ESG: whatever it takes to be (un)aligned

ESG data and ratings are now a huge industry. ESG has given a new impetus to financial institutions, while they were still dealing with public skepticism in the aftermath of the financial crisis. The emergence of “sustainable finance” has seen a change in perspective: better to be perceived as driving positive change, not misery.

The key finance players have all developed ESG offers. Not least the index providers. What might sound counter intuitive, given the ongoing debate on what sustainable investment truly means, is the quality of company-disclosed data and the unclear consequences for portfolio construction methodologies.

Tackling global warming can only happen at a diversified portfolio level and benchmarks increasingly use both negative (exclusions) and positive screening (weight according to ESG profiles). This is an important departure from the traditional capitalization-weighted market portfolio, but can it match an ambitious sustainable strategy? In addition, it remains unclear what being aligned to “below 2°C”, “Paris Cop 21” or “net zero by 2050” will mean for investors.

Our view is simple. ESG efforts are best served by pro-active investors acting independently of indices. ESG’s qualitative nature also means it is changing fast meaning that running with indices is both of no value and dangerous. ESG, which last century would have been called normal pro-active investment, gives active managers the opportunity to defend strong views.

The State of ESG Benchmarking

One thing that ESG has not yet meant for the financial world is more competition. Indeed, the biggest players have been quick to spot the rise of interest from savers to foster the extra-financial characteristics of their investments. From asset managers to rating agencies, market participants have been reinforced, if anything, by ESG becoming mainstream. Oligopolistic providers such as rating agencies or index providers are making a killing. This gives an insight into the pace of the future transition towards “sustainability”: don’t expect these players to disrupt themselves (at least too quickly). And a smooth transition is indeed priced into most traded assets.

The continuous growth of passive investment holds true for ESG and therefore the S&P and MSCI provide many ESG and environmental benchmarks. Is it then possible to have the best of both worlds: being passive and ESG compliant?

Below, we focus on the ESG offer of MSCI, as a major index provider and member of the Technical Expert Group, which is currently helping the EU Commission to define its green taxonomy.

The MSCI offers ESG-focused indices, with versions for most regions, based on its ESG research. In these indexes, the MSCI re-weights stocks according to their proprietary ESG ratings. The aim is to maximize exposure to stocks with positive ESG outcomes. Companies involved in tobacco and controversial weapons are excluded. Achieving sustainability requires many active decisions and these enhanced indices are indeed rather active strategies, because they are based on continuously monitored negative and positive rules. However, how do they match sustainability requirements?

As precise ESG criteria and data continue to be defined, aggregated ESG ratings must be criticized for what they have been able to tell investors. They strongly differ from one provider to another: a 0.61 correlation has been found by a MIT survey for five ESG raters on 823 companies. This equates to total discrepancy of views. By comparison Moody’s and S&P Global are correlated at 0.99 for credit ratings.

Investing in these ESG-enhanced indexes thus amounts to passively following an active strategy, which imposes its own view on what sustainability means. Since these strategies are mostly based on quantitative criteria and are not that transparent most of the time (because of the complex underlying ESG ratings methodology), one is left to ponder if this is wise and fits with the fiduciary obligations of money managers.

Demand from final investors may have created an opportunity for the fund management industry but it seems likely that good advice entails more than matching indices.

Among the latest MSCI-launched indexes, two series of provisional climate change indices are aimed at complying with the minimum requirements recently approved by the EU Commission (still subject to member state approval) to define climate benchmarks. It looks as if there is little that a quality investment portfolio would have not gone for.

A Strong Sense of “Déjà Vu”

Source: MSCI Documents Factsheet. As of Dec 31, 2019

For the sake of the exercise, we matched that “discovery” to AlphaValue’s own independent metrics.

A Detailed Picture with AV ESG Data of the 10 most Paris Aligned Stocks According To MSCI

Given the numerous criteria used (based on the EU green taxonomy work, see below), this index is the result of an active investment strategy. As a result, it favors already-large market caps in sectors which are not carbon intensive. As these names are already (in most cases) the most sought after in the market, throwing them into yet another index merely serves to inflate their already inflated prices. Indices create imbalances in markets by encouraging herding. The ESG derivatives will only make a liquidity accident more likely to happen.

Furthermore, these benchmarks are likely to fail to capture the stocks offering the most crucial social and environmental innovations, due to their focus on quantitative-based rules. The biggest companies of the resulting index will presumably have a much lower carbon footprint, but will they for all that develop the products/solutions consistent with the Energy Transition and a sustainable economy? To stress this point, many surveys have indicated that most of the “green” innovations come from companies whose activities are currently the most GHG-emission intensive.

For instance, Berkshire Hathaway, though one of the biggest players in renewables in the USA via its Energy division, is excluded from the S&P 500 ESG Index. This points to another problem: the difficulty in finding pure players.

Another problem arises when bench-marking the low carbon transition: the benchmark itself i.e. the whole investment universe. The pipeline of consistently “sustainable” investable projects is still the missing element. Adopting a benchmark-investing approach thus risks giving a premium to not- so-green and not-so-social companies. After all, in the kingdom of the blind, the one-eyed are kings.

As for yield, it is TINA (there is no alternative)

In a market increasingly oriented towards passive investing, these new benchmarks will direct billions of investment flows. As an example, BlackRock is looking to double its ESG ETF offering by 2021.

For them, it is business as usual. They record large inflows by selling whatever is the flavour of the month, while keeping charges as low as they can so as to see off the competition. This strategy may, however, fall well short on delivery on ESG issues, which requires a longer investment horizon horizon. At AlphaValue, we acknowledge that ESG means much bigger capital intensity than the market is currently pricing in. This will have an unavoidable impact on valuations and leads to complex iterative models between higher capital intensity (lower ROCEs) and demand for ESG assets, meaning cheaper capital at least facially.

Conversely weak and crude benchmarks may end up slowing the pace of the transition toward sustainability. Strangely enough, Larry Fink, BlackRock CEO, agreed with this in his 2020 annual letter: “In the near future – and sooner than most anticipate – there will be a significant reallocation of capital”, while as a shareholder supporting very few climate proposals.

Standardization should be welcomed in the ESG space, but not one in favor of the status-quo which prevents “a fundamental reshaping of finance” (another Mr. Fink expression). At this point, it is clear to us that investors cannot go ESG while seeking “broader equity market returns”. By way of illustration, the MSCI ACWI Climate Change’s tracking error is 0.96% with MSCI ACWI…

It is also clear that the quantitative approach to ESG is not enough, in that companies’ ESG profiles and ESG criteria themselves will evolve and fast, as part of a continuing discovery process by the corporates themselves (actually the biggest market movements are likely to come from these changes).

EU will soon tell us what being Paris-climate-agreement-aligned means

In its work on Sustainable Finance, the EU Commission defines “two types of climate benchmark” the “EU Climate Transition Benchmark” (CTB) and “EU Paris Aligned Benchmark” (PAB). These two benchmarks will set the standards for all climate-labelled funds in Europe.

Source: TEG Final Report on Climate Benchmarks & ESG disclosures (September 2019)

One of the biggest lessons of the 2008 financial crisis is still being ignored: putting blind faith in benchmarks and ratings (here ESG) eventually explodes in investors’ faces. As big asset managers and benchmarks providers enter into an unholy alliance to sell e“newly labelled but old products” as solutions, they are likely to remain part of the problem for efficient capital reallocation toward sustainability.

So far ESG investing has almost-exclusively demonstrated its exceptional ability for market players to find new business. To quote an old line from a famous French play, “What an Art needs most, is not people who understand it, but pay well for it”. This is certainly true for financial institutions in need of fresh business; it might be less so for the planet.

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