Issue #5
ESG as a Duty
Another month, another part of the IPCC report. Last year, the first part concluded global warming was accelerating faster than expected. In February, the second part showed how dramatic the impact of climate change already is, with half the human population at risk today! On this front, Swiss Re Institute estimates natural damages related cost for 2021 at USD 270 Bn, of which only USD 111 Bn were insured. (You can read their publication here.) This is again a new record… with much more to come.
With this background, the last instalment of the IPCC report focuses on solutions. To reach the 1.5°C or even the 2°C global warming target, we need CO2 emissions to peak now! And this requires major transitions, not only in our energy systems, infrastructure use or technology implementations, but also in terms of socio-cultural and behavioural changes.
The good news is that the overall financial cost of these transitions would be fairly low and largely compensated by avoided costs, for example those related to natural damages. Basically, McKinsey estimates in their net-zero transition report we would need to invest USD 1 000 Bn more per year. This is comparable to the USD 640 Bn of subsidies that still go to fossil fuels and the USD 270 Bn of natural damages related costs mentioned above. It is about 1% of global GDP to avoid losses that could be 5 to 20 times larger!
Now for the bad news. Despite this huge incentive to invest of a 5 to 20 times return expectation, the IPCC report is clear:
“Tracked financial flows fall short of the levels needed to achieve mitigation goals across all sectors and regions.”
Please invest more!
Now, we fall back onto the usual argument in favour of sustainable investment:
The world is burning and social inequality is rising! We need a “just transition” and a “global reset”, so please invest in our ESG funds (and everything will be fine).
This pitch calls on our emotions very effectively: a bit of fear, a bit of guilt and an easy way out. The underlying assumption is that since ESG funds take into account environmental and social factors when deploying capital, their investments will lead us towards a sustainable world. Unfortunately, it is not that easy.
Yes, building a sustainable world requires sustainable investments; but this does not mean that sustainable investments will necessary lead to a sustainable world! For that to be true, investments need to finance the right actions in the right places at the right time. This is much easier said than done.
The easy part: the right time is now! And there is so much to do that the right places are pretty much everywhere… obviously, this will have to be refined, especially to assist countries where the adaptation needs are dramatic, like sinking islands.
Materiality
So I will focus here on the right actions: those that will help us make material progress towards a sustainable world. I argued in previous letters and articles that financing such actions requires a “double materiality” perspective.
“Simple materiality” looks at the effects of the environment on the company: what are the financial risks and opportunities for the company? For this reason, it is also referred to as “financial materiality”. This is the point of view adopted by most sustainable investors… but it is really just good management and, as such, is the minimum any customer should expect from their bank or asset manager.
On the other hand, “environmental & social materiality” looks at the effects the company is having on the environment and society. With that knowledge, investors and companies can work to improve the footprint of their actions, both by reducing their negative and increasing their positive effects.
Double materiality looks at both financial materiality and environmental & social materiality. Oversimplifying a bit, the first ensures profitability while the second ensures sustainability.
Unfortunately, only a minority of sustainable investors are using such a framework of analysis. And this is the source of much misunderstanding and greenwashing accusations. Investors integrating ESG factors in a “financial materiality” framework might sincerely believe they are doing the job. After all, they are investing in the whole range of “ESG opportunities”: solar panels, wind turbines, efficient robotics, electric cars, new isolation materials, etc. But less financially material topics like biodiversity loss or social justice are left aside.
Fiduciary duty
With all this, why are so few investors focusing on double materiality?
When I ask this question to investors, I am almost always opposed the argument of fiduciary duty. We are expected to act in the best interest of our customers, i.e. the end investors. This relation of trust is sacred and our role as professional investors is to maximise returns within the risk limits accepted by our customers. Basically, we would love to do more, but it is really our end customer’s choice to make.
All right. But if fiduciary duty is so sacred, why are we collectively lying to end investors? Let’s be honest: when non professional investors buy “ESG products” en masse as they do today, they want their money to make a difference and to feel good because of that. What we are giving them is too often business as usual with a “simple materiality ESG factor integration overlay” and a mumble-jumble sauce they have no chance of understanding.
Regulations can help on that front. In Europe, SFDR is progressing with the latest technical standards adopted last week, the Taxonomy development is ongoing and MIFID II will bring new obligations to ensure that the ESG preferences of customers are taken into account. In the US, the SEC is now moving in the same direction with proposals to impose climate related disclosures, in line with TCFD. All this is great and will certainly be a subject for a future letter. But it takes time to design and to implement such regulations! And that time is running very short…
If we really want to avoid the worst possible future, professional investors like every other human being should not wait for regulations to force them to do the right thing. They should do it now, simply because it is the right thing to do! Or maybe, they could try to benefit from a first mover advantage…
In a nutshell, we have a fiduciary duty to our customers just as we have a moral duty to the larger society.
Ethics
Once in a while, I like to read Alexander Solzhenitsyn’s Commencement Address of 1978 at Harvard University, A World Split Apart. This great Russian philosopher is spot on! Yes, we hide behind legalistic rules and lack collective courage.
But our actions have consequences. For example, slavery is hardly conceivable today. But the triangular slave trade is a historical reality, the consequences of which are still felt to this day. But how did it start? How could it become so systemic? Did traders understand what they were doing? Did they have a soul?
Traders of the 16th century century were human beings. Actually, one often ignored fact is that white sailors were more likely than black slaves to die during the trip! About a third never made it back… Not only was this a dangerous adventure, but sailors had no financial value compared to slaves.
Back to our point, traders were respecting their fiduciary duties and the rules of the day. There is no doubt many knew it was ethically wrong, but there was a market. After all, they did not directly enslave people… they merely bought them in an African port to send them on plantations in the unknown world. With hindsight, we know the undeniable counterargument: the market existed because there was a demand.
Individually, slave traders were following the rules. Collectively, they were responsible for one of the most horrific episodes in our history.
Had the ship owners and traders of the time taken a “double materiality” view of things, history may have been a bit different. Now, today, we are collectively setting the stage for ecological and social damages barely imaginable… and the future will judge us.
Individually, should we not at least try to look at the world through this double materiality lens?
Yes, this requires a deep dive out of our comfort zone. We need to integrate many topics we are not always familiar with: development economics, SDGs with their interrelated targets and indicators, climate and social sciences, transformation, etc. The task can seem daunting! But let me reassure you: the journey towards a sustainable world can also be extremely beautiful and rewarding! Just like the diver on the cover picture… she will discover a new world full of colours, corals, plants and animals. And she will come back richer and with a story to share!
As usual, I do not pretend to hold the truth and I am happy to learn from you all! 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