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Using a sledgehammer to crack a nut?

Why “good” and “bad” are too blunt for ESG

Cracking capital conversations

When talking about ESG (environmental, social and governance) integration, it’s still common for capital allocation conversations to focus on exclusionary policies, and partitioning the “good” from the “bad”.

But the reality is that such a blunt categorisation is like using a sledgehammer to crack a nut. The impact of any given company will lie on a continuum: coal power, for example, may be responsible for an increase in deaths from air pollution, yet international comparisons of energy consumption levels with life expectancy indicate a positive association,[1] and much electricity in emerging markets is generated by coal. When it comes to ESG, there is more than one shade of green.

Data dividends

Aided by the remarkable growth in the quality and quantity of ESG data and analytics, investors are now able to ask much more sophisticated questions about individual companies, not just sectors. As regulations from the Department for Work and Pensions recognise, the issue is no longer simply about ethics, but about financial materiality: who will be the winners and losers of the low-carbon energy transition?

What are the least polluting, most energy-efficient companies? What percentage of a company’s revenues come from ‘green’ products and services? Which companies have high standards and transparency across their supply chain? Which companies are most exposed to changes in regulation, such as a rising carbon price?

Through Bloomberg terminals alone, investment managers now have access to more than seven million ESG data points[2] to assist in identifying climate-related risks and opportunities. Taking advantage of the explosion in data, some investment managers are going further, channelling the deluge to construct proprietary ESG methodologies and models, across all asset classes and strategies. Many such strategies are designed to retain the risk/return profile of a traditional index, while simultaneously achieving an impact on climate-related metrics. In practice, this means that exposure to high-emitting companies and fossil fuel producers can be significantly reduced without excluding sectors altogether, thereby maintaining diversification. With the EU warning that standard benchmarks are likely to be aligned with ‘catastrophic’ scenarios of global warming,[3]we anticipate that interest in alternatively weighted ESG benchmarks will continue to increase.

A hard nut to crack

In our view, the scale and transformation required to steer and help companies along their low-carbon journeys cannot be achieved simply by a blanket disinvestment from “bad” companies or sectors. The growing popularity of mainstream investment options that reward companies taking positive steps toward sustainability, while aiming not to compromise on performance, is both practical and encouraging. Together with effective, persistent engagement from investors, such investment solutions should help to provide the extra strength to crack the nut of ESG integration.

 

[1] https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3114817/

[2] Goldman Sachs – The PM’s guide to the ESG revolution (2019)

[3] EU Technical Expert Group on Sustainable Finance interim report on benchmarks and disclosure, 2019.