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Investment management and dynamic ESG


Published: 19 Aug 2022

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How can investment management firms navigate the changing priorities for investment triggered by an evolving definition of ESG?
In July, BlackRock CEO Larry Fink warned we should worry more about the rising cost of food than petrol. He told the FT the dramatic spikes in oil and mineral costs after Russia’s invasion of Ukraine had distracted traders from the long-lasting and extra harmful impression of food inflation.  
Data from the ONS shows that the cost of food in the UK increased 9.8% in June 2022 over the same month in the previous year. It is the highest food inflation since March of 2009, mainly due to rises in the price of milk, cheese, eggs, vegetables and meat, while the global food price index (a measure of the monthly change in international prices of a basket of food commodities) averaged an all-time high in March 2022 at 159.3 points. 
The climate change crisis has developed cost-of-living risks and complexities that are now skewing the focus on, and indeed changing, Environmental, Social and Governance (ESG) issues that dictate investment directions. In other words, the meaning of ESG is shifting. 
So, what does this mean for investment management firms? 

The ultimate cost of living crisis 

“Food prices and gasoline prices are linked,” says Kaisie Rayner, a sustainable finance practitioner and founder of A Future Worth Living In. “Our financial system does not exist in isolation; it is one of many systems upon which our lives are dependent, [including] biosphere, social, economic.” 
Rayner calls the climate crisis ‘the ultimate cost of living crisis’. In failing to tackle the challenge head on, she says, we have locked in warming of at least 1.5 degrees and associated climate-linked inflation which are already impacting both energy and food prices. 
This puts investment firms under more pressure than ever. “Investment firms are bound by a fiduciary duty and, increasingly, climate change is understood through this lens because it presents foreseeable and material financial and systemic risks,” explains Karl Mallon, Climate risk analyst and CEO of firm Climate Valuation.  
“The key to navigating it is to conduct a rigorous materiality assessment to determine which aspects of climate change are most relevant to the firm. For example, rapid transition (for energy investments), acute physical risk (for insurance and logistics), chronic physical risks (for long-life, real assets and agribusiness) and litigation risk (for nearly all companies failing to manage climate).” 
“Take net zero, which many investment management firms have signed up to now through the Net Zero Asset Managers Initiative,” adds Sandy Trust, Director, Sustainable Finance, Business Consulting, Ernst & Young LLP.  
“Active investment managers need to make investment decisions that align with the mandate of the fund and their clients’ needs and are used to thinking about financial risk and return. Now they are required to consider the carbon characteristics of the fund both now and in the future, to deliver financial returns, manage material financial risks, including those related to climate, and deliver impact on the carbon dimension,” 
This requires new data, processes, management information, risk appetites and reporting – as well as an ability to interact with investee companies and assess their carbon trajectory. An investment decision now needs to take all this into account as well as the financial risk and opportunity.  
“There are windfall profits to be made, but in chasing short-term, unsustainable returns investors could be missing the opportunity to invest in the sustainable leaders of the future and making the cost-of-living crisis even worse,” warns Rayner. 

Managing ESG credentials 

So, what funds offer the best returns while delivering on ESG credentials and is it possible to have both? The correlation between ESG performance and financial performance is an area of intense research and debate.  
“In simple language,” says Mallon, “‘ESG credentials’ are a proxy for good management. If a Board or a firm’s management can anticipate, understand and manage the material environmental and social risks and opportunities facing its business, then it is likely to be managing its business well, overall.”  
Climate change is going to fundamentally alter the operating environment for business the world over, so it is logical that returns will be stronger overall for funds that have foreseen and prepared for these risks.  
However, investment returns are driven by more than ESG factors. “ESG has, broadly, outperformed for a decade until the Ukraine crisis, where a combination of macro factors including rising inflation and energy prices have led to, for example, energy stocks outperforming,” says Trust.  
“My personal view is that over the long-term investing in areas that are likely to see significant growth such as batteries, renewables and alternative protein, is likely to yield outperformance – but even in rapid growth sectors it can be hard to pick winners.” 
But the arrival of mandatory disclosure for ESG and climate-related risks will bring transparency to the complex and growing market for ESG investment. In recent years there’s been a weight of money flowing into ESG-labelled funds. “This has often benefited entities with a perceived lower-carbon profile – tech, banks, property,” says Mallon. “However, shifting capital will not in itself solve underlying ESG problems, there’s maturation around data and impact measurement still to occur. In the long run one could expect the best returns to derive from robust, science-based data and sound judgement by well-educated Boards.” 
This idea of shifting capital is a crucial element. It is what will help determine our future. “Fundamentally, all investment decisions have an impact, and how we allocate capital creates the world around us,” says Rayner. “The companies we chose to finance create the goods and services of our economy.” 
The best, more enlightened, investors not only consider how ESG risks and opportunities might impact the value of the companies they invest in, but they also realise the inherent creative force of capital. “They’re more likely to invest in companies that are contributing to a thriving, prosperous and sustainable future [along with] managing ESG risks well,” Rayner adds. 

Highlighting greenwashing 

The question is whether greenwashing is now becoming more problematic as oil and gas companies' profits rise? Earlier this year The Clean Energy study, published by authors Mei Li, Gregory Trencher, and Jusen Asuka, examined the records of ExxonMobil, Chevron , Shell and BP to determine whether the carbon cutting actions each had pledged were, in fact, upheld.  
The report said: ‘Financial analysis reveals a continuing business model dependence on fossil fuels along with insignificant and opaque spending on clean energy. Until actions and investment behaviour are brought into alignment with discourse, accusations of greenwashing appear well-founded.’ 
“I would say that greenwashing is an important and hugely difficult topic,” admits Trust. “One of the difficulties here is that an assessment of sustainability requires both position and direction. For example, on the carbon dimension I need to understand the emissions of a stock today but also its direction on net zero. Has the company committed? Is that commitment credible? Will it achieve decarbonisation targets? Is the rate of decarbonisation quick enough? So, I think greenwashing is difficult to manage, hugely important and hugely challenging.” 
“Responding to climate change is a structural rather than a cyclical change,” says Mallon, adding that “‘greenwash’ is a temporary and dangerous feature of this transformation, driven by corporate leadership that has failed to recognise its long-term structural nature. We’re going through a phase where old habits are still being flushed out of a system undergoing structural change whereby better data, stronger regulatory frameworks and mandatory disclosure will make it easier to assess which companies have cogent strategies and which do not.” 
Oil and gas companies’ profit surges on the back of high prices and stronger demand have created a short-term need for their product while a fundamental energy transformation is underway, but a prudent investor will recognise the underlying trend rather than being dazzled by its dramatic edge effects. 
Over the long term, the best ‘real returns’ adjusting for inflation, will only be achieved by balancing financial returns with investment in a sustainable future. ‘The alternative is a bag full of money which you can no longer spend, in a dystopian hothouse future not worth living in,’ concludes Raynor.