Issue #4
What Ideal for Sustainable Finance
War is shaping a new world and the Earth poles are 40°C warmer than normal… Maybe it is time we all think hard about our responsibilities.
What are we doing? Why are we doing it? And how should we do it?
ESG to date
Sustainable finance became very technical over the last ten or fifteen years. Before that, the lack of data made us rely on common sense: excluding harmful industries and asking simple questions to the companies we wanted to invest it. For example, we would ask a mining company how many accidents they had per tonne of extracted mineral. If that number was too high of if we felt the management did not really care about fatalities (as the financial cost could be very low in some geographies), then we would just not invest. On the contrary, if the management could explain the difficulties and we could see progress, we might have invested and stayed engaged.
We now have a lot more data and processes. We look at a collection of Environmental, Social and Governance “factors”. These factors are assembled into models and weighted against each other. We can build a nice scorecard for our mining company; but this “tick the box” approach means the number of casualties becomes one data point out of many… Therefore, it can be compensated by other “good” data points, like having enough women on the board and a training procedure (whether it is enforced or not). By transforming the pain of a family who lost a child in a mine into a “data point”, we render everything relative and loose sight of fundamentals.
To make matters worse, many investors started looking at ESG as a simple risk management exercise, considering ESG factors only through the lens of financial risk; this is the so-called “simple materiality”. Don’t get me wrong: risk management is crucial for investors! But ESG with a simple materiality lens is just good risk management. It is the minimum customers can expect from their bankers and asset managers!
Today, few investors actually look at “double materiality” which includes the risks posed by companies to the environment and society.
Semantics
The limits to the technical approach of ESG are made very clear by the semantics used in articles such as this one from the Los Angeles Times: How did ESG funds wind up investing in Putin’s Russia? A few examples:
- Semantics 1: What are BlackRock’s “ESG Aware” exchange traded funds? Is being “ESG aware” the same as being aware that the world is warming up while exploring the crust of our planet to extract more fossil fuels? This is “simple materiality” at it’s best! Looking at ESG only as a risk management exercise means being “aware” of the harm and investing anyway. Financial professionals may be “aware”, but the larger public is not! People will read “ESG” in the name of the fund and imply sustainability; this terminology flirts dangerously with greenwashing. And in so doing, it hurts the credibility of an industry that lives on trust.
- Semantics 2: “Sustainable and ESG funds aren’t the same as ethical funds.” Yes, ethical funds will follow a set of ethical or religious values to exclude certain sectors or activities like drugs. In this sense, sex might be sustainable without being ethical. However, once again, the larger public should not be required to understand the intricacies of our industry! Acting and investing in an ethical way is the least our customers and the larger society can expect from us. On this front, ESG might actually have regressed over the last decade…
- Semantics 3: “The war has broader implications for ESG investors than just ethical ones.” Really??? What is more important than ethics? Money? Fame? I get it, the sentence is taken out of its context: ESG investors are using more complex strategies than the simple exclusionary filters of so called “ethical funds”… Once again, ESG investors loose themselves in technicalities, focusing their analysis on “scientific” factors and excluding pretty much anything else. It might be understandable. It is harmful nonetheless.
What now?
The limits of this technical integration of ESG factors into investment processes are clear. The ethical and cultural values that underline ESG criteria have been drowned by the complexity of automated and quantitative approches. Some would qualify these approaches as “scientific”, but that is probably too strong a word. They have mainly become “mechanical”.
Now, just like politics have influenced the European Taxonomy by temporarily tagging gas (if it replaces coal) and nuclear power as “green”, maybe it is time we let our investment analysis be influenced by ethical and political factors? And if so, up to what point?
I grew up as an investor in a “free world”, with humanistic values and a strong international exposure. But I was reminded recently by an investor I was interviewing for an upcoming book that the act of investing means taking a political stance. When we finance a company, we are explicitly enabling its actions and the effects they will have on the world, the environment and the society. In that sense, investing cannot be politically neutral.
So we must take a step back, look at the big picture and decide what world we want our kids to live in.
It is hard. Just like rats in their wheels, our horizon is blurred the drudgery of daily chores. But what is life like 200 meters from this textile factory we have financed? What will our kids think about our actions? We often complain our parents left us too much debt… What our we leaving our kids?
Coming back to the Los Angeles Times article, I could not agree more with Philippe Zaouati of Mirova:
“This should be a moment of recalibration for ESG investors”.
What next?
I want to believe recalibration is possible: we need to look seriously at the larger impact of our actions (the “double materiality”) and refocus on the “G” of governance as it is the foundation for any action.
This will not be free: it is hard work and implies we will have to forego “opportunities”. I had my time as a fund manager investing across Asia and I once was presented with a very attractive investment in China. The problem? The founder and CEO of the company was managing it from behind bars! Many of my competitors invested anyway and it worked out great for them. I missed the opportunity… without any regrets.
Good governance is a condition for trust. Everything else builds on that trust, including the “E” and “S” factors.
And as we restore this foundation for trust, we need to think about the impacts we want to have on the world. Dominique de Villepin, a former French Prime Minister famous for the incredible speech he gave at the UN Security Council against the Irak war in 2003, recently said in an interview that “one is more credible when defending an ideal than interests… that might be negotiable”.
So my question to ESG investors: What is your ideal?
Now, as the last decades have shown, words are not enough and acts need to follow: what step can you take today that will bring you a bit closer to that ideal?
I do not pretend to have definitive answers to any of these questions. But I would love to know what you think! Please share your comments, ideas or questions.
As usual, this letter, originally published on LinkedIn, is meant to open a discussion: join it here.
Lenny Kessler