In the wake of the recent crypto crisis, I have seen some accuse crypto investors as being on Mount Stupid, no disrespect. Mount Stupid, a cognitive bias associated with the Dunning-Kruger effect, where there is a mismatch of confidence and competence on a topic, as seen below. Ironically some could argue that this Arcus itself is an example of the Dunning-Kruger effect. That said, not one to shy from self-reflection, it made me ask the same question of the ESG (Environmental, Social & Governance) investing industry. In today’s Arcus, I share my thoughts on where this industry is vis a vis Mount Stupid and the potential path forward. What might sound like a somber start to 2023, I see as a constructive start to the next phase of ESG and even Impact investing in the listed space.
Investing history is littered with costly examples of the Dunning-Kruger effect in action. Just in my almost 30 years of investing, the Dot.com Bubble, CDO-CLO fiasco during the GFC and more recently Crypto investing seem like relevant case studies. Unlike these examples though, I don’t see ESG-Impact investing creating a financial asset bubble (not yet). Rather there is an ESG-Impact expectation bubble with possible disappointment, if not acted upon soon.
What is ESG Investing?
For many this is the first question, or base camp of Mount Stupid. Kofi Annan, UN Secretary General’s 2004 “Who cares wins” report introduced ESG as a factor to consider for companies and therefore financial markets. In investing terms, is ESG an asset class in itself for asset owners to allocate to? Or a newly discovered strategy (like value, quality or growth) through which investors can generate superior returns on different asset classes? Or just an evolution of the traditional investment process integrating ESG for better risk management?
At Panarchy Partners we do see ESG investing as another investing strategy, but we call it Purpose investing. Without limiting ourselves to Kofi Annan’s ESG classification, we honor E, S & G through our Panvesting philosophy. We analyse a firm’s Purpose through its Environmental, Social, Human and Financial capital credentials before investing. Many see ESG or sustainability initiatives as costs. We however see them as purpose driven intangible investments, underappreciated by the markets and therefore able to deliver certain financial returns over time. It is now for us to prove that these intangible investments create significant financial value while progressing human, social and environmental capital.
Expectations of ESG Investing
The pace at which ESG investing has grown is impressive with Bloomberg estimating US$15trn of ESG Assets Under Management (AUM) in 2014, hitting US$38trn in 2021 and US$53trn by 2025 (one third of all projected AUM in 2025). Despite this and potentially owing to this success, ESG Investing has been called a complete fraud, a scam, a dangerous placebo, with the famous Dean of Valuation at NYU, professor Aswath Damodaran going as far as saying that “ESG is the most oversold and overhyped concept in the history of business.”
Why the scepticism? The simple answer is that the industry has yet to deliver on investor expectations. I see two key expectations of ESG investors:
Financial Returns – Sceptics believe these are being overpromised at best (superior returns vs an unconstrained index) and misrepresented at worse (tech stocks pretending to be ESG stocks).
Delivery of Good ESG and possible positive Impact – There is limited proof that ESG investing is actually allocating capital correctly to deliver good. Either capital is not going to the right companies or companies are not delivering good ESG performance. Sceptics also highlight irrelevant and inconsistent ESG ratings; greenwashing by companies and reclassification of Funds as just some examples of non-delivery of this expectation.
I sympathise with the above criticisms and know that the onus of answering them is with the ESG investing industry. It is with this responsibility, that navigating through Dunning-Kruger’s Mount Stupid and subsequent stages towards competency may help answer our skeptics on the above two expectations.
Navigating Mount Stupid
The scary thing about being on Mount Stupid is that you don’t even realise you are there. Personally, my climb up it could be mapped out by my Arcus articles over the years. I attach a link to all previous Arcus editions and let you be the judge of my ascent.
As for the industry, at the risk of sounding like an apologist, Mount Stupid in ESG investing is still rising at a breakneck pace pushed by the numerous sustainability standards, frameworks and regulations. The learning curve is steeper and longer for all the ESG investment tribes (asset owners, fund managers, NGOs, regulators, etc). This has led to an increased confidence gap between the industry claims and delivery for the beneficiaries.
Following are some tips for ESG fund managers and also asset owners to navigate and peak Mount Stupid. Let’s focus on the two key expectations.
ESG investors need to show:
How does ESG affect the value of a company?
How do markets price in ESG? and
How do investors get rewarded?
The value of a company, as per Damodaran, is determined by its discount rate and cash flows. There is some early anecdotal evidence of lower cost of capital (discount rate), as seen by better priced green bonds, which ironically means worse returns for green bond holders. As for operating free cash flows, there is inconclusive evidence of improvement via ESG adoption.
As for the pricing in of ESG related market inefficiencies, it is still early days. This is not surprising given there is not enough measurable, consistent and comparable ESG data for statistical testing. As an example, in 2021 MSCI ESG ratings for half the S&P 500 names increased while nothing actually changed other than the methodology used by MSCI.
Proof that investors are being rewarded for ESG factor investing through better risk adjusted returns is still mixed..
There are many claims of good ESG companies have low volatility (risk). These claims are countered by a view that profitable companies generally have low volatility and are also able to look good in terms of ESG, so its profitable companies and not high ESG that is the cause for low risk.
As for returns, there are no claims of undisputed proof of superior returns (alpha). Instead, many are comfortable claiming that with high ESG companies you are not getting worse returns. So why not do it?
“There is ESG alpha available but fund managers have been very bad at harvesting it…” (Speaker at CFA Institute Conference 2019). This is no longer an acceptable claim. Alpha against which benchmark needs to be determined before such a claim can be made. Where is that acceptable benchmark?
Asset owners are still asking whether ESG investing can deliver enough absolute returns, superior relative returns, concessionary vs non-concessionary returns and how to have proper ESG attribution.
Good ESG or Positive Impact
Asset owners and fund managers are not aligned in what is being solved for. Fund managers are trying to prove alpha and ESG as a factor, while most asset owners are still looking at how to invest away from this risk or towards this opportunity. How to materialise ESG … e.g., climate risk.
The terms ESG and Impact are no longer a linguistic debate and are not interchangeable.
Listed equities, listed bond Funds and ETFs need to show additionality/contribution of their investments before they can claim to be IMPACT investments.
Most ESG ratings show how ESG factors impact a company’s bottom line (first level of materiality) and not how the company impacts on all other stakeholders (second level of materiality). One cannot use ESG ratings to prove impact claims.
Within the E of ESG, climate and carbon claims need serious understanding and deliberations before they can become a fund managers investment commitment or an asset owner’s portfolio objective.
Navigating the Valley of Despair
If I focus on my tribe, fund managers, recent events may have put some into the valley of despair. As reported by Bloomberg and Morningstar, the likes of BlackRock, HSBC, AXA, Invesco, NN Investment Partners, Pimco, Neuberger Berman, Robeco, Deka and many others, downgraded their ESG Funds from EU Sustainable Finance Disclosure Regulations (SFDR) Article 9 classification to Article 8. EU SFDR Article 8 & 9 classifications were not meant for Fund labelling, instead they are meant to ensure ESG disclosures to protect investors. Fund Managers however have incorrectly used them to label their Fund’s ESG & Impact credentials. As EU recently clarified in more detail what disclosures were required for Article 9 Funds, many of the above Funds were reminded of what they didn’t know. Mount Stupid is still rising.
The good news is that despite its name, traversing the Valley of Despair will not be as painful as it sounds. ESG investors as an industry have a remarkable and refreshing willingness to share and learn from each other. An underlying desire to do good by its participants has allowed the ESG investing community to show intellectual humility to address issues that need to be resolved. A case in point, whether listed equities, bonds, etc can be seen as “impact” investments or not. In June 2021, a GIIN (Global Impact Investing Network) working group shared a paper detailing how listed equities may be able to achieve the core characteristics of Impact. The industry is working together to come up with reliable solutions.
Climbing the Slope of Enlightenment
Climbing the slope of enlightenment will not be limited to fund managers, but will be done alongside asset owners, regulators, NGOs and eventual beneficiaries of ESG investing. For ESG and Impact investing to become institutionalized we will need to answer the question: “is ESG investing an asset class, another market inefficiency to be harvested, or just an enhanced process for traditional investing?” Again, focusing on the two expectations of ESG investors, the following areas of investigation should help us climb the slope of enlightenment.
For asset owners, they should be able to show that ESG investment returns meet their fiduciary responsibility requirements. E.g., a US investment fiduciary needs to see that ESG is in the financial interest of the beneficiary, from a risk return perspective. With time and more live portfolio outcomes, the industry will show how ESG investing leads to risk reduction and required financial returns.
Regulators across the globe will need to also upgrade and clarify their stance on whether asset owners such as pension funds can allow non-financial factors to drive investment decisions and therefore outcomes.
In coming years, ESG investors will have enough if not too much data to support claims of market inefficiencies being exploited. This should see ESG investing accepted as factor investing and no longer just an improvement in the investing process.
We should expect accounting of ESG intangibles to uncover value creation. As an example, there is financial value being created through carbon reduction strategies along with positive environmental impact.
Impact investing has raised the issue of intergenerational financial returns alongside non-financial impact of the investment. Progress on E & S issues could become part of a beneficiary’s needs, rather than just financial returns. If so, then it opens the door for Impact investments in the listed space as an asset class.
We should see ESG benchmarks and targets reconstituted and recalibrated. Unconstrained index of companies will not suffice as a fair benchmark to meet expanded beneficiary needs. In the near future, I see asset owners attaching an IPCC temperature target to their financial return expectations.
Good ESG or Positive Impact
Asset owners and beneficiaries will need to become clear on what they expect from ESG, sustainable or impact investing outside of financial returns. Is it minimizing harm, or actual catalytic investments?
Fund managers will play a key role in how their clients transition their portfolios to a new expanded outcome. Asset owner’s portfolio transition will be an iterative process. Asset owners will only be able to classify ESG-Impact investments, once the managers can show detailed attribution of their financial returns and proof of impact on non-financial capital such as E or S.
Regulators will play a key role in aligning the asset owner’s expectations with fund managers capabilities. In the last 18 months ESG-Impact Fund disclosure requirements have been released by the likes of EU SFDR, HKMA, Singapore’s MAS or Australian ASIC, to name a few. These will continue as the regulators also climb the slope of enlightenment.
Global standard providers such as CSRD, ISSB, GRI, CDP, TCFD, SASB and many other are coming together to consolidate ESG and Impact reporting. This will be helpful not only for issuers (firms) but also asset owners and fund managers.
Academic work on ESG, sustainability and impact is in full flow. Whether it be the creation of an ESG-efficient frontier, or valuing of ESG intangibles, we should expect non-financial capital factors to expand the now old and possibly dated capital markets theories of the last century.
At Panarchy Partners we see Kofi Annan’s ESG drive as the introduction of other forms of capital (Human, Social and Environmental) into the profitability models of companies and thus changing the way capital markets value those models. This has also led to asset owners expanding their expectations beyond financial returns and fund managers like us evolving our decision making to deliver on those expectations. From a high level, without discussing potential divergence in the S values within ESG and with a limited lens of a fund manager, the aim of this Arcus was to review where the industry stands today. Also, where we can expect it to go as it summits past Mount Stupid and delivers on what is expected of ESG investing.