‘Brown’ or ‘dirty’ industries could become the most sought-after targets in capital markets. Investors focused on environmental, social and governance factors are concentrating increasingly on achieving the highest impact through transition, rather than on minimising headline risk. They have much to gain from steering corporate shifts to more effective lower-carbon strategies. These more sophisticated and targeted strategies are set to take over today’s dominant tactics of blunt exclusions and integration through blended scores. Over the next two to three years, this could affect market dynamics significantly both in terms of asset classes and sectors.
Two factors are driving this. First, the motivations behind ESG investment are changing. Rising public interest in the climate agenda over the past two years has forced many to turn to ESG investing as a way to manage reputation risk. This has even created incentives for ‘greenwashing’, where pretending to do something about ESG is seen as better than doing nothing. Still, on balance, this has been a positive and needed first step. There is an urgent need to act on climate change, and it is important to raise awareness among investors.
To avoid headline risk, negative screening strategies are an easy first step. They are a crowd-pleaser, fitting for today’s social media- and headline-driven markets. In September, British broadcaster David Attenborough released a documentary on ocean plastic. Greta Thunberg, the Swedish climate activist, regularly tweets against oil companies. It’s time to divest.
A 2020 survey of central banks, sovereign funds and pension funds by OMFIF and BNY Mellon showed that exclusions and ESG integration were the most popular responsible investment strategies (Figure 1). A separate survey of investment managers and others conducted earlier this year by Citi produced similar results (Figure 2).
But ‘most popular’ does not mean ‘most effective’. And as the motivations for ESG investment evolve, effectiveness is becoming more important than popularity. The OMFIF-BNY survey found that while reputational considerations remain important, public asset owners are increasingly drawn to ESG by superior risk-adjusted returns (Figure 3). This has intensified in recent months. The pandemic has sharpened awareness of portfolios’ vulnerability to non-financial sources of systemic risk. The emerging consensus in OMFIF’s Sustainable Policy Institute roundtables is that ESG is becoming more about protecting portfolios and less about promoting values or safeguarding reputations.
Once that realisation kicks in, the limits of exclusionary and integration strategies become clearer. As Sandy Kaul, global head of business advisory services at Citi, told an OMFIF panel, ‘the whole approach around exclusions and integration of blended ESG scores is resulting in unclear linkages between the allocation of capital and the actual impacts on corporate behaviour that capital is helping facilitate.’ A key issue is that such approaches usually evaluate companies based on their current performance (such as their carbon footprint). This is relevant, but of limited use to determine a firm’s preparedness to deal with future risks. Measuring risk should be dynamic, not static.
A shift in motivation is necessary but not sufficient to cause a shift in behaviour. The second enabling factor relates to developments in disclosures regulation and data technology. Strategies that engage companies more directly have so far been primarily action- rather than outcome-oriented. This is changing.
Regulation such as the new European Union disclosure rules or the UK’s November decision to move towards making climate disclosures mandatory following the Task Force on Climate-related Financial Disclosures framework, as well as emerging frameworks on materiality, will increase transparency.
Having information on specific ESG aspects rather than blended scores will help issuers, companies and investors better understand and value portfolio risk. Improvements in technology, too, are enabling investors to more accurately measure whether companies are not just reducing ESG risks but also whether they are creating positive impact, as documented in a September report by OMFIF and Refinitiv.
In what is becoming an increasingly crowded space, what seems like a subtle alteration can significantly impact market dynamics. As investors become less reliant on blended scores and exclusions and better able to measure and tie capital to specific indicators and behaviours, the possibilities for ESG investing will grow. As Kaul noted, ‘a lot of the companies that are being excluded today are probably going to become some of the most sought-after investment targets because they have the potential to change the most and therefore boost their underlying long-term valuation.’ This is not to say that investors should go to the opposite extreme and look at ‘dirty’ sectors as good investments simply because they could improve. If they don’t set themselves up for such improvements, they remain a bad investment.
The shift will be felt through the relative popularity of different asset classes: active ownership strategies have so far mostly been in equities, taking the form of exercising shareholder voting rights or to engage with boards and management. Bonds and structured loan products will have a greater impact if they are contractually tied to specific outcomes. Developments in ESG data will play a vital role in enabling this.
Danae Kyriakopoulou is Chief Economist and Director of Research at OMFIF and Chair of the Sustainable Policy Institute.