ESG Growing Pains

This FactSet Insight shares our notes from a Jan. 25 CFA Society New York conference on sustainable investing titled “ESG Now and Beyond.” (agenda here) Our overall take from the presentations is that organizations and governments are truly wrestling with several meaningful issues raised in achieving ESG goals. Those issues were colorfully referred to as growing pains. Some of the key points we noted.

1. The past year has been exhausting for ESG practitioners and theorists. The pandemic revealed vulnerabilities in society that had been less evident to investors and somewhat primed the market to wrestle with externalities. The Russian war in Ukraine heightened the need to consider, along with ESG goals, both energy security and the assurance of a working supply chain for important metals. And recent extreme weather has motivated all states to think about adapting to the issues—e.g., sea walls, waterways, crop protection, desalination—regardless of views on causation. Through these periods, the outperformance of the fossil fuel industries and the underperformance of climate-tech has led to a period of challenges and rethinking of many ESG investment concepts, including fund construction, data, scores, and labels.

2. Tradeoffs between goals. The UN has 17 sustainable development goals (SDGs), and investors are coming to realize that companies must make choices between them over time. Research has shown that additional corporate spending to reach carbon emission goals, for example, often squeezes out other spending on safety or employee benefits. Similarly, investment in a manufacturing plant could provide jobs but may add emissions or contribute to biodiversity loss.

3. Time frame differences. Most investment managers are concerned with short- to medium-term performance whereas others think long term in line with their beneficiaries’ lifetimes. Many ESG issues are longer term, so arguments about ESG fund efficacy may be about time frames. Ironically, while most of the mathematical value of a company in a discounted cash flow (DCF) usually lies in years 10+, the market is usually concerned with years 0-10 in a DCF. Interestingly, too, a focus on a short-term ESG criteria may favor one type of investment whereas a focus on longer-term ESG criteria may favor another investment.

4. Where does ESG investing accountability begin? An early theoretical comment shared was that investors are ultimately responsible for conveying their wishes to their investment managers, who engage with corporates to achieve goals. Polls have shown that investors increasingly desire some impact on ESG goals. However, the degree of impact is less important. Coupled with the scale of the issues, the practical sense among the speakers was that policy makers and industry are ultimately the ones that must lead.

5. Divesting all fossil fuel holdings? One speaker remarked the market was reminded in the past year that divesting all fossil fuel holdings for ESG reasons has an embedded cyclical bet on the direction of oil and gas prices. It is not a one-way trade and will, at times, turn against a long-term shareholder.

6. Simplify and harmonize. There are several new and revised standards being promulgated in Europe, the U.S. and elsewhere in 2023, with additional agency guidance on the final standards to follow. Two of the main goals of the new standards are to simplify and harmonize global guidelines to make reporting more consistent, comparable, and widespread. Fewer topical metrics will result, but among the remaining more will be mandatory.

7. While simplifying, complexity is being added. Recent world conferences on climate progress have shown that biodiversity is a rising environmental topic. Given biospheres can get down to the square mile, and firms with global operations will have many, varied local biospheres, coming up with uniform guidelines and metrics will be difficult. Perhaps just being able to define current biodiversity will be a first positive step that companies will be taking.

8. ESG scores vs. PMI? Principle materiality indicators (PMI) are measures deemed worthy of tracking for the most significant ESG issues a company faces. Environmental examples might be carbon intensity by revenue, hours worked without incident, tons of hazardous waste, or fuel use per unit of output. These are similar to operating key performance indicators (KPI) used to operate a company or analyze an investment. Some panelists suggested an overall “E” score, for example, may fade in importance or be supplemented by company-reported PMI. Investors could then track PMI performance against goals. The importance of harmonizing what is measured, then, becomes important for adoption of consistent PMI reporting across industry.

9. ESG scores didn’t help in 2022’s energy rally and technology decline. The market has been wrestling with the efficacy of aggregated scores for some time, and some panelists stated many funds and ETFs don’t depend on the overall scores much. A company with high “E” scores but low “G” scores (Tesla was an example given) would look average in the aggregate, yet it might be valuable to express environmental values. Instead of aggregated scores, funds tend to use component scores, judged risks in the investment horizon, and outside information with a strong eye toward tracking error. All that said, many funds are evaluated for greenwashing by measurement against the aggregated scores, so it will take time to sort the debates on labeling and portfolio construction. Ultimately, however, funds will better explain what their approach is—with better and more consistent holdings data helping defend the explanations.

10. Europe leads the ESG movement and will be establishing practices that the rest of the world will have to follow regardless of what, for example, the SEC or U.S. companies are willing to accept this year. While still evolving, European rules will require estimates on customer (scope 3) emissions, for example, and will likely include carbon-based tariffs on traded goods. It will put pressure on countries trading with Europe to adopt similar regulations, including carbon taxes even if their home regulators don’t require them.

11. Negative carbon. There seems to be an emerging consensus around the need for negative emissions (capturing carbon out of the air), hydrogen, and small-scale nuclear. We highlight the rationale for negative emissions projects in particular because they are underpinned by the reasoning that the world likely will overshoot that atmospheric carbon level, which suggests an average temperature increase greater than 1.5 degrees centigrade.

There is a positive take! On a brighter note, many of the speakers seemed to convey that while the ESG world is under a great deal of turmoil, it’s more about growing pains rather than a terminal condition. The issues are just too important to society and indeed carry material economic risks for companies and governments in the long term.

The point was also made that investors have been using a wide range of fundamental investment criteria that waxed and waned in efficacy long before ESG came along. Performance of stock prices the past few years and the recognized importance of energy security have been helpful, too, in a healthy, ongoing rethink of ESG. The result may be less of a focus on pure ESG scores and more on the analysis, financial materiality of risks, and the improvement process. Indeed, bringing ESG data "interoperability" with the financial statements may be the end game. Recognizing all the divergent points of view is an important step toward reconciling them.

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