Growth in ethical funds is accelerating, but our ability to assess them isn’t

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Also last month a court in the Netherlands ordered Shell to cut its CO2 emissions by 45 per cent by 2030 in an action brought by environmentalists.

Companies are being asked or even compelled to furnish their ESG credentials if they want to attract funds that increasingly are being allocated by funds that use some form of sustainability framework, and avoid being targeted by activist investors for their perceived ESG shortcomings.

The funds, with fiduciary obligations to their clients, can justify activism – and attract more funds under management and generate more fee income – by pointing to superior financial outcomes for their own investors.

Those outcomes, however, aren’t quite as clear-cut or as easily measured as it might appear.

One of the striking findings of the UBS survey was that four of the top five sustainable investment themes cited by the respondents were climate-related – renewable energy and energy efficiency, climate change adaption and mitigation, pollution prevention and control and sustainable water and wastewater management.

There’s an easy and obvious strategy for meeting that checklist and delivering superior investment performance.

All a fund manager has to do is to tilt their portfolio towards tech stocks, particularly the mega techs that have dramatically outperformed the overall market over most of the past decade. Those stocks have a very light carbon footprint.

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It is also conceivable that all ESG does is screen out poorly-managed and poorly-performing companies, and that non-ESG-labelled funds that screen for well-managed companies and have a sophisticated risk-management process could (and do) produce equally stellar, or better, returns.

Performance of ESG funds might also be impacted by the flows of funds into the sustainable investment sector, which could act to drive the share prices of companies that have few controversies over their environmental impact, their governance or social impact. If enough funds have similar investment screens, the money flows could be material.

A more complex question is raised by sectors with large carbon footprints. Can, or should, an ESG-labelled fund investment in a mining company? What if the company is producing superior financial returns while actively trying to reduce not just its own carbon emissions, but those of its carbon-intensive customers?

Too many frameworks

Economies, particularly developing economies, will need coal-fired energy, oil and gas and iron ore and other resources that have large carbon footprints for decades to come.

While it is an easy decision for an ESG-labelled fund to make, is it socially responsible to reduce access to capital for the companies that provide those resources or, more particularly, for those that are actively trying to reduce the emissions throughout their supply chain?

Governance factors are, to date, perhaps more clearly correlated with financial outcomes, although there are exceptions. It could also be argued that, increasingly, sensitivity to wider social issues is a differentiator for companies that are reliant on a social licence to operate, and impacts the performance of their shares.

Good governance today would, of course, include policies to mitigate a company’s climate impact and protect its licence to operate.

At the broadest level, there is an interesting question as to whether adoption of an ESG framework for investing is a moral decision by the fund manager and its investors, or a financial one. It is the proposition that ESG drives superior outcomes that conveniently merges the two.

There is an interesting question as to whether adoption of an ESG framework for investing is a moral decision by the fund manager and its investors, or a financial one.

What’s clear from the UBS report is that there is no agreed framework or set of principles or guidelines that define what constitutes ESG-acceptable investments, or how ESG-influenced funds should measure and report on their performance, although there does appear to be increasing adoption of the Sustainability Accounting Standards Board’s standards.

The SASB is a not-for-profit founded a decade ago to develop global industry-specific standards for financially-material sustainability issues. Only about a third of the respondents to the survey use them.

Most of the respondents agreed that there were too many frameworks, which means retail investors are trying to compare apples and oranges when they select their fund manager.

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We also know — because the US Securities and Exchange Commission told us earlier this year — that there can be significant discrepancies between the funds’ public disclosures of their ESG approaches and their actual practices, and between their stated policies and their proxy voting.

There is a sense in the proliferation of funds claiming ESG credentials that while many of them are conviction investors, some of them are simply trying to get their share of a fast-growing fee income flow.

ESG is, from a corporate’s perspective, creating a fusion of activists, particularly environmental activists, with their shareholder bases.

That adds another layer of complexity and potential instability to the myriad of considerations that boards and managers have to grapple with as they try to drive financial performance while meeting shareholder and community expectations.

It would be helpful if there was a greater consensus and clarity around ESG principles, more transparency in the relationship between what ESG-labelled funds are saying and doing, and clearer and more granular attribution of the drivers of the funds’ returns relative to funds that don’t claim the socially responsible branding.

As the sector continues to grow, of course, the disciplines and protections and a stronger insight into the relationship between investing with a moral overlay and performance will inevitably develop. This will help make discussions of ESG funds’ comparative returns and their influence on companies and economies far better informed.

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