Evolving into an Eco-Friendly System: The Real ESG Challenge

Climate change and other
environmental challenges moved to the center of global consciousness in 2019.

In just one sign of the times, Time Magazine chose
the teenage environmental activist Greta Thunberg as its Person of the Year. And
across the world, people have grown more conscious of their environmental
footprints and adapted their consumption habits accordingly, by recycling more,
using less plastic, and even heeding Thunberg’s advice to cut down their
travel, among other measures.

Financial Acceptance

This green consciousness is taking
particular hold in the finance sector. Clients’ demand for socially
responsible investments increased as households and individuals sought to use
their capital and savings to create more positive impacts. 

Supply has been quick to respond. Financial
institutions have signed on to the UN Principles for Responsible Investment
(PRI) in ever greater numbers, and the number of environmental, social, and
governance (ESG) funds, led by passive strategies, is
growing exponentially gathering more and more assets under management
(AUM).    

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UN PRI Signatories

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As these trends have gathered force, asset managers have felt the pressure, and some have truly embraced the green zeitgeist and gone all in on sustainability.

So is the
world finally starting to win the fight for the environment?

Though these developments are steps in the right direction, it’s
still early days and more needs to be done. After all, the most widely used tools in the ESG toolbox
— negative screens based on companies
revenues — often cover less than 2% of an
index and are hardly game changers.  The financial community is so fixated on performance
and benchmarking that even passive ESG funds, which account for most of the ESG
trend, are designed to track their equivalent non-ESG index.

The problem lies in the system.

The real difficulty in investing for
a more sustainable future is that our monetary and incentive structures are not
designed to confront environmental challenges or to reward any “green” effort.
At least not yet.

Let me explain: In our current monetary system, a “green” pound generated by Company A is as valuable as a “non-green” pound generated by Company B. Each pound the firms produce in profit has equal purchasing power .

If Company B is trading at an attractive
discount to its estimated intrinsic value relative to Company A, it will likely
have more appeal as an investment.

That is, unless the system evolves and gives the
green pound more
value than the non-green one.

There are two ways to accomplish that:

1. The investment community can apply a sort of “green multiple” on industries and companies.
2. Governments can tax the non-green pound or subsidize the green one.

Each of these approaches comes with challenges.

Fiduciary Duty

The sales pitch from the sell-side
is that responsible investing is like responsible eating: It won’t negatively
affect performance. But in practice, if a vehicle with a passive investment
approach comes to exclude 20% or 30% of an index, buy-side investors and their
clients become much more nervous about the financial implications.

In reality, few are willing to put
their or their client’s savings and financial well-being at risk for purely
environmental reasons.

So while the sell side has adapted
and fully embraced the ESG trend as a way to raise AUM, the buy side’s approach
has been much more conservative, as shown in the chart above. The fiduciary
duty to deliver performance to clients falls on them. Not on the sell side.

In most cases, the mandate given and signed by
the client to his investment manager is return focused. The manager generally
has no explicit duty to reduce environmental impacts.

Most sustainability-focused asset managers
maintain that ESG and performance go hand in hand. While this might be the
case, it makes their compliance officers nervous: How can they put this into a
legal contract? How can the ESG performance of a portfolio be measured? How do
we prove that restricting the investment universe to “good” companies is “good”
for portfolios returns?

In reality, companies and their activities are
too complex to be classified as green or non-green. So
screening based on such binary categories is pointless. Firms are and produce a
mix of green and non-green pounds, so the only way to develop a true picture is to focus
on their transparency. But there is no formal regulation around the disclosure
of ESG metrics. So that true picture remains elusive.

Governments need the money.

Governments face a similar dilemma. How can they act “responsibly” while maintaining the inflow of tax revenue from cash cow companies? How do they keep their economies competitive and their people employed when other nations may have less stringent regulations?

But there is a way forward.

The challenge is great because the
solution requires collective effort while progress can seem sluggish, sometimes
painfully so. Changing mentalities and relying on individual initiatives is by
nature a slow and fitful process.

And capitalism is not a system that rewards
restraint. But that doesn’t mean we should abandon the model. Just as
capitalism may contribute to the problem, it can also provide the solution. If
it adapts.

That adaptation requires a mechanism that
decreases the purchasing power of the non-green pound and
boosts that of the green one.

Here again innovation could provide the answer.
Blockchains could trace the origin and path of each pound and render a verdict
on its cleanliness. A multiple will scale the pound’s value up or down
depending on where it goes, tracking it as it moves from clean to dirty hands
and vice versa.

In such an “adapted” framework, “responsible” or
impact or ESG investing would be embedded within the system itself. And that is
essential. To make sustainability a reality, action can’t be an effort but a
reward in and of itself. When that equation becomes discernible, the reward
obvious, people will buy in.

Of course, this vision is not yet realizable.
Until it is, we will have to rely on transparency.

And that requires a reporting framework for
companies, one with well-defined metrics and that can set objectives and
measure progress.

Developing that framework is the next step in
the ESG challenge in 2020 and beyond.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ Craig Easton

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