter of 2023, could be the canary in the coal mine if we don’t advance.

Ownership to the fore

The defining feature of ESG 2.0 will be ownership. Climate change is a systemic risk which cannot be diversified away, and one can neither change nor manage what one does not own.

ESG 1.0 has generated perverse incentives with undesirable outcomes, including the sale of physical assets from public to private markets and the transfer of carbon-heavy equity positions in secondary markets. Such trading removes ownership responsibility but passes it to investors less focused on ESG.

The consequence is obvious – poorer stewardship of carbon-intensive assets leads to higher real economy emissions. Selling parties allow themselves a brief hurrah for decarbonising their individual portfolios but society – and the financial risks we all face from climate change – are worse as a result.

Asia – no way around it

ESG 2.0 is especially important for Asia as the region becomes increasingly integral to our financial system. Asian economies are undergoing massive growth and development, provide significant goods and services to the West and are playing a key role in ‘friend-shoring’ as globalisation is recalibrated.

From an ESG perspective, Asia’s economic rise manifests in higher CO2 emissions, consumption and renewable energy usage. Countries have a duty to grow their economies and improve quality of life for their citizens. This has created a balancing act for investors who must juggle growing emissions and growing renewable energy deployment.

Active stock pickers hold the upper hand by taking calculated, managed sustainability risks and identifying companies that understand sustainability improvement and returns are symbiotic over a long-term investment horizon. Providing capital is the easy bit, finding the right businesses is another matter.

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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