abrdn: Equities and Sustainability: was 2022 the death of ESG?

Some context here is useful.

Interest in environmental, social and governance (ESG) factors in investing rocketed during the early days of the Covid pandemic some three years ago.

Many factors contributed to this phenomenon, but the effects were: public and investor interest soared; flows to ESG strategies accelerated; and valuations in some segments of the market began to surge.

Some of those factors reversed over the course of 2021 and 2022, the net effect of which has been that the efficacy and performance of ESG investing came under scrutiny.

Changes in interest-rate expectations, the relative performance of energy and commodities securities, allegations of ‘greenwashing' – the misrepresentation of sustainability credentials – and, more recently, the political debate surrounding ESG in some countries, all helped sharpen criticism.

The problem(s) with ESG

Although the sustainability movement pre-dates this, the term ‘ESG’ was first coined in 2004 as part of a UN Global Compact Report – Who Cares Wins. That same report, citing a World Economic Forum survey, discussed barriers to ESG integration including:

• Problems of definition of ESG issues
• Problems of making and measuring the business case
• Problems with quality and quantity of information
• Problems of skills and competence
• Problems of differing time horizons

Almost 20 years later, none of these challenges have been satisfactorily resolved. This failure to reach something approaching consensus has contributed to the misunderstanding of, and scrutiny over, ESG we’ve seen in the past few years.

The ‘Big 3’

We see three issues in particular:

1. Confusion as to what ‘ESG’ refers to.

The ESG ‘family tree’ encompasses distinct strategies that may include ethical investing, social investing, ESG integration and impact investing.

In the early days of ESG, the focus was generally, but not exclusively, on exclusions – strategies that focus on what you can’t own (e.g., gambling stocks).

Over time, the focus turned to ‘ESG integration’. This places a greater focus on ensuring that ESG factors are considered as part of an investment process, generally with the aim of understanding the overall quality of management and broader business. We can think of this as generally, but not exclusively, concerned with minimising the negative impacts of investments.

Finally, and more recently, we’ve seen the emergence of an investment strategy that seeks to maximise the positive effects of investments – impact investing.

These three strategies are quite different, yet fall under the single banner of ‘ESG investing’. With such a wide spectrum of strategies available, it’s understandable there’d be some degree of confusion around what an ESG fund should invest in, and the outcomes that can be expected.

2. Confusion around the role of fossil fuels and commodities in an ESG portfolio.

The last few years have seen strong performance from securities linked to commodities and fossil fuels. Many ESG funds (definitional issues notwithstanding) may have a lower, or zero, allocation to these sectors.

After Russia’s invasion of Ukraine last year, we’ve seen this lack of exposure represent a drag on ESG fund performance. There are a few points here worth elaborating on:

• Hard commodities and fossil fuels can, and may well, either out- or underperform for periods of time. Over the short to medium term, the performance of these assets is driven by supply and demand. In recent years, we’ve seen material supply- and demand-side shocks, leading to both under-, and subsequent, outperformance by these assets. To suggest that the recent performance of fossil fuels is evidence that ESG is ‘dead’ is clearly unfair and inaccurate.
• Some ‘ESG’ funds will not have exposure by virtue of their strategy – particularly those focused on investing in clean-energy technologies. To suggest that outperformance of fossil fuels in some way invalidates ’ESG’ is simply wrong. If anything, higher fossil fuel-prices typically act as an incentive for further investment into cheaper renewable-energy sources.
• Some ‘ESG’ funds may legitimately have exposure to hard commodities and even to fossil fuels. Many hard commodities (e.g., copper) are fundamental to the transition to low-carbon energy. Unfortunately, the mining of commodities can be dirty, dangerous, and disruptive to communities and efforts to preserve biodiversity. Yet should ‘ESG’ funds avoid commodities?

Meanwhile, some ‘ESG’ funds may also have legitimate exposure to fossil fuels where there’s a focus on helping a company transition towards to a cleaner energy. A more nuanced discussion is therefore required around commodities and fossil fuels, rather than a general and blanket view that neither commodities nor fossil fuels belong in an ‘ESG’ portfolio. To suggest that an ‘ESG’ fund owning fossil fuels is somehow incongruent is to mis-understand the breadth of strategies that ESG encompasses.

3. Confusion over whether funds do what’s expected.

Allegations of ‘greenwashing’ have dogged the industry in recent years. While there are many reasons for this, the two points raised above haven’t helped.

With ‘ESG’ or ‘sustainable’ casually thrown around as catch-all labels, there’s sometimes confusion over what an ‘ESG’ fund should be investing in and what kind of outcomes should be expected.

Claims of ‘greenwashing’ are often closely related to a fundamental misunderstanding of what ‘ESG’ means. This can often lead to unrealistic expectations.

ESG – alive and kicking

Despite the above, ESG is not dead.

While scrutiny has intensified, we’ve not seen any change in tone from our clients, fund flows remain resilient even in volatile markets, while the opportunities, if anything, are clearer than they were in early 2020 (given, for example, the momentum of climate change).

What we’ve seen is greater scrutiny of processes and outcomes, with stakeholders wanting to see more evidence of approaches to ESG for strategies, particularly with reference to the stated aim of a particular investment. The emphasis is on disclosure and verification – a positive market development.

Areas for improvement

However, our industry needs to work harder to address the five barriers to ESG integration first raised in 2004. Failure to do so, or to at least provide greater clarity, will continue to hinder further progress. This isn’t easy – some of these issues won’t, or can’t, be satisfactorily resolved. The issue of differing time horizons, for example, is broader than the ESG debate.

But there are areas where the industry can do better. Part of this involves better fund naming and labelling. Part of this involves better communication around processes and outcomes. Taxonomical clarity will come in part from regulators in many markets, but globally this is an area where the industry can do more.

Finally, part of this involves using language to better convey sustainability ideas. Perhaps ‘ESG’ isn’t dead, but maybe the terminology we’ve been using is past its expiry date and needs replacing?

At a time when we need to address urgent global challenges – to minimise negative impact and maximise positive effects – addressing these concerns is paramount in winning and retaining the trust of capital markets.

This article was originally published on the abrdn website.

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