Of the many debates around ESG investment, the central issue is a question of terminology and genuinely establishing the role of an investment manager, ESG or otherwise. This has been particularly well exemplified by the complaints made by a number of US pension funds against the ESG policies of large asset managers, particularly those engaged in operating large ETFs.[1] The debates in the US really stem from a perceived lack of clarity by the customer about the agenda and process of the investment manager, with particular concern that these might have changed after the initial point of investment. The specific objectives of a fund or an individual manager can vary hugely, but the role is always to pursue those agreed objectives with integrity and transparency; the discussion around ESG investment must, therefore, focus on clear terminology, as it is not just helpful, but foundational to best practice in investment management.
Part of the difficulty in clarifying language around ESG investment is that there are several ways in which one could legitimately claim to be pursuing an ESG-aligned agenda: from using voting rights to exert pressure on key issues in companies of all sectors, to exclusively investing in those industries deemed to be actively beneficial or progressive, and everything in between. As the case proves, however, the party that genuinely struggles with this breadth of meaning is the customer. Once a term applies to too many concepts, it loses any utility, and this is clearly the point being reached for ESG or ‘sustainable’ investment; there is now virtually no meaningful information imparted to the potential investor through the use of such nomenclature.
Some of the tools supposedly created to help bring transparency to the process of ESG investment have become embroiled in the issues, adding to a sense of general obfuscation which can even feel cynical at times. Several organisations have developed proprietary ratings systems, often in the style of credit ratings, by which a company or product can be scored for its compliance with certain standards. A number of problems very quickly arise related to the need for companies’ scores to be comparable across sectors and related to quantifiable metrics. These necessities have led several of the largest providers of ratings, such as MSCI, to adopt industry-relative rating systems, in order that one can compare companies across different sectors. The problematic result of this approach is that it is perfectly plausible for a fossil fuel producer to receive a higher score than a healthcare provider, or even possibly a green utilities provider, depending on how the ESG criteria are defined. The real result of rating systems like these is that, far from increasing clarity in ESG investing, they have simply provided a means of greenwashing funds which may well have not altered their holdings since claiming sustainable priorities. It is also worth noting that the disproportionate beneficiaries of these systems are large, index-based funds, rather than those with a higher active share.
One important push for clarification on the issue of terminology is coming from the EU, whose Sustainable Finance Disclosure Regulation (SFDR) is beginning to hold ‘ESG’ funds to account. Many of the funds claiming the title are divided into Article 8 funds and Article 9 funds. An Article 9 fund must have sustainable investment as its objective, thus requiring every investment to be justified in relation to this. A fund complies with Article 8 if it ‘promotes’ ESG considerations in its investment process.[2] The specifics require the investor to take ESG into account when making an investment, using a consistent and, crucially, demonstrable methodology. The UK is also soon adopting a similar structure. The European Securities and Markets Authority has suggested that a tighter, more prescriptive EU Ecolabel should be introduced to provide clear requirements for funds claiming ESG credentials, due in part to the fact that, whilst they require specific levels of disclosure, the SFDR articles do not set explicit minimum ESG standards. These regulatory frameworks represent a significant step forward, particularly for the customer, who can now refer to a more concrete definition in some cases. The proof of the efficacy of the regulation in holding organisations to account has been shown through the de-rating of some of the largest ETFs from Article 9 to Article 8 funds, as not all the investments were in sustainable assets.[3] Interestingly, MSCI still give many of these funds AAA ratings.[4]
The importance of greater transparency in exactly what is being claimed, both in values and process has also been reinforced through the recent accusations concerning Adani Group. Over 500 funds claiming to be Article 8 compliant contained stocks bearing the Adani name, a significant proportion of which were through direct holdings. It would most likely come as a shock to the end investor that a fund with governance as a key principle would have allowed investment into companies vulnerable to such accusations.
Aubrey operates a range of funds, some of which are run on ESG principles and qualify as Article 8, and some where ESG is not a major driver. When we claim to be carrying out ESG investment, however, we do so with real conviction; a proprietary and detailed ESG analysis is carried out on all securities during the investment process. The analysis seeks to identify shortfalls and risks, and is followed by active engagement with management on any identified weaknesses. This is an ongoing process, conducted at least annually. Most importantly, we exclude controversial sectors. Our ESG is not a matter of so called ‘best in class’. If a sector is considered harmful, we do not invest in it.
Whilst a lexical minefield, there are several reasons to be optimistic about the outlook for ESG investment. The growth of funds describing themselves as ‘impact’ strategies, whilst still varied in definition, does provide a helpful point of differentiation for the customer. The EU is also continuing to lead the charge on standardising the sector; alongside the SFDR initiative, the EU is in the process of publishing a standard of methodology and disclosure for those making sustainable investments. Just as SFDR has forced affected asset managers far beyond the confines of Europe, this new legislation could similarly bring about a much broader homogenisation of disclosure expectations across the investment market. Whether successful or not, this legislation only goes to underline the simple fact that transparency and disclosure must remain at the centre of investment management, particularly when considering extra factors like ESG.
The covenant between the investor and the investment manager is based on an alignment of objectives and methods. When it comes to achieving or measuring these objectives, attempts to obfuscate or complicate will only continue to breed controversy and debate around issues where there need not be either. It is to this end that Aubrey continues to communicate its investment processes to clients, whilst also always pushing for maximal disclosure from companies.
[1] https://www.ft.com/content/4df73458-6871-47ba-ad64-00cd7b3ed12c
[2] https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019R2088&from=EN p11
[3] https://www.ft.com/content/47fe8139-1672-4d6c-a19b-d3a7cae4757b
[4] https://www.msci.com/our-solutions/esg-investing/esg-fund-ratings-climate-search-tool/funds/hsbc-msci-europe-ucits-etf-eur/68051902
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