Stuart Kirk: ESG must be split

The writer is a former chief investment officer at HSBC Asset Management and a former editor of Lex

Many people are surprised by the recent backlash from ESG. Not me. Popular spinners entice enemies and worthiness is rarely a shield. Even Mother Teresa understood it now and then. The timing is also correct. War, inflation and market woes have pushed ESG down the agenda. Booming energy and sagging tech stocks make it vulnerable. Where have the former dissidents been, you might ask?

However, questioning the ESG is now accepted. Too late for some. I have received hundreds of messages since infamous moral money speech from others being thrown under an electric bus for raising their hands. I support ESG, as it happens. But I have long argued that it has an existential defect. Fix this and ESG can thrive.

The shortcoming is that ESG from birth has two meanings. Regulators have never bothered to untangle them, so the entire industry speaks and behaves for different purposes. One implication is that portfolio managers, analysts, and data companies have understood ESG investing for years. That is: “considering environmental, social and governance issues when attempting to assess the risk-adjusted potential return of an asset”. Most funds are ESG on this basis. Weather, corporate culture or poor governance always affect pricing to some extent.

But this approach is very different from investing in “ethical” or “green” or “sustainable” assets. And this second sense is how most people think of ESG – trying to do the right thing with their money. They prefer a company that doesn’t burn coal, avoids nepotism, and has diverse senior executives.

Then the two meanings are completely different. One side considers E, S, and G as inputs to the investment process, the other as outputs – or goals – for maximization. This conflict leads to countless misunderstandings.

For example, in an ESG input world, it is possible to own a Japanese pollution producer with bad governance if these risks are seen as less important than other income drivers. Ditto if they were discounted in the stock price. But try saying it to a Dutch pension trustee with a focus on ESG output.

Or consider a green wash. There is no such thing in the context of ESG input, because sustainability is not the bottom line. You could accuse the fund manager of not taking these inputs into account to the extent they say. But it’s just a matter of process. Have German managers ever raided an office because a value manager bought too many growth stocks? No.

Likewise, it is unfair to accuse ESG output funds of greenwashing. That’s because there is no uniform measure for “green”. The new European fund passport is supposed to tell investors what percentage of a portfolio’s assets are sustainable. But people have calculated this differently. Is an oil company always “unsustainable”? What if 30% of its revenue were from renewable energy? What about 60%?

Fund statements are also a nonsense when ESG has two meanings. Asset managers are constantly asked to demonstrate that their ESG portfolio has a better average ESG score than the index. But for funds where the ESG is the only input, any score without reference to valuation is meaningless. After the big sell-off on stocks with bad ESG ratings, you might want to have loads of stocks if they’re cheap enough.

As for the ESG output funds, their report has the wrong numbers anyway. Almost all portfolios are still measured against input indices, such as MSCI, even when holdings are selected on an output basis. Very few clients I’ve met in my previous role understand this – yet these reports form the basis of fund selection.

The only solution to these problems is to split the ESG in two. A range of designated ESG entry-level funds will address the most common complaints. Of course they sometimes underperform; all current management activities. What about Elon Musk whining about inconsistent scores? It’s no different for earnings forecasts.

However, none of the above applies to ESG output funds. Here, the industry must be honest about the trade-off between profit and “doing well”. And it’s impossible for index providers to rate “goodness”. Investors may disagree on whether future carbon taxes will hurt car company profits, but everyone should have the same amount of emissions. Standardized scores are a regulatory priority.

A bright future for both forms of ESG is possible if each makes sense on its own terms. Still, go ahead and categorize the two, and large areas of the ESG landscape would make no sense, nor would the debate necessary for the industry to thrive.

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