By Shailesh Dhuri
The backlash against ESG continues. Several opinion makers have called for an end to ESG in recent week and months. However, the underlying principles have merit and a place that will live, even if the form evolves.
The backlash against ESG grows. Mainstream media is not just carrying anti-ESG articles, it is now giving a sensationalist spin. ‘Billions flow out of ESG as investors turn their backs on green’ investing, wrote an article in a major paper. Read the sub-text, the articles mentions an outflow of £2.5 billion out of ESG funds in five months, that is negligible considering ESG focused funds are estimated to have £2.5 trillion of assets.
‘ESG is beyond redemption: may it RIP’ said the headline in a global business paper. Media seems to be working overtime to turn a push into a shove.
To be sure, there are issues that need fixing. However, the concerns of the large asset owners like pension funds or sovereign funds or regulators are very different from the issues being voiced by armchair experts. In this article, we will unpeel the layers to show the genuine issues versus those voiced in some of the recent media articles with frivolous headlines.
The ‘ESG fails investors’ stance comes from the underperformance of ESG focused funds in the last couple of years. The Ukraine war has led to fossil stocks and arms companies outperforming, while simultaneously stoking inflation that has dampened demand in normal business sectors and slowing down major economies. The only sectors truly outperforming are the ones shunned by ESG.
This criticism reflects poor understanding of factor investing. It is well accepted that a factor strategy may not always outperform. For example, in a runaway bull market, value will underperform. In other words, mere short or medium term underperformance is no reason to discredit a factor.
A recent piece asserted that ESG fails corporates too; ‘higher ESG score can increase value smaller and serving niche markets, while decreasing value at other companies where it adds to costs while doing nothing for revenues’, said the article.
We argue this is short-termism. Are these critics trying to suggest that companies should stop focusing on Net Zero? If so, they are denying climate change and The Paris Agreement, which is a legally binding agreement agreed to over 190 countries. Trump had made US exit Paris Agreement, Biden got the US back in. Most other countries are firmly committed. How will the countries reach Net Zero, if their corporates disregard it? ESG has social goals as well for corporates, like respect for local communities, and treating employees equitably. If corporates are encouraged to disregard these goals, then we will be back to cowboy capitalism.
‘ESG lowers risk, so means lower returns’ is another favourite criticism. This is classic theoretical, arm chair understanding of investing. The key is the sequence of events. Consider this: A fund buys a stock; the company works on improving ESG metrics – for example, better governance, better supplier relations, reduced energy consumption, better product governance – in other words, business risk reduces; the market recognizes this, bids the stock up. Will an investor underperform or outperform in such a scenario? Risk is not static; management action changes it. In fact, long investing is mainly a bet on the management’s ability to outperform in risk management. The purpose of ESG ‘engagements’ – investors discussing improvements with portfolio companies – is to reduce risk. This reduction in risk will not lower returns, but will increase it.
ESG also has the key G pillar, which most commentators ignore. Agency problem is a well-defined problem and G addresses that between owners and managers.
In short, most of the arguments made in recent media articles are off the mark, and likely biased with political agenda.
This is not to say the ESG market does not need change. Reforms are needed at various levels: corporate disclosure frameworks and in the way rating sellers work and are regulated.
On November 17th, 57 organizations, representing over EUR 8.5 trillion in assets, released an open letter for the European Union to act on corporate ESG disclosure standards. “Preparers and consumers of environmental, social and governance (ESG) data all over the world are still struggling with a profusion of reporting frameworks and standards like that do not enable consistent and comparable disclosures. We therefore strongly support the initiative of the International Financial Reporting Standards (IFRS) Foundation to create an International Sustainability Standards Board (ISSB) to develop globally accepted standards for sustainability reporting that can be adopted worldwide” said the letter.
ESG ratings sellers have created a mess that needs to be cleaned up, large institutional investors have been asking for greater regulation of rating sellers. One of the recent calls for change came from the Norges Bank Investment Management (NBIM) that wrote an open letter to the European Commission (EC) in August this year asking for changes to the rating provider (ESG Seller) ecosystem. In the letter, NBIM said, “We concur with the European Commission’s assessment that the ESG rating market suffers from deficiencies which could undermine investors’ and rated entities’ confidence in ratings” NBIM urged the EC to require used the ESG Sellers to improve the transparency on the characteristics of ESG ratings, their methodologies and data sources.
It must be noted that while it asks for reforms, NBIM is totally supportive of ESG. “As a long-term and global investor, we consider our return to be dependent on sustainable development in economic, environmental and social terms” wrote NBIM in its letter.
In other words, the real players in the market are working to strengthen ESG practices, they are not calling for an end to ESG. For a sustainable future, that is what is needed.
(The author is Shailesh Dhuri, CEO, Decimal Point Analytics, and the views expressed in this article are his own)
