Published: April 7, 2022. Last updated: December 30, 2022.
What is ESG?
The term ESG was coined in 2004 by Clements-Hunt and his team while working at the U.N. It is an investment strategy that promotes investing in companies that perform well in the following three categories: Environmental, Social and Governance. ESG has disrupted traditional ways of thinking about risk – it provides a framework to consider the present and future impact. Reporting with this framework gets companies to reconsider how they approach risk management in a way that meets the challenges of this century. Such challenges include climate change, war crimes, and poor corporate governance.
Companies are usually rated according to many factors and then provided a final ESG score based on their performance across all three categories. It is important to note that ESG does not measure environment or social impact – that is called impact investing, which goes beyond ESG assessments. The leading ESG rating firm, MSCI, says that ESG ratings are “designed for one purpose: to measure a company’s resilience to financially material ESG risks”. Hence, these ratings are not fit to measure a company’s actual environmental or social impact, and impact investors use different tools for that. ESG has three different investment approaches: positive screening, active ownership, and ESG integration. You can read about ESG and impact investing in more detail in our previous post What is Sustainable Investing?
How does ESG investing work?
ESG investing is an investment strategy that promotes investing in companies that perform well in any or all of three categories: environmental, social, and governance. For example, it could mean they do not harm the environment with their practices, treat their workers and the communities fairly, and work to achieve gender equality among their leaders. The companies are usually rated according to many factors and receive a final ESG score based on their performance across all three categories.
ESG investing has three different investment approaches:
- Positive screening (or often referred to as best-in-class screening): Applying positive screening means that you are selecting best-in-class companies in a specific sector and avoiding companies below a set ESG threshold (below a specific ESG score). Using this strategy could mean that you are not avoiding an entire sector but are only investing in the best companies in there. Take the oil & gas sector, for example. Total, the French oil company, is considered a leader in the oil & gas industry. Their ESG score (provided by some of the ESG rating agencies) could be high enough for certain asset managers to include it in their funds. Investors using positive screening are often criticized that they do not maximize positive impact this way and only use the strategy as risk management to mitigate the downside. Still, this strategy is considered successful, especially if you combine both the negative (SRI) and positive screens for your investments, which gives you something closer to an ESG integration strategy.
- Active ownership: The active ownership strategy means investing in companies with harmful practices to influence them by voting in their board meetings to change their strategy. For example, it could mean that you invest in an oil & gas company and vote during their shareholder resolutions to advocate the transition to renewable energy solutions. You could achieve this by investing in funds whose managers are known to vote in line with your values. In this way, you could be following a market index that is fully diversified by including a wide range of companies in your portfolios. However, you need to be careful following this strategy as some investment managers don’t walk the talk. Some asset managers are re-branding their traditional investment funds as ESG funds. However, they are not voting in line with what they are promoting, and this practice is called greenwashing. If you want to pursue this strategy successfully, you need to check the investment funds and investment managers and need to follow up with the managers if you feel that your values are not represented in boardrooms.
- ESG integration: ESG integration integrates ESG factors into traditional investment processes to improve long-term portfolio risk/return. When done right, ESG integration is the next evolutionary step in sustainable investing from socially responsible investing. It also avoids the sectors where your values are not aligned while also allowing you to invest in the best scoring companies from an ESG perspective. While there is no perfect framework for ESG integration, efforts are being made by the CFA Institute and the Principles for Responsible Investment (PRI) to create “a best practice report” for equity and fixed income investments. The Task Force on Climate-Related Disclosures (TCFD) also provides resources for ESG investors as well as the 2° Investing Initiative with their Paris Agreement Capital Transition Assessment (PACTA) tool.
Why question things now?
In the initial launch of the ESG framework, there was a clear message: think, document, do. It has become clear that by many, there is limited evidence of the ‘do’, poor effort in the ‘document’, and halfhearted effort in the ‘think’. There is a growing weight of legislation behind ESG, yet there still seems to be a gap between the potential of ESG and the reality of its use. So why are things being questioned now? As Euromoney put it: Russia attacks, investors flee. Where next for ESG? With the ongoing Russian invasion of Ukraine, investors are revisiting the framework and borders of ESG. Putin’s war crimes have shone a spotlight on the cracks in the world of ESG. The attacks on Ukraine have exposed some of the dubious choices financial managers selling ESG investments have made. Yahoo Finance stated that ESG funds held about $8.3 billion in Russian assets just before the war, including energy giants and bonds sold by the Russian Government.
Is it the framework that’s the issue? Is it the application of the framework? Are there specific risks that need to be reviewed? This article breaks down the three main areas in question.
The questions behind ESG investing
Funds are “dumping” Russia left, right, and center for humanitarian, ethical reasons, and rightly so. Recent events are turning a harsh light on sustainable development as banks and investors ask what ESG really means. If ESG is about risk management, why were so many still investing in Russia right up until the point of war? Russia was at risk of committing humanitarian crimes before the day of invading Ukraine- it was no surprise and not the first time. According to Our World in Data, Russia scored poorly on human rights metrics with a rating of 1.19 in the latest data collection. We need to consider how so many countries, companies, and funds are in a position where they need to divest from Russia? Why are they invested in the first place if ESG ratings would account for humanitarian risk under the “S”?
Some argue that ESG started in a good place but is too vague (thus allowing misuse of ESG ratings) or too rigid (thus resulting in stocks that scored high in ESG performing poorly). Sustainable investing became so popular that many new financial products appeared to have been “created”. ESG stickers got put on old unethical funds – essentially for greenwashing – causing the apparent “record-breaking year” for sustainable funds. According to Bloomberg Intelligence, the global ESG market equates to $40 trillion of assets. It’s clearly a popular framework, but how is it that so many funds can score well in this risk framework, yet it is clear the world is not mitigating risk all that well when it comes to climate change and war crimes.
Others argue that it is not the boundaries that present difficulty. Rather, ESG is just being executed poorly on a wide scale. A Deloitte survey found that companies are indeed working towards improving sustainability reporting. Still, there remains a vast gap to meet ESG transparency demands. Areas lacking include data quality, reporting consistency, technology, and governance. The survey looked at the most significant players with revenues greater than $500 million in finance, accounting, and sustainability.
In questioning functionality, the answer is not a simple yes or no. ESG is functional but is poorly executed by many and requires greater flexibility in some sectors. This framework must continuously adapt to our ever-changing world – what is considered a risk, who poses that risk or is affected by its changes. The question is, how do we keep up with it?
The second thing being questioned is the ethicality of ESG? Is the label of ESG being used to make money rather than to manage risk? Pioneer of ESG, Clements-Hunt, has spoken out about the misuse of the ESG label. He says that “anybody who uses ESG, sustainability or green purely as a marketing device is heading for trouble”. The finance sector seems to have misused and abused the title of ESG for funds and products that do hardly anything to account for environmental, social, and governance risks. While the EU is a pioneer in sustainable finance regulation, its imperfect rules around sustainable investments have arguably contributed to the inescapable greenwashing of financial products. Despite the good intentions, since the introduction of SFDR (Sustainable Finance Disclosure Regulation), it has become even more tricky to fish out the greenwashed funds.
In response, Morningstar Inc has tightened its sustainability criteria and consequently stripped the ESG label off about 1,200 funds (~$1trillion in assets under management) after an investigation revealed the funds did not deserved the label.
Alongside the stripping of the ESG labels, states are divesting to maintain ESG ratings. The Church of England cut all Russian investments from its portfolio. Abrdn chief exec Stephen Bird called the country “non-investable” on ethical grounds and set out to exit £5 billion in related assets. In addition, Norway divested a $1.3 trillion sovereign wealth fund from Russia. If divesting from Russia is considered the moral and ethical thing to do, what conditions must meet to re-invest? Online grumblings are critiquing the last-minute divestment of Russian assets. The condition is the absence of war to declare Russia ethically investible – does that fit with the understanding of ESG as a risk management framework? And how far back do you go? China has announced that its relationship with Russia will remain unchanged – does that mean companies should also divest their Chinese assets? This situation is a stark challenge that sustainable investors face in balancing client demand for just and sustainable investment with the desirability of returns from lucrative industries like the defense sector.
Clemens-Hunt anticipates an ESG shakedown – those that have not used the ESG framework properly will face severe consequences. In the coming months, we expect to see greater honesty in markets because where there is lazy analysis and misinformation, there is bound to be a failure. Investors need to be vigilant against greenwashed funds. For ESG to remain a reliable framework, stricter reporting measures must be in place.
The hottest question right now is the place of defense stocks in ESG. Are defense firms and ESG preferences compatible? There are four prominent opinions: no way; yes way; it’s not my job to care; it’s complicated.
The no-way opinion. Some have a strict approach of absolute zero exposure to the industry altogether and do not see it to be compatible with ESG. Before the Ukraine-Russia events, this seemed to be a fairly popular opinion. However, is this all that achievable? Can you have zero exposure if you invest in other industries such as technology and software? Arms trade and war are much more than just artillery; the defense sector taps into a wide range of investment themes- identifying assets that contribute to these activities may not be so straightforward.
The yes-way opinion. Others consider whether Russia’s invasion of Ukraine has made defense stocks ESG friendly. In response to the energy crisis, the financial industry and media have called for oil and gas to be rehabilitated, and others have put the defense sector into the equation. Is supplying weapons to an invaded country following an unprovoked war a social good? You could say that providing defense materials to Ukraine is a humanitarian cause, but the problem is that most defense companies don’t just serve the “good guys”. They serve dictators, armed nations, underdogs, invaded, and more. It is a sector that both maintains peace and causes irreparable harm. Is the response to omit defense funds altogether from your portfolio? Or invest knowing that some will go to good causes, but some may go to bad? Initially, it’s up to the portfolio managers whether they want to provide this option. Second, it’s up to the investors to decide where they sit with the issue. As summarized by the Financial Times, having a static framework will not work. There are good and bad in most companies and industries.
It’s not my job to care. Unsurprisingly there are still some people that don’t engage beyond their work and the impacts their decisions make in the world. Sadly, these people often hold hugely influential positions. As CityWire neatly summarized why defense stocks appear in ESG funds:
“Some of the managers said that, from an ESG angle, defense is necessary to maintain world peace, while others said they are not paid to put morals into an investment strategy.”
Unfortunately, the defense industry thrives off inequality and the disruption of peace. Since the invasion of Ukraine, BAE Systems’ share price has risen by more than 17%. Defense spending is a lucrative investment, especially in the powerhouses of the global economy. In 2022 the U.S. spent £590 billion, China £192 billion, Russia £118 billion, the U.K. £52 billion. We all must take responsibility for the world that we create, whether with our money and actions or other people’s. ESG institutions must train fund managers in economic ethics and social responsibility just like those in the A.I. industry.
It’s complicated. The issue is that defense stocks are a broad category- some companies directly manufacture lethal weapons while others produce goods that don’t involve killing but can be used for civil activities. It is essential to distinguish these differences and that sometimes they are very subtly different. Does a company producing a bolt used for the trigger of a gun have the same ESG rating as the manufacturers of the weapon itself? The arms trade is excluded in many funds; however, the production of non-weapons or non-bespoke products such as bolts, valves, crates, etc., are only avoided in higher-ambition sustainable portfolios. Can ESG and defense firms accommodate each other? Some people suggest a tolerance for conventional weapons where fighter jets and tanks are okay, but cluster bombs and landmines are not. The ultimate solution is transparency – the “document” of think, document, do. Investors should have all the information they need to make informed choices around industries they wish to not invest in, whether the defense industry or others.
At FLIT Invest, we give you the power to curate your investment portfolio according to your values. You can opt for themes like Gender Equality, Clean Water, and Affordable Healthcare and opt out of industries like fossil fuels, military weapons, and civilian arms. Take ownership of your money – where are your dollars going? What initiatives are you supporting? Do your values align with those industries? It’s time to take charge and vote with your dollars for a better future. Sign up today to make your impact.