ESG Investing: How Right Becomes So Wrong

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How Did You Get It So Wrong?

John M Lund Photography Inc/DigitalVision via Getty Images

ESG: Conceptually Simple, But Simply Complex

“ESG” has become an esoteric buzzword, but what does it really mean and how should we think about in the context of our investing?

Each of us has a moral compass, and it stands to reason that there are some investments that we will avoid because it violates our sense of right and wrong.

For example, illegality aside, we all know that there are huge profits to be had from the narcotics trade, but we have no desire to pursue such opportunities because they are morally wrong.

It is for this reason that I would suggest that ESG is very nuanced and needs to be tailored to each investor.

Said differently, there is no “one-size fits all” when it comes to ESG.

However, the approach being taken to ESG investing by asset managers, and to some extent by corporate entities, is based on a one-size fits all assumption.

By definition, investing is opinionated and exclusive to each of us.

Some people accept that anthropogenic greenhouse gas emissions are an existential threat and so will have an aversion to oil companies that produce hydrocarbon fuel. Others form a view that global warming is no big deal and so are happy to invest in oil majors.

The Russian invasion of Ukraine has certainly put ESG theory to the test. The arms industry has been shunned by the ESG crowd on the basis that it costs lives. But is there not a counter view that the manufacture of arms acts as a defensive deterrent?

Had Ukraine not agreed to nuclear disarmament under the Budapest Accord in the mid 1990s, there is a good chance that Russia would never have invaded, war would have been averted, and hundreds of thousands of lives could have been saved. Is it socially responsible to ostracize the arms industry from capital markets on grounds of ESG?

The truth is that there is no right or wrong answer to this question. As with politics and religion, different people will formulate differing views. It is for this reason that I argue that it simply is not possible to manage ESG objectively. It is very subjective.

So, every fund manager needs to formulate his or her own fund manifesto and let that be the basis upon which investors decide whether or not to apply capital to that particular fund.

The issue, I would suggest, is that ESG is being done badly. Too many people are getting it entirely wrong by treating it as a “tick-box” exercise as I shall go on to explain.

The nuances of ESG are often missed by asset management firms that try to create an algorithmic screen for use by their fund managers. This approach is destined to fail because it is quite impossible to ascribe an objective numerical value to subjective ESG criteria.

More particularly, asset managers wish to distinguish themselves on grounds of having a stronger ESG ethos than their competitors, so how does an algorithmic approach based on the same third party ESG data used by every other asset manager achieve that goal?

Just as equity analysts publish a unique subjective investment thesis based on the fundamental economics of a business, so should ESG analysts publish their unique subjective view on the moral compass of corporate entities. Only then is an asset manager able to distinguish itself from the competition and to stand out as a champion of socially responsible investing.

There is something of a self-serving flywheel at play here. Said differently, the motivation for being ESG compliant is wrong as I shall explain.

Asset management companies in turn want to attract money from self-righteous investors. They know that they are likely to be able to charge higher fees for funds that are managed both on financial and ethical criteria. In turn, corporate entities know that institutional investors are increasingly paying close attention to ESG criteria in order to generate bigger fees from self-righteous investors and so, in order to attract capital from the markets, they try too hard to appear ethical and in doing so often shoot themselves in the foot (see examples below including Unilever and Lloyds Banking Group).

This has attracted criticism. Professor Aswath Damodaran at the Stern School of Business at New York University has recently launched a scathing attack on the ESG sector.

“I believe that ESG is, at its core, a feel-good scam that is enriching consultants, measurement services and fund managers, while doing close to nothing for the businesses and investors it claims to help, and even less for society.”

The Professor asks, who benefits? He constructed the diagram below to demonstrate how much of the ESG industry is currently self-serving.

Aswath Damodaran, Stern School of Business

Personally, while I agree that many in the financial sector are seeing ESG as a gravy-train, I disagree with the Professor that it is a scam and that it serves no social purpose.

This paper highlights issues that ought to be considered and offers an entirely different perspective. It offers real ESG case studies including:

  • A bank that wanted to promote gender diversity but introduced a disastrous policy that inadvertently introduced gender discrimination into the workplace where none had existed before

  • A leading consumer goods company that has become so focused on political correctness that it has adversely prejudiced its commercial performance. The same company decided to take the moral high ground on a highly contentious political issue that resulted in large scale divestment by large shareholders that did not share the same political view

  • A country that changed course and decided to implement policies that were inconsistent with pre-agreed global environmental objectives

Faced with any of these situations, what would you do? Would you sell your shares in these companies? Would you divest interests in the sovereign debt of a country that you felt was acting irresponsibly?

The chances are that you are unable to easily answer these questions. I hope that by the time you finish this article, you will be better placed to deal with such questions.

What Is ESG And, More Importantly, What Is It Not?

Environmental, social and governance (ESG) integration is “the practice of incorporating ESG information into investment decisions to help enhance risk-adjusted returns, regardless of whether a strategy has a sustainable mandate.” ESG is often used interchangeably with the term “sustainable investing” but the two are patently not the same and therein lies the first problem.

Author’s diagram

The United Nations Principles for Responsible Investment (UN PRI) defines responsible investment as an approach to managing assets that sees investors include environmental, social and governance factors in:

  1. their decisions about what to invest in; and

  2. the role they play as owners and creditors.

Listed under the headline of “misconceptions” the PRI also provides a long list of what responsible investment is NOT.

  • responsible investment does not necessarily require investing in a specific strategy or product… exactly how an investor practices responsible investment varies widely;

  • responsible investment does not require sacrificing returns;

  • responsible investment is not the same as sustainable, ethical, socially responsible and impact investing

  • opposed to an approach which makes moral or ethical goals a primary purpose, responsible investment can and should also be pursued by the investor whose sole focus is financial performance.

Investing is all about risk versus reward. So, having evaluated the ESG risk, if the reward is sufficiently large, why wouldn’t an intelligent investor accept that investment opportunity?

The answer is that he may. This is the key distinction between ESG investing, which is actually about risk evaluation, and socially responsible or sustainable investing as is explained below.

Broadly, when it comes to investing based on non-financial considerations there are six distinct types which are often wrongly conflated:

  1. ESG investing is about incorporating environmental, social and governance information into investment decisions to help enhance risk-adjusted returns. This does not have to be sustainable. For example, an oil and gas company might be considered a good ESG investment if it is offsetting its emissions in its operations, has a strong safety record and is giving back to the communities where it operates. The ESG criteria needs to be objectively measurable.

  2. Socially Responsible Investing (SRI) is where moral investing trumps ultimate returns.

    1. Exclusionary SRI investing includes divesting and/or screening out companies that do not meet specific investment criteria. Examples may include the tobacco industry, the arms industry, fossil fuels or gambling.

    2. Inclusionary SRI investing is when the investor positively seeks out companies that meet or exceed thresholds in relation to socially responsible criteria.

  3. Impact investing or Sustainable investing is concerned with bringing about a positive change by virtue of making an investment. This may be by virtue of providing capital to deliver a measurable social and/or environmental objective alongside financial returns. Perhaps investing in renewable energy technology or electric vehicles. Impact is measured on the basis of “intentionality,” “additionality,” “materiality,” and “measurability.” This investment approach is best defined by pursuing the three pillars of sustainability: economic growth, environmental protection, and social progress, also referred to as “people, planet, and profits.” Profits are an important element because it is difficult to sustain anything that is continually loss making. Said differently, sustainability is dependent upon profitability.

  4. Activist investing is where the investor procures change within a company by taking a sizeable stake and exerting influence on the board. This may or may not involve bringing about ESG changes.

  5. Ethical investing is subjective. It is a set of dogmatic rules that apply to a subset of investors but not to the entire investing community. It usually involves people who faithfully adhere to that rule set without question, often based on faith. This includes Islamic finance and Quaker finance.

While these six types of investing are different, there will be areas of overlap between them, but these terms should not be used interchangeably.

Rather unhelpfully, the European Union has conflated these terms in the definitions section of the Sustainable Finance Disclosure Regulation (SFDR) in which it defines “sustainability risk” as an ESG event which could cause a material negative impact on the value of an investment.

The Theory Of ESG Is Perfectly Sound

A company that is well managed and which generates durable earnings by deploying capital in a manner that is morally justifiable on both social and environmental grounds must be a good investment.

Conversely, a company that acts in an unethical manner with no moral compass is a high-risk proposition which, all else being equal, ought to be avoided.

However, ESG investing is far from black and white.

Fink, You Got It Right?

The man credited with bringing ESG to Wall Street is BlackRock (BLK) Chairman and CEO Larry Fink. He is without doubt one of the most powerful and influential financiers in the US.

In 2012 Fink began an annual ritual of writing an open letter to CEOs. These have become required reading for many chief executives. These letters have always sought to encourage companies to disclose more about how they provide for workers, the environment, and the community at large.

On 6th January 2022 Fink gave his thoughts to a conference call of customers and commentators reiterating what he had said at conferences in Davos, Venice, Riyadh, and Glasgow over the past twelve-months. “Climate risk is investment risk.” he said. “Profits and purpose are inextricably linked.”

Fink describes himself as a conservative Democrat. His position is to harness the power of American capitalism in order to address the issues of the day. It is his belief that investors and businesses should work alongside the government, because when companies play such a role, they reduce the need for governments to engage in deficit spending to tackle key issues.

Under Fink’s leadership, BlackRock helps investors by offering funds focused on environmental, social, and governance-minded investing. The sales pitch is that companies attentive to societal needs protect shareholder returns. Since investing is a game of risk versus reward, ESG investing assists by mitigating risks while capitalizing on the societal objectives of the day. Done properly it ought to be a win-win situation.

However, in the words of fifteenth-century monk and poet John Lydgate,

“You can please some of the people all of the time, you can please all of the people some of the time, but you can’t please all of the people all of the time.”

In 2020, Fink announced that BlackRock would be increasingly disposed to vote against boards and companies that do not report their climate risks in formats BlackRock endorses.

In response, real-estate investor Sam Zell said to CNBC, “I didn’t know Larry Fink had been made God.”

In fact, Fink, the man leading the ESG charge, seems to be displeasing people on both sides of the fence:

  • Activists are unhappy: Five Democratic senators wrote to Fink in 2020 saying BlackRock needed to support more shareholder resolutions to match his promises. In France that year, activists stormed BlackRock offices, flung papers and paint and scrawled “GREENWASHING” above a desk.
  • Investors are unhappy: In 2021, two Republican senators wrote to a large 401(k)-type US pension plan expressing concern that BlackRock was putting its CEO’s views ahead of investors’ needs and infusing left-leaning priorities in its voting guidelines.

It is clear that even those with the very best of intentions will still be susceptible to the hazards of the minefield that is ESG investing.

One possible solution was mooted by Dan Loeb of the activist New York hedge fund Third Point. In 2021 it took a large stake in oil giant Shell (RDS.A) and sought to break it into two parts. “You can’t be all things to all people,” is how Third Point puts it. It argues that “Future Shell,” focused on renewable energy, would attract growth-oriented investors who value environmental, social and governance factors, while “Legacy Shell,” focused on existing oil resources, would hand most of its free cash flow back to investors and so appeal to those who value steady income. The climate would gain because total new investment in fossil fuel would fall.

A careful balance will need to be struck if both activists and investors are to be appeased. The really important take-away from this section is that ESG investing can be a very powerful tool if done properly and with the requisite forethought, but it should never be viewed as a check-box exercise undertaken merely to keep up with competitors or because it is fashionable to do so.

This is summed up nicely by Evan Greenberg, the CEO of insurance company Chubb and long-standing fishing buddy of Fink. He stated,

“I believe Larry chose consciously to approach it as an opportunity, rather than something he is expected to do.”

Challenges With ESG Investing

The challenges arise in terms of the implementation of ESG screening:

  • Which data source is reliable for the purpose of making ESG decisions?

  • How is the data being collated and kept up to date on a real time basis?

  • How frequently should ESG screening be applied to reassess existing investments?

  • How much reliance should be placed on third-party solution providers?

  • How can ESG be implemented in a manner that distinguishes a fund from its competitors?

  • What lessons may be learned from mistakes of others in implementing ESG policies at corporate level?

  • How does a business avoid being accused of Greenwashing (“Greenwashing” is when misleading or unsubstantiated claims about environmental performance are made by businesses or investment funds about their products or activities)?

  • ESG must not become a check-box discipline undertaken because it is fashionable to do so.

  • How can ESG investment decision making within a large business become objective so that no matter who applies it, the same outcome is reached?

  • Is the ESG policy framework defensible if scrutinized by audit, the media or by investors?

  • Does the investor wish to become an active impact investor driving change within companies that have scope to improve their ESG ranking, or does it become a passive investor with a focus on businesses that already have a good ESG ranking?

This paper attempts to address these challenges and, more importantly, to point out where so many companies are going wrong.

How Right Can Be So Wrong

The corporate world is riddled with evidence of ESG done badly. Two examples are provided here for illustration. The first is Unilever PLC (UL) (OTCPK:UNLYF) and the second is Lloyds Banking Group plc (LYG).

1. Unilever and the Political Correctness Trap

Unilever plc, a multinational which owns a vast array of more than 400 food and household brands including Dove soaps, Rexona deodorant and Ben & Jerry’s ice cream, has self-styled itself as a champion of ESG investment criteria and it emphasizes ethical credentials over traditional financial metrics.

In 2019, Unilever CEO Alan Jope said, “evidence is clear and compelling that brands with purpose grow. In fact, we believe this so strongly that we are prepared to commit that in the future, every Unilever brand will be a brand with purpose.”

Terry Smith, the man often described as the English Warren Buffett and founder of London-based investment management company Fundsmith, is a top-10 shareholder in Unilever. He takes issue with Jope’s approach to ESG.

In his annual shareholder letter to his own investors, Smith states, “Unilever seems to be [sic] laboring under the weight of management which is obsessed with publicly displaying sustainability credentials at the expense of focusing on the fundamentals of the business”.

“A company which feels it has to define the purpose of Hellmann’s mayonnaise has in our view clearly lost the plot,” he wrote. “The Hellmann’s brand has existed since 1913 so we would guess that by now consumers have figured out its purpose (spoiler alert — salads and sandwiches).”

Smith is not alone in his criticism of Unilever’s approach to ESG.

For example, Unilever seems to have taken political correctness to illogical extremes. Last year Unilever announced that it was removing the descriptor “normal” from its soaps, shampoos, and other personal care brands, saying the word was not “inclusive” and had a “negative effect on people.” The word “normal” is often used to describe what type of skin or hair – such as normal, dry, fine, or oily – is recommended for a particular beauty product.

Dr Bella d’Abrera from free-market think tank the Institute of Public Affairs was reported in The Daily Telegraph as describing the move as “ridiculous.” She said “Being ‘normal’ and ‘ordinary’ is not triggering for anyone except for the Unilever marketing department. By desperately trying to be ‘inclusive’ Unilever is alienating the majority of its customers who fall into the ‘normal’ hair category. The folk at Unilever are clearly on another planet…”

As a final example, in July 2021 ‘Ben & Jerry’s,’ a Unilever brand, announced that it would stop selling ice cream in the Occupied Palestinian Territory of the West Bank.

Political views should never be conflated with commercial objectives – the two are often diametrically opposed.

The political move was not well received by investors with a different political position, and this culminated in several state pension funds in the US including New York, New Jersey, Florida, and Illinois selling their shares in Unilever for violating their policies against boycotts, divestment and sanctions activities related to Israel.

Unilever’s shares have fallen 9 percent over the past year, despite the UK market having risen 11 per cent in the same period. ESG done badly clearly is not good for business!

As an investor incorporating ESG information into investment decisions to help enhance risk-adjusted returns, how would you rate Unilever? Would you invest in them, or would you avoid them?

2. Lloyds Banking Group and the Statistical Box Tick Trap

In 2014, Lloyds Banking Group plc, a British bank, was the first FTSE100 organization to establish a gender target to improve its quota of women. Lloyds Banking Group has committed to becoming a leader in gender diversity and it espouses the belief that companies with proportionate gender diversity see increased performance and that they make better decisions.

I can speak about this case study from firsthand experience. I worked at Lloyds Banking Group when this policy was introduced.

In 2014, under the leadership of Antonio Horta Osorio, the bank set itself a target to increase the number of senior management positions held by women from 28% to 40% by the end of 2020. The target was very nearly achieved. In the event the bank reached 37% by the target date.

The 40% target may appear arbitrary, but it was in fact a stepping-stone towards achieving 50% gender diversity, a new target set in 2021 to be achieved by 2025. Lloyds Banking Group is striving to achieve a perfect balance of men and women in senior management positions (if not in the entire business) based on the fact that this is representational of the gender split in the general population as a whole.

Whether this decision was made on sound commercial grounds by the Executive Committee or driven by the bank’s public relations division is impossible to know. However, the bank has invested heavily in advertising the fact that it was among the first signatories to the “Women in Finance Charter,” that it has been recognized as a “Times Top Employer for Women” for the last ten years and that it has featured in the “Bloomberg Gender-Equality Index” for the last three years and so you may draw your own conclusions on that question.

When the target was first set back in 2014, the bank established an internal mandate on employment and promotion in order to help it achieve its diversity goal. Essentially, if a senior-management vacancy arose and if the bank division in question did not have the requisite ratio of men to women, then the mandate stipulated that female candidates were to be favored in the selection process. This applied both to new hires and to promotions from within.

The policy was not well received by employees at the bank. There was a large increase in resignations from men who had seen their career progression prospects eroded significantly. But more significantly, women objected vehemently on the basis that if they were ever promoted then they wanted to know that it was on merit and not merely because they were wearing a skirt. In short, morale at the bank collapsed.

During the period 2014 to 2022 Lloyds Banking Group has produced a very lackluster performance with income from its loan book and trading activities down significantly. This has necessitated a 20% reduction in staff numbers and the value of the business has also fallen by almost one-third based on its market capitalization. Compared to its peers, Lloyds Banking Group has under-performed by quite a significant margin.

Author’s Table

There is no evidence of a direct causal link between the introduction of a gender equality policy and the poor performance of the business over the same period. However, this data certainly rebuts the assertion that Lloyds Banking Group used to justify its gender diversity policy when it said that companies with proportionate gender diversity see increased performance and that they make better decisions.

More importantly, there had never been any evidence of discrimination in the workplace as a cause of the 2014 gender imbalance at Lloyds Bank prior to the implementation of this policy. Ironically, it was the introduction of a gender equality policy that introduced discrimination against men into the workplace.

ESG should never be seen as a statistical check box exercise or as an opportunity to gain positive publicity points.

Within the “social” element of ESG it is important that there are equal opportunities for all. This implies that the target ought to be one of achieving a zero-tolerance policy relating to discrimination in the workplace. Decisions around new hires or promotions should be solely based on merit notwithstanding gender, ethnicity, sexual orientation, etc. In the context of Lloyds Banking Group, it means gender equality in terms of opportunities. It does not mean, diversity in the form of proportional representation in accordance with the demographic composition of the general population.

In fact, empirical evidence suggests that different genders are simply attracted to different roles. By way of example, as of March 2021, the proportion of women in nursing roles within the NHS (National Health Service in the UK) was 88.6%. Imagine if the NHS were to set targets of gender equality within nursing. To do so would result in a large number of female nurses being out of work while men were shoe-horned into their roles simply to tick a statistical box. There is no evidence of discrimination in nursing that has led to a huge gender imbalance. Instead, the situation may be explained on the basis of gender-based personality traits such as compassion which lend themselves to nursing and caring roles.

Similarly, banking and finance has historically been a male dominated profession in exactly the same way that nursing has always been female dominated. If, for example, 70% of people applying for a particular finance role are men then, all else being equal, statistically men will tend towards occupying 70% of those roles. There is nothing wrong with this if it is a natural occurrence and not the result of discrimination.

Exaggerating for effect, it would make no sense to require basketball teams to have an equal number of short and tall players (the equivalent of the Lloyds Banking Group gender diversity approach). There is a good reason that basketball teams are full of extraordinarily tall people. It has nothing to do with discrimination, instead it is based entirely on merit. Tall people have the correct attributes to succeed in the field of basketball whereas short people do not.

The same is true when it comes to ethnicity. By way of example, approximately 7% of the UK population is classified as Asian, yet a very disproportionate 30.2% of doctors working in the NHS are Asian. There is nothing wrong with this outcome. This is not evidence of any kind of discrimination at play, it is nothing more than representative of cultural preferences for certain types of careers.

By extension, if more Asian people tend to work in particular professions including, but not limited to healthcare, then a priori it must be the case that there will be disproportionately lower numbers of Asian people in certain other professions. So why in the name of ESG do companies strive arbitrarily to achieve proportionate ethnic representation across their business simply to tick a statistical box?

As an investor incorporating ESG information into investment decisions to help enhance risk-adjusted returns, how would you now rate Lloyds Banking Group?

ESG Done Correctly

We have looked at two examples of ESG done badly. By contrast, and for balance, there are illustrations of it done properly.

By way of example, Johnson & Johnson (JNJ) announced a new power purchase agreement (PPA) in December 2021, allowing it to power all its US, Canadian and European operations with renewable energy by 2023. The deal is a major step towards the company’s goals to power all of its operations with 100% renewable electricity by 2025, and to achieve carbon neutrality across global operations by 2030. At the end of 2020, 54% of J&J’s global electricity came from renewable sources.

In The Context Of Your Business

Having discussed the pitfalls of implementing an ESG policy with references to BlackRock, and having provided examples of how not to do ESG with references to Unilever and Lloyds Banking Group, ask yourself these questions:

  • Should Unilever meet ESG eligibility criteria as an investment by putting misguided political correctness before business fundamentals?

  • Should Lloyds Banking Group meet ESG eligibility criteria for having introduced discrimination into its business, albeit unintentionally?

  • If a company is operating in an industry that had no economically viable carbon emission abatement opportunity (such as aviation, shipping, chemical and steel manufacture) and which was expanding, so increasing its own carbon footprint, should carbon offsetting be sufficient for it to comply with ESG eligibility criteria?

Most financial institutions and investment funds would be unable to answer “yes” or “no” on an objective basis to these and similar questions. That would suggest a lack of coherent policy around ESG.

The consequences of incoherency include:

  • confusion amongst employees

  • misalignment of decision-making from one part of the business to another

  • an inability to satisfactorily answer questions around ESG decisions posed by auditors, the media, or investors

  • a poorly implemented ESG policy that would be exceptionally difficult to defend

In such circumstances it would be enormously beneficial to construct a decision making matrix for use by anyone in the future for the purpose of arriving at an objective outcome on any ESG issue.

Author’s Diagram

Embedding an ESG process in the business will, invariably be an iterative process. Essentially, this may be summed up in five steps:

  • Step 1 – Define the full gamut of ESG risks

  • Step 2 – Assess investments for ESG risks

  • Step 3 – Systemically implement a coherent approach to dealing with ESG risks

  • Step 4 – Embed ESG policies and procedures

  • Step 5 – Ongoing assessment of ESG policy, refining on an iterative basis as required

Are There Any Short Cuts?

Third party tools are available which facilitate decision making.

Rating agencies including Moody’s, Fitch and S&P are all offering ESG evaluation services. So too, unsurprisingly, are the likes of BlackRock.

An example is Aladdin Sustainability offered by Blackrock which ostensibly gives investors the data and tools to meet the challenges of sustainable investing. Aladdin offers clients access to headline ESG metrics from industry-leading ESG data providers at no additional cost.

The problem, however, as BlackRock acknowledges on its own website, is that there is no one-size-fits-all approach.

Accordingly, outsourcing your ESG decision making to third-parties is like pushing a square peg through a round hole.

This may be why Tariq Fancy, formerly BlackRock’s first global Chief Investment Officer for sustainable investing (2018-2019) has recently warned that so much around ESG investing is subjective and that both data and third-party ratings are unreliable.

This is why each financial institution engaging in the ESG space needs to formulate its own bespoke defensible approach. Only then will it be able to distinguish itself from the competition and truly represent the needs of its customers.

Product-Based ESG

1. Equity Markets

ESG in the context of equity investments has been covered in much detail earlier in this document. However, I would like to throw a few rhetorical questions out in order to stimulate thinking about ESG policies for fund managers.

  • While the creation of power from solar and wind is carbon free, the manufacturing inputs required in the creation of wind and solar assets is very carbon intensive.

    Solar panels are essentially huge semiconductors, requiring plastics and the heating of silicon dioxide to such high temperatures that only the burning of hydrocarbons is sufficient. The panel further requires a second heating with rare earth metals to allow for high enough conductivity to harness the power of the sun. Silicon dioxide is quartz, which must be mined. Mining, of course, is hugely energy intensive, requiring massive equipment fueled with diesel. The frame and plexiglass cover sitting on top of the semiconductor solar panel are plastic. We only get plastics from the refining of hydrocarbons. Grid-scale solar panels are said to have 25–30-year economic lives, but they degrade and become inefficient over time, so they must be replaced. Recycling requires huge carbon inputs.

    Similarly, wind turbines are made from materials such as epoxy typically made using chlorine and carbon fiber which uses polyacrylonitrile. Epoxy is stronger and occupies the portion of the turbine nearest the steel tower. The carbon fiber is lighter but weaker so exists at the edge. These are energy intensive industries that rely on hydrocarbon power. Then consider that the torque applied as the wind blows the blade is substantial and requires very deep foundations with an enormous amount of concrete at the base of the turbine. Cement (the base in concrete) production creates almost 10% of carbon dioxide emissions worldwide. The next time that you see wind turbines or solar farms, think about all the coal, gas and oil that goes into the production of green energy.

    Is investing in renewable energy as socially responsible as you thought?

    My view on this issue, for what it is worth, is that short term carbon emissions in the production of renewable infrastructure are more than offset by the long-term reduction in carbon emissions that result from their deployment.

However, ESG in the context of equity investing is far from black and white. There are only shades of gray.

It simply won’t do to take a dogmatic superficial view in order to tick an ESG box. Instead, it is necessary to take a position on all of these topics and to hold true to that position. There is no right or wrong. ESG legislation is not prescriptive in this regard, it simply requires transparency and full disclosure. It is aimed to avoid green-washing and any attempts to attract investment under false pretenses.

The answer, for a fund manager, is to take a position and to publish the rationale for the policies adopted by the fund. Accordingly, investors that share the values of the fund will invest in it. Those that do not, will not and that money will instead find its way into alternative investments. In this regard, ESG fund management becomes an issue of moral politics backed by good advocacy.

2. Fixed Income Markets

Tariq Fancy argues that sell-side financial institutions have an obvious motivation to push ESG products given that they usually have higher associated fees. Fatter profits for the service provider invariably mean a haircut on returns received by the investor which creates a conflict of interest.

Fancy, in a recent online essay, says that “Green Bonds, where companies raise debt for environmentally friendly uses, is one of the largest and fastest-growing categories in sustainable investing, with a market size that has now passed $1 trillion. In practice, it is not totally clear if they create much positive environmental impact that would not have otherwise occurred.”

This raises the issue of evaluating ‘additionality’. Perhaps an investor is happy to accept a lower financial return because the motivation for making the investment is to achieve a combination of financial reward and a social or an environmental benefit. But if the social or environmental benefit would occur with or without the investment there is no additionality, and the investor is arguably being short changed.

3. Sovereign Debt

Evaluating a country on an ESG basis when transacting in the sovereign debt markets is challenging because countries, unlike corporate entities, are subject to political constraints.

In any democracy a country’s leadership must dance to the populist tune otherwise it will not be in control for very long. Unlike the corporate world, at sovereign level there is no AGM at which activist investors are able to ‘encourage’ management to change course.

It is also critical to consider the interdependency between ESG factors, the economic strength and political stability of the state, and the ability of its government to both raise finance and repay debt.

One needs to consider the conundrum that depriving a country of the ability to raise money (or making capital more expensive) by withdrawing from sovereign debt markets on ESG grounds will, ironically, deprive that state of the financial ability to address many ESG issues.

Additionally, with political administrations each having their own agenda and changing typically every four or five years, this suggests that the future direction that a country chooses to take is as important, if not more so, than its historic ESG record. In most democratic states there is a system of bipartisan politics which sees parties at opposite ends of the political spectrum taking control periodically and adopting very different policies.

Donald Trump’s decision in 2017 to withdraw from the Paris Climate Accord is a case in point.

How does a fund manager respond to such a change in policy?

Is an appropriate response to stop buying US Treasuries for a fund?

Is divestment of US Treasuries from a fund justified (after all there has been a material deterioration in ESG criteria with global consequences)?

Being a signatory of the Paris Climate accord is one of the prerequisites of Febelfin certification, something sought by many European fund managers, and so the U.S. would no longer have been eligible for that after the Trump withdrawal.

This issue is particularly acute in the case of the US because it has become the global reserve currency due to the petrodollar agreement of 1974 (which opens a Pandora’s box of ESG issues).

In 1974, the United States set up the petrodollar system with the Kingdom of Saudi Arabia and then the rest of OPEC, which was an agreement wherein OPEC countries would only sell their oil in US dollars (no matter which country was buying it) and would also invest a good chunk of those dollars that they earn in Treasury securities. In exchange for this commitment, the US would provide military protection, arms deals, and other benefits to the Kingdom, as well as maintain stability in the region with its military might.

If you want to go down the rabbit hole of the geopolitics on this situation and the cost associated with this relationship, simply start with the Wikipedia article on the subject of US and Saudi relations to see how much the US looks the other way on Saudi issues in order to keep them in this deal. Let’s just say that the US Dollar is not exactly the most ESG friendly asset out there.

This agreement, maintained for nearly five decades now despite multiple scandals, made it so that every energy importing country in the world needs dollars, and they would generally sell their non-oil exports in dollars as well so that they would receive dollars to buy oil. This maintained the dollar as the global reserve currency despite the United States’ default on the 1944-1971 Bretton Woods system, and specifically it put the US Treasury security at the heart of the global financial system as the primary reserve asset.

Meanwhile, the accumulated US trade deficits from this system and associated policies are a staggering $14 trillion:

Trading Economics

All of those trillions in accumulated trade deficit dollars are surplus dollars for other countries, like OPEC nations, Japan, Germany, Switzerland, Taiwan, China, etc. Those countries take those dollars and buy a lot of US assets for their foreign-exchange reserves, sovereign wealth funds, and pension funds. Decades ago, they primarily bought US Treasuries, but they increasingly now use those dollars to buy other assets as well, including US corporate bonds, US equities, U.S. real estate, and US private companies.

At the end of World War II, the rest of the world owned about 2.6% of non-bank U.S. corporate equities. Then, from 1974 to 2021, this percentage rapidly increased, and the foreign sector now owns about 25% of non-bank U.S. corporate equities. This chart shows the value of US equities held by foreign entities. It’s up to over $12 trillion:


The exponential increase in U.S. government debt instruments owned outside of the U.S. is similar. So, how systemically destabilizing might it be if U.S. Treasury Bond liquidity suddenly contracted in response to the short term ESG actions of a tyrannical US president? Withdrawing liquidity from the U.S. sovereign debt market is probably futile given the depth of that market, but if withdrawing liquidity by asset managers is able to have a significant impact to influence US policy decisions, it would destabilize the global economy because it would hurt almost every other global economy as much as it would the US. This would be a systemic risk of epic proportions.

The question that flows from his is whether implementing sovereign level ESG criteria with respect to US Dollar denominated assets is indeed socially responsible investing.

One cannot advocate making exceptions for the US because the spirit of ESG requires the formulation of a non-discriminatory approach to every country.

Is it the place for investment managers to become political in any event and is it necessary? Consider that ESG and sustainability risk at country level is already factored into credit rating agencies sovereign ratings.

For example, Jair Bolsonaro’s presidency has certainly seen some degradation of the ESG standing of Brazil and, concurrently, the cost of its debt. The central bank has been forced to raise its federal funding rate (the Selic) in a bid to control inflation and to increase risk premiums for investors, and with nearly 35% of existing domestic bonds indexed to the Selic, each rate hike not only increases the cost of newly issued debt, it also raises the cost of a large share of outstanding debt.

If a sovereign ESG framework is deemed desirable, the key issues to consider are:

  • What is an ESG framework in the context of sovereign debt markets intended to achieve?

  • How is this objective to be achieved and at what collateral economic cost?

  • How is ESG to be measured at country level (even the World Bank has conceded that ESG scoring of sovereigns is too difficult at this time)?

On this last bullet ESG data in a Sovereign context can be more readily available than for other asset classes, but it is not always timely or accurate, and may involve bias.

As alluded to above, the World Bank and others have not yet formulated a methodology for objectively scoring sovereign states on an ESG basis. Instead, data is made available to facilitate the subjective decision making of users with regard to ESG assessments at country level.

JP Morgan Asset Management has, for example, developed its own proprietary sovereign ESG scoring framework which distinguishes between developed and emerging market investment processes.

It is evident that sovereign level ESG implementation is hugely problematic and requires very careful planning and messaging in order to get it right.


This paper spells out the hazards and pitfalls surrounding ESG investing. It has explained how many of the largest corporations have managed to get it so wrong. On a product level basis, it has looked at the challenges, particularly around sovereign debt.

It is evident that almost all businesses want to be seen to be doing the right thing, but so few understand how to properly achieve that objective.

Most ESG projects being run by asset managers, financial institutions and corporate entities are either tick-box exercises or else campaigns run by the public relations department in order to win positive publicity. Very few organizations are getting it right.

An asset management firm ought not to see ESG and sustainable investing as something that can be achieved algorithmically. Instead, it is an opportunity to stand out from the competition by standing up and being heard in much the same way as activist investors operate in the equity space. If you were, for example, to publish analysis on a company which included an opinion on its approach to meeting ESG objectives (perhaps calling out Unilever in the way that Terry Smith has, although perhaps with a touch more diplomacy) then that, in my humble opinion, is the way to play the ESG card. Customers and potential investors will take notice. Corporate entities will take notice. Sovereigns will take notice.

I hope that this article has offered you a new perspective and a deeper understanding of ESG investing. There is a great deal of white noise out in the market which has the potential to confuse investors. My advice is to be diligent. Open your eyes. Do not invest in a business simply because it gives lip service to ESG. If a company is trying to tick ESG boxes, then that is a potential red flag. The company ought to be acting in a responsible manner without forcing the issue. And, last but by no means least, remember, ESG integration is “the practice of incorporating ESG information into investment decisions to help enhance risk-adjusted returns, regardless of whether a strategy has a sustainable mandate.” Financial return should never be sacrificed simply to tick a box.


There is so much happening on the regulatory front including two new pieces of regulation worth calling out: one in Europe and one in the US.

  • In Europe, we have a Mifid II amendment that will go live in August 2022. It will require financial advisers to consider clients’ sustainability preferences in addition to their financial objectives and that has the potential to really accelerate retail money into sustainable products.

  • In the US, we have the Department of Labor (DOL) which will make it easier for retirement plans to consider ESG factors and invest in sustainable funds.