ESG maturing, far from settled…
We have been asked on several occasions whether we believe ESG-Investing has reached a state of reasonable maturity in capital and financial markets?
On each occasion I have proffered a rather hurried and wholly inadequate answer in the negative. In this blog I attempt to address this by cataloguing evidence of where greater maturity and/or standardisation is needed.
By way of reminder, Martialis takes no sides in the question of whether ESG investing adds value. If there is a value-assessment debate it is for others to determine, though we view the ultimate goals as laudable.
What follows should not be considered complete. While I have attempted to filter objectively, the starting point for the catalogue is inevitably opinion-based, or based on our experiences, and as usual – everything is contestable.
Some fundamentals
Let me start by making two general observations on the question of whether matters-ESG are ‘settled.’ This is a somewhat different question to whether they are, as yet, mature.
Firstly, modern investing owes much to the earliest open-air markets that started to evolve in and around the Warmoesstraat in Amsterdam in the late 15th Century. In their seven hundred-plus years evolution various approaches to investing have advanced and diversified, but never settled. Hence, at this relatively early stage, we should expect the ESG-investing domain to likewise advance and potentially diversify over time.
Secondly, while the world’s capital markets are truly enormous, it’s not clear whether there are sufficient ESG-rated securities to meet demand at any point. For example: if the world’s savings pool were directed entirely at ESG-rated assets above a certain score, their availability would be an obvious limitation. This is also food for thought for those who might be concerned at prospective concentration and/or asset hoarding risk (a topic for another day.
With this aside, I focus on reasonably objective areas that demonstrate that more mature ESG investing environment remains ahead of us.
The catalogue
John Feeney’s recent blog underscored the benefits of industry standardisation in benchmark setting, noting that:
“Markets depend on a level of benchmark standardisation that makes each dealer and end-user confident of the performance and valuation of each product.”
And:
“Most deep and liquid markets depend on a standard benchmark for risk resetting which is widely available and used in the majority of traded products.”
While John was pointing to the benefits across traded products, I think it is reasonable to extend these contentions to global finance more generally.
What we know is that in domains such as, say, transport, standardisation that turned cargo freight into uniform cargo in the form of ISO-standardised containers and pallets has driven incredible efficiencies. We can also agree that in financial markets high degrees of homogeneity have dramatically improved the efficient movement of capital between economic agents.
Thus, the catalogue that follows leans heavily on our enterprise view of the attractiveness, benefits, and likely efficiency-gains of adopting highly standardised and transparent approaches in markets:
ESG Ratings
Whereas the credit rating domain settled around a group of core agencies with well-understood approaches and ratings actions, the ESG ratings space continues to evolve.
As John noted, ESG evaluation criteria vary between multiple different rating platforms and are typically not independently verified, thus there is “no existing robust and standardised measure of ESG which captures a wide range of inputs and could be classified as a financial benchmark.”
Separately, it’s reasonably clear that ESG ratings are themselves an emerging specialisation, evidenced most recently in the unfortunately high ratings achieved by FTX on governance measures by a prominent ESG ratings firm.
Investment managers should note that ratings and ratings standards are neither fixed, nor a one-way bet.
2. Pricing (particularly sustainability premium or ‘greenium’)
We would normally view pricing as the rather obvious interaction between buyers and sellers known as price discovery in transparent markets, but this is a feature of mature markets. In less mature settings the pricing of individual deals may be shrouded by ‘tailored estimation’ (in the absence of an observable markets), and price discovery may be problematic given the one-sided nature of demand.
And this appears to be the case with ESG deal price-setting.
We note that in a recent ISDA survey, The Way Forward for Sustainability-linked Derivatives, the association asked members how ESG premiums are determined. Of 69 survey respondents a clear majority (45) indicated they “did not know how these premiums are determined.” ISDA also referred to the SLD market (sustainability linked derivatives market) as being “nascent” and described the sustainability premium or “greenium” as a “new concept in derivatives trading.”
These are obvious features of illiquid or partially formed markets such as those found in the price of highly complex derivatives.
3. Primacy
Corporate finance valuations have generally advanced down return or risk-compensated return dominant pathways. This was the logical advance of finance theory driven by advances in thinking around CAPM models and the like, aided by return-based concepts such as RoIC, RoCE, and RoE and broader economy concepts such as those found in the macroeconomics field.
While the layering of ESG filters within investment processes can take many forms, the question of ESG primacy arises. At what point should ESG filters be applied? Is there a fixed line, or some flexibility? What of exceptions? Should ESG factors take precedence, before traditional valuation approaches are applied?
We note that there are a variety of approaches being taken among clients, and other investment entities with whom we are close. Few are attempting a strict Blackrock ETF-like approach, though all have found themselves under pressure to respond in some fashion.
4. Portfolio Construction
Portfolio construction and asset allocations are considered by many to be at the heart of investment management performance.
Linked to the question of ESG-primacy is the question of whether a filtering process (particularly very strict approaches) may have unintended consequences in terms of optimal portfolio construction?
This is an emerging yet important topic. Is a traditionally risk-efficient portfolio, one suited to one or more beneficiaries under traditional allocation approaches, corrupted when ESG filters are applied (particularly if stringent filters remove whole sectors from consideration)?
There are a range of views on this, and I do not propose to dig into them here, however, we note that ESG scores for certain investable sectors are more readily achieved than in some others. At a minimum, we would expect this to have a bearing on portfolio concentration (and this may have played-out across the sweeping return-themes of 2022, in the dramatically skewed returns to energy sectors compared with new-economy stocks).
5. Emerging Standards
Perhaps the greatest area driving ESG towards maturity at present is that of the impending transparency, particularly in the sustainable finance edge of ESG. We see this as being driven by a range of government and regulatory agents.
There are simply too many global initiatives in-train to mention at present, but by way of example:
Australia - National Sustainable Finance Strategy,
We view these as likely to shape and enhance ESG maturity by bringing a degree of standardisation, but this will take time.
In this sense such initiatives are to be welcomed, but they are not yet embedded or systematically applied. They are also occurring on a multi-jurisdictional basis, and though we can acknowledge the work of the UN, there appears to be only vague international coordination.
We urge investment managers to watch these developments closely, since differing or changing standards can have a bearing on portfolio composition considerations.
6. Fiduciary Risk
We covered this topic in my blog of November 9th; ESG & Mandate Risk, which received reasonable interest and viewership. Judging by the number of follow-up engagements on the topic we expect the fiduciary question to linger.
Opinions certainly vary among readers as to whether fiduciary risk rises or falls away, but this itself is a sign that the question of fiduciary responsibility is not entirely settled. It may also be prone to shifting political sands on a jurisdictional basis (down to state level in the US as one example).
More recently, we have seen additional thought pieces on this topic appear, for example, Does ESG investing have a problem with fiduciary duty?, and related news that demonstrates there is a distance to travel before maturity is reached:
We continue to assess the various risks within this space.
Summing up
To sum up, we have been taking stock of the ESG domain for considerable time and have had several interesting client engagements on the topic. Much of what I have expressed here has been driven by such engagements, which have been highly productive and somewhat illuminating.
Our role is always to consider what is happening and be in a position to help inform decision-makers as their navigational needs arise, and as they ask where they should be positioned as events unfold To this end, it is helpful to be challenged on any topic, but on the question of how mature the ESG domain is for investment managers this has been very much the case, and we expect the challenges to continue.
While we are inclined to point out that there is a potentially long way to go, we can at least note that ESG investing is maturing but not yet settled.
As always in finance, some complexity remains, and market participants will have to keep adjusting.