- Do we really have clarity of purpose when trying to make a difference through sustainable investing? The fear is that many in the finance industry do not know where they are going with ESG (environmental, social and governance). Consider our obsession with measurement and labelling of different ESG activities. From ethical to responsible to social investing, the list of labels, and different ways of measuring impact, sustainability, carbon-intensity, ‘green-ness’ and ‘ESG-ness’ is long. Yet none of them provides perfect answers.
- At Natixis Investment Managers, we would argue that the core objective of the responsible investment and ESG movement, which has led to the establishment of the Principles for Responsible Investment (PRI), is to help find solutions to societal problems through investment – problems now captured in the United Nations Sustainable Development Goals (SDGs)1. But are ESG integration and active ownership, two central pillars of the PRI, getting us much closer to those solutions?
- Since the emergence of ESG, a new set of measurement standards, performance benchmarks, detailed reporting and regulations has inevitably followed, but these are in many way useless because there’s still no common understanding of the wildly different aims people have in mind in pursuing ESG strategies: values-alignment, financial outcomes (risk/return), and/or real-world outcomes.
- Some investors have therefore begun to see ‘impact investing’ as a way of escaping the vagaries of ESG, also driven by the creeping awareness that negative screening2 and other exclusionary practices are unlikely to have ‘impact’ in the sense that they do not influence company behaviour or solve problems. And indeed, to date, there’s no empirical evidence that explicitly links sustainable investors’ negative screening approaches to changes in ESG practices. But studies also find that most funds with the ‘impact’ label are more of the ‘impact-alignment’ than the ‘impact-enabling’ variety – ie to the extent they have impact that would have happened without the investment and the label.3
- One of the great attributes of the financial services industry is its ability to innovate to meet the needs of an evolving world, but are we now so obsessed with the labelling of activities that we’re unable to move forward with enabling? Perhaps, instead of focusing on quantifying, labelling and measuring, we should be rigorously asking, what’s really going on?
Glossary of ESG Terminology
Active ownership involves entering into a dialogue with companies on ESG issues and exercising both ownership rights and voice to effect change.
Best-in-class selection prefers companies with better prospects of or improving ESG performance relative to sector peers.
ESG integration refers to strategies that integrate ESG factors into fundamental analysis to pursue alpha and manage risk, or may use sustainable themes to identify investment opportunities. Certain ESG strategies may also seek to exclude specific types of investments.
Exclusionary screening refers to avoiding securities of companies or countries on the basis of moral values and standards and norms.
Impact investing relates to strategies that may invest in companies/ organizations with explicit intention to generate positive social or environmental impact as the primary objective, alongside financial return.
Sustainable investments are ESG investment strategies aimed at generating financial performance through investments that focus on companies that are moving society towards a more sustainable future.
Thematic investing refers to investing that is based on social, industrial, and demographic trends.
Greenwashing is the practice of conveying a false impression or providing misleading information about how a environmentally sound a company's products are.
The PRI (Principles for Responsible Investment) is a United Nations-supported international organization that works to promote the incorporation of environmental, social and corporate governance (ESG) factors into investment decision-making.
When the concept of ESG arrived on the investment scene, among many things, it underpinned the UN-backed PRI, from which many asset managers’ and asset owners’ Responsible Investment Policies have been written. The principles have been widely embraced and they have spawned a true industry: ESG teams, ESG data providers, ESG conferences and ESG funds.
Arguably, a core objective of the PRI is to help find solutions to significant problems like climate change, modern slavery, inequality, poverty and hunger – many of which are captured in the coloured cubes of the SDGs. For asset managers, our challenge is to try to help solve these problems through things like ESG integration and active ownership. The purpose of our endeavours is to shift capital to where it’s most needed and have a positive impact – in short, to make a better world. All the while, we should be taking into account the investment needs of our clients.
"If you want to inspire confidence, give plenty of
statistics – it does not matter that they should be accurate,
or even intelligible, so long as there is enough of them."
~ Lewis Carroll
English author - works include 'Alice's Adventures
in Wonderland' and 'Jabberwocky'
Still, it begs the question, why are we not making as much of a difference as we would like to? Perhaps we focus too much on headline statistics, such as the percentage of AuM taking ESG into account, or the number of engagements we have with corporates. It’s why some have suggested that ESG has become not a means to an end, but an end in itself.6
Similarly, much of what passes for ‘impact investing’ today is arguably just the labelling of things that would happen anyway. A 2020 study by the think tank 2 Degrees Investing Initiative found that 99% of environmental impact claims made by a selection of funds were not aligned with regulatory guidance that requires them to be specific, unambiguous and substantiated.7
The authors of the study suggest that policymakers, by not addressing this issue, might well be hampering the much-needed shifting of meaningful sums, which would jeopardize their own environmental policy objectives and could result in widespread greenwashing and misselling. Indeed, it’s something for which German bank DekaBank recently came under fire, with consumer protection group VBW filing a lawsuit against the bank, claiming it was misleading clients about the positive effects of its impact equity fund.8
For investors to add value, they need to look beyond the metrics and get into the weeds of a company, rather than trying to assess it using an Excel spreadsheet.”
~ Alex Edmans
Professor of Finance of London Business School
Florian Heeb, a researcher at University of Zurich's Center for Sustainable Finance and Private Wealth, comments: “We say that impact is the change in the real world that is caused by your activities. You always need to think about what would have happened without your investment. It sounds trivial, but it connects to something we call ‘additionality’ – you need to cause impact rather than own it. You don't have impact by being exposed to impactful companies, rather you have to change companies themselves to become more impactful.
“To clarify that, we make a distinction between investor impact and company impact. Company impact is what a company causes in the world. We often talk about Tesla and how many tons of CO2 emissions it saves by replacing petrol cars with electric cars. Investor impact is the effect you have as an investor on what a company does. Can you reduce negative impacts or make a company with positive impact grow faster? We see a lot of emphasis on ‘company impact’ currently, but there’s a lot more work to do on how investors influence companies.”
Aswath Damodaran, Professor of Finance at the Stern School of Business at NYU, puts it like this: “The ESG bandwagon may be gathering speed and getting companies and investors on board. Yet, when all is said and done, a lot of money will have been spent, a few people – consultants, ESG experts, ESG measurers – will have benefitted, but companies will not be any more socially responsible than they were before ESG entered the business lexicon.”
Made to Measure
Admittedly, the emergence of ESG has brought with it a new set of labels, standards, performance benchmarks, metrics, detailed reporting requirements and disclosure regulations which, presumably, are meant to measure the progress we’re making through ESG. We would argue that these are not the result of a genuine desire to establish that we’re making progress, but of the finance sector’s obsession with measurement.
On many ESG themes – and more broadly – whenever a problem is identified there’s a tendency to begin by quantifying and labelling things, rather than first diagnosing the problem and figuring out what treatment is needed to enable a solution. Obviously, if we all agree on the problem, the diagnosis and the treatment, then it makes total sense to measure it and to label it – to help us to see if we’re making any progress. But the obsession with measurement and labelling is often making us skip the important first steps.
Alex Edmans, Professor of Finance at London Business School and CEPR Research Fellow, says that, in asking how we measure sustainability, we are asking the wrong question: “Sustainability isn’t something that you can measure; it’s something you assess. This involves starting with quantitative metrics but then supplementing them with qualitative information… For investors to add value, they need to look beyond the metrics and get into the weeds of a company, rather than trying to assess it using an Excel spreadsheet.”
Besides, even the best intentions often lead to unintended consequences. For an example, just look at food labelling. The 2014 EU mandate for companies to provide ‘back of pack’ nutritional information per 100ml or 100g was intended to allow consumers to compare two products like-for-like.9
Yet the regulation also states that brands can voluntarily add their own ‘per portion’ values to nutritional tables. It led to food packaging quickly getting out of step with portion sizes: the recommended serving suggestion of 30g of cereal barely covers the bottom of the bowl!
While the idea initially seemed like a good one, perhaps there’s a lesson here for ESG investors in that, when the labels become an end in themselves, there is a tendency to lose sight of the bigger picture.
The notion that if you pack your reports with metrics it will solve problems and give rise to the kind of behaviour change that you want – that's just a huge mistake.”
~ John Kay
British economist and author of ‘Radical Uncertainty’
What’s in a Name?
‘ESG investing’, ‘sustainable investing’, ‘socially responsible investing’, ‘ethical investing’, and ‘impact investing’ are terms often used interchangeably. Moreover, many ESG funds are marketed with ‘ESG’, ‘SRI’, ‘sustainable’ or ‘impact’ in their name, with or without an official SRI label.
Each describes, however, heterogeneous investment approaches that have important differences. Furthermore, many product providers have their own categorisations in their product documentation, which can further deepen the confusion.
Yet, by being unclear about these differences, using vague definitions and loose terminology, investors’ expectations about the financial or non-financial benefits of these investment approaches might not match the actual objectives targeted by the investment manager. Every investment manager therefore has a responsibility to be clear about the meaning, intent and outcome of every investment strategy, no matter the sustainable or responsible lens that is applied.
In a bid to help matters, regulators are now stepping in. But this only risks additional complexity and confusion as investors – especially those straddling multiple countries or jurisdictions – grapple with various taxonomies and frameworks.
Ian Simm, founder and CEO of Impax Asset Management and a member of the UK Government’s Energy Innovation Board, says: “As soon as governments get involved in establishing what ‘green’ is, the subject takes on a whole different complexion. It becomes the basis for regulations, for behaviour, for forming a view in the private sector that there's an absolute interpretation being shaped.
“The EU deemed it necessary to set the global tone for what is green; other countries have now reacted, saying, well, what's green for Europe might not be green for us – we want our own taxonomies. So we’re in the situation where six years ago, we had multiple private sector taxonomies that were low-key, optional and nimble. Today, different countries in different blocks are trying to establish definitive statements about what green actually is.”
Just Getting On With the Job
Of course, one of the great attributes of the financial services industry is its ability to innovate and develop new products and services to meet the needs of an evolving world. At Natixis Investment Managers, we naturally seek to obtain the labels that our clients request us to have – that’s a non-negotiable for any client-focused organisation. However, we also feel obligated to ensure that a label is not or does not become an end in itself. The worry is that, as an industry, we’ve become so hung-up on the labelling of activities that we’re now unable to move forward.
“I’m reminded of Goodhart’s Law,” says Alex Edmans. “‘When a measure becomes a target, it ceases to be a good measure’. In other words, when we set a specific goal, people will tend to optimize for that objective regardless of the consequences. And we see this in many other areas of life, like with schools, for instance, where some people have become so obsessed with measuring their grades that it leads to just focusing on what was examined, rather than a love of learning and other important things.
“So, without being too cynical, in the investment world that means that if you put a label on it, essentially, you can charge money for it. In an industry that is becoming increasingly commoditized, some will create an ESG product where they can bifurcate stocks into brown or green – based on a small number of factors – and create an index of only green stocks. But those so-called green stocks might actually perform poorly on the other ESG dimensions not taken into account.”
Nobody knows the future, so while we can make estimates, forecasts and scenarios, it’s important to recognise that it’s all they are.”
~ Victor Van Hoorn
Executive Director of Eurosif
British economist John Kay – who co-authored the book Radical Uncertainty with former Governor of the Bank of England, Lord Mervyn King – goes further. Using the example of risk modelling in the banking sector prior to the global financial crisis, he stresses that when people take financial models too literally, populate them with invented numbers and base important decisions on them, the models can become not just misleading, but dangerous.
“Instead, we should have been asking, what’s really going on?” says John, who now sees similar mistakes being made in sustainability circles. He continues: “I find my position on this odd, because I'm a natural quantifier. I've spent much of my life building models of various kinds. But I just go on finding these made up numbers more and more ridiculous. And the notion that if you pack your reports with metrics it will solve problems and give rise to the kind of behaviour change that you want – that's just a huge mistake.
“I like using models, but models are sort of parables; ways of understanding the world rather than ways of controlling the world or predicting it. Climate change is an extreme example of this. It is actually asking what are we talking about in qualitative terms: what can we do to stop warming by a particular date, where do these numbers come from and how comfortable are we with these dates? For me, it’s more about technologies that allow us to store or generate energy – we should be focusing our attention on that.”
In summary, John references a famous spat between two leading economists, where Keynes is supposed to have said of Tinbergen: “The worst of him is that he is much more interested in getting on with the job than in spending time in deciding whether the job is worth getting on with.”
We might say the same of the ESG community, as it always seems to be preoccupied with getting on with the mainstay ESG jobs of quantifying, reporting, labelling, carbon-footprinting, scoring and measuring. Perhaps it should pause sometimes to ask if these jobs are really worth dedicating so much valuable time and resources to.
Name of the Game
To see where our obsession with measurement and labelling might be leading us, it’s instructive to witness the marketing frenzy that accompanies any new ESG development. Take carbon footprinting or portfolio temperatures, for instance. There is little or no debate about how all the data will help make better investments or make a better world. Rather, it’s a competition over who can ‘label’ the most assets under management as ‘Paris-aligned’.
Few discussions take place about the lack of quality of the data that is needed for this, or the lack of regard for academics pointing out that the methodologies are of dubious scientific quality. Yet what matters even more than discussions about the data, is discussions about how to interpret the data. The frenzy around getting the perfect dataset hides the fact that we will need other important bits of information to determine whether a high or low number is ‘bad’, and should prompt action, or in which scenarios certain numbers would be ‘good’ or ‘bad’.
Victor Van Hoorn, Executive Director of Eurosif – the European association for the promotion and advancement of sustainable and responsible investment, says: “The reality is that all sustainability issues are extremely complex. So there's a philosophical question as to whether we will ever have accurate and precise data or whether the modus operandi is going to be that we'll all have to continue to make judgment calls based on imperfect information. Rather, we should be asking whether the data is going to tell us anything meaningful.
“Ultimately, whereas I think a lot of people are used to financial information, which tends to be backward looking and historical, with sustainability information, what's really relevant is that you have to make a forecast. Particularly with climate change, you have to make a forecast about three to four decades into the future. It’s not realistic for people to think that you might have the perfect answers for that. Nobody knows the future, so while we can make estimates, forecasts and scenarios, it’s important to recognise that it’s all they are.”
I think we've got to label, but maybe we need to label differently in order to enable better decision making.”
~ Ashby Monk
Executive and Research Director
of the Stanford Global Projects Centre
In the case of climate change, few in the ESG community realize that the main driver of climate-related investment risk is the likelihood of government action. In this sense, they are confusing what they would ‘like’ to happen, with what is ‘likely’ to happen.
As a citizen of the planet, of course we are hoping governments will take action, just as we hope that the prices of the shares we hold will go up. But as investors, we have to be more dispassionate: to understand the risks in my portfolio, I have to understand how ‘likely’ government action is, just as I try to understand the factors that will drive the valuation of the shares I own.
Indeed, Dr Akande, Dean of the Business School at Webster University in St. Louis, used the phrase ‘Hope is not a strategy’ as the title of his letter to then US President, Barack Obama. His goal was to advise the president on how to breathe life back into the US economy.
The song remains the same in impact investing too, as evidenced by the ‘SDG labelling’ of portfolios. Great importance is placed on having those little coloured squares in a glossy report. Yet they are so wide ranging that any good marketing team could find a way to show how their company is contributing to one or more of the SDGs. There’s little discussion about how genuine the process behind it is, how credible the companies’ activities are that led to the labelling, or what this all really tells you about achieving the SDGs. And the reality is that some will be helping to achieve them far more than others.
“This is still the early days of the impact investment ecosystem, and really there's still pretty poor data available,” says Ashby Monk, Executive and Research Director of the Stanford Global Projects Centre. “Most of the ESG landscape feels more like bond ratings than objective measurements of company behaviour. Instead of getting a per ton-type of number to indicate a particular company’s carbon reduction, you get a score of 71.
“But what does that really mean in the context of that company, or the next company? I think we've got to label, but maybe we need to label differently in order to enable better decision making. How do you tell a story to stakeholders about 71? You can’t. I want to empower more storytelling about sustainability, which is why we need real outcomes and impact data.”
Measure in a Context
Similar issues exist when we look at the scoring of asset managers’ ESG activities. It often boils down to being about the size of ESG teams, the number of engagements, the number of data providers a firm works with or the percentage of AuM that is labelled ‘ESG’. This is in the literal sense, as with the French Label SRI, or figuratively, in the sense that it’s defined as ‘ESG’, ‘responsible’, ‘sustainable’ or ‘impact’.
Virtually none of this tells you anything about the qualitative elements that we should be ‘enabling’ – like making sense of ESG factors and incorporating them into financial markets. Surely we should be discussing how and when they are relevant, whether they drive performance, relate to risk management or drive change in companies, and which kind of data is most useful for these things?
Moreover, it's not the information on the investors themselves but on the companies they invest in that really matters. Victor Van Hoorn comments: “We know there are questions around the quality of the data and that the data is not always comparable, or that a lot of it might be self-reported or not subject to robust enough scrutiny. Then there is the question around whether some of those companies you invest in will be outside Europe and therefore might have different political ambitions or different interpretations of what a robust framework looks like… the underlying data from companies is one of the missing links and that's probably where a lot of work still needs to be done.”
Few seem to care that ESG teams, because they often know little or nothing about financial markets and investing, might not be best positioned to work on all this. More attention is given to the size of the team rather than it's capability; the fact that there are 50 ESG people in the team, while a competitor has just 20. Yet taking our roles as investors seriously means understanding materiality of ESG factors, and playing an active part in a company’s governance – enabling the company, board and management to deliver on its purpose, strategy, and so on. This requires a fundamental understanding of economics, finance and strategy, not just biodiversity – no matter how important that is to the future of the planet.
Not many ESG teams, regardless of their size, are equipped or organized to effectively play these roles, especially as many are more or less independent from the investment teams, the portfolio managers and analysts. In other words, it is easy to obtain the label ‘Large ESG Team’, but very difficult to demonstrate how that team enables the outcomes we seek.
John Kay comments: “Before asset management firms had heads of ESG, I remember having a meeting with an asset manager and I was struck that the CIO and the head of corporate governance introduced themselves to each other – it turned out they were meeting for the first time. In my view, monitoring governance should not be about ticking boxes, it should be about having an effective process for making management accountable for what they’re doing and that shouldn’t be separate from the investment function. Yet many asset managers still have an ESG group that’s probably not very close to the people who are making investment decisions.”
It's very important for investors to recognize that ESG is an artificial construct, or even a gimmick.”
~ Ian Simm
founder and CEO of Impax Asset Management
and a member of the UK Government’s Energy Innovation Board
Most ESG-related regulations, too, are based on the premise that once we have labelled, the enabling will follow. Among the initiatives pursued by the EU over the past few years, there’s the taxonomy to classify what constitutes a sustainable investment and the Sustainable Finance Disclosure Regulation (SFDR). But because the starting premise isn’t clear or agreed, the regulatory text is often a bit of a jumble and as a result people interpret it differently.
“I think it's very important for investors to recognize that ESG is an artificial construct, or even a gimmick,” says Ian Simm. “It should really just be a device to encourage a conversation about the purpose of capitalism, to make sure that we don't take a narrow view of opportunity or risk, and to have a proper debate about investment beliefs.
“If investors could all agree that this was the right way to think about ESG, then we can stop looking for ESG data and ESG benchmarks and ESG scores, because, expressed in this way, they don’t really mean anything. It would be less confusing to have an informed debate about governance issues alongside a discussion about risk and opportunity arising from a broader, longer term set of factors – of which environment and social are just two.”
At Natixis Investment Managers, we think the financial services industry should be devoting more of its time and money to framing these problems and defining what role it can genuinely play to help tackle them. When that’s all clear and agreed it will be simpler to agree on the metrics that will help us keep track of implementation. Only then can we see if we’re really making any difference.
2 Note: Negative screening’ refers to applying filters to potential investments to rule companies out of contention for investment due to poor performance on ESG related standards based on an investor’s preferences, values or ethics.
3 Source: 2 Degrees Investing , and University of Zurich’s Florian Heeb and Julian Koelbel: http://www.csp.uzh.ch/dam/jcr:ab4d648c-92cd-4b6d-8fc8-5bc527b0c4d9/CSP_Investors%2520Guide%2520to%2520Impact_21_10_2020_spreads.pdf
4 Sources: ‘Greenwish: The Wishful Thinking Undermining the Ambition of Sustainable Business’, by Duncan Austin; ‘Can Sustainable Investing Save the World?‘ by Florian Heeb and Julian Koelbel; ‘The good and bad news for people working in sustainable finance’; by Hugh Wheelan; ‘ESG. So far, a triumph of form over substance,’ by Tom Steffen.
5 Source: USA Today
6 Source: Taken from a speech by Jean Raby, former CEO of Natixis Investment Managers, at the 2020 PRI in Person conference.
7 Source: 2 Degrees Investing
8 Source: https://citywireselector.com/news/deka-fights-lawsuit-on-misleading-positioning-of-its-impact-equity-fund/a1466962
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed-income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.
Sustainable investing focuses on investments in companies that relate to certain sustainable development themes and demonstrate adherence to environmental, social and governance (ESG) practices; therefore the universe of investments may be limited and investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. This could have a negative impact on an investor's overall performance depending on whether such investments are in or out of favour.
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