The ESG acronym is on the lips of investors worldwide. I can’t think of any other investment phenomenon that has spread so fast, from pension funds to private equity fund managers.
Yet astoundingly, when you really interrogate it, no-one seems to know what it means. Sure, it is “environment”, “social” and “governance”, but regarding a portfolio strategy, just what should you be doing to make your portfolio ESG compliant?
Talk to large global fund managers, and you’ll find some that think ESG is just another way of pursuing alpha. By eliminating companies that are involved in exploitive environmental practices, or who treat customers and staff exploitatively, or who practice poor governance, your portfolio ends up being one that will outperform.
Other funds have a quite different view — ESG comes at a cost because you are restricting your set of possible investments, but it is a price worth paying because you are avoiding reputational risk. Still others use ESG strategies as a way of positively seeking out investments that will change the world — those developing technology to make green energy or to dramatically improve sanitation at low cost.
So ESG can be positive in the sense of actively seeking investments, and negative in the sense of screening them out. It can be about improving returns over some neutral benchmark, and about making the world a better place at the cost of returns. This is an astounding range of interpretations and practices.
This spills into controversies such as the decision to exclude electric vehicle manufacturer Tesla from the S&P Global ESG index last month. If you think ESG is about screening out companies, it makes sense — the company’s labour relations and some features of its governance meant it scored poorly. But if you think ESG is about changing the world, it makes no sense — Tesla is disrupting the vehicle and battery market in a big way that is accelerating decarbonisation.
Recent research I undertook with my firm Intellidex for the UK government revealed a disturbing way this is playing out in global investment flows: ESG is biasing investment away from emerging and frontier markets. The markets where investment can have the greatest impact in terms of eliminating poverty and improving wellbeing are finding it more difficult to attract capital because of ESG.
There are many reasons for this. Many investors have built models that use public indicators such as the corruption perceptions index, the press freedom index, the labour rights index, CO2 emissions rankings to get an ESG score of a market. Now, which do you think scores better from such a process between, say, Sweden and Swaziland?
This screening approach does not mean an outright knock out. But, in general, it means that developing countries are losing weightings in ESG indices compared to the neutral index. This is problematic. If you think ESG should be directing capital to achieve certain desirable social and environmental outcomes, such as those encapsulated in the Sustainable Development Goals, then it is going to let you down.
A further problem is the lack of quality data available from emerging and frontier markets. An ESG model may want to rank companies on their internal gender equity, for example. Developed market companies produce such information routinely, but few in the frontier markets do. The cost of information gathering is often higher.
The other problem is that the “E” and “S” have quite different data features — thanks to developed world efforts, many environmental measures have been developed. But that is not true of social measures. You can judge a company on its impact on CO2 emissions, but how do you judge it on its impact on inequality, health standards or literacy?
As investors grapple with building models they can apply in practice, environmental concerns tend to dominate because it is easier to measure. Emerging market should have a competitive advantage in offering “S” outcomes, yet “S” is low priority in global approaches.
For a country such as SA, this is obviously a concern. SA is in many respects ahead of the curve in understanding ESG, and its companies are quite sophisticated in giving investors the relevant information. But it does them no good if investors are applying a “sovereign ESG ceiling” with SA downweighed because of high carbon emissions and corruption perceptions.
The solutions are to rethink what matters in ESG. Conceptually it is still evolving and we need to change course from the exclusion approach. What we need instead is a focus on additionality — how does my investment add to positive environmental and social outcomes? Such an approach needs a higher risk tolerance for potential negatives, such as the quality of governance at sovereign level.
For those who want ESG to be an ally to global development, this is a conversation they must embrace.