“A company may be considered sustainable because of the product it produces and yet be a laggard when it comes to managing its ESG issues”.

Praveen Gupta: With Exxon staying put in the S&P 500 ESG Fund and Tesla being taken off, is there really such a thing as an ESG stock or an ESG standard?

Tamara Close: There has been much debate as of late about what constitutes an ESG stock, whether certain stocks are appropriate for ESG funds and whether certain ESG funds should even be called ESG funds.

Where a lot of the confusion reigns is the conflation between ESG and Sustainability. A company can manage their material ESG issues very well but not be a sustainable company, and a company can be sustainable while still having low scores on ESG issues. For instance, an oil & gas company may manage their scope 1 & 2 carbon emissions, the health & safety of their employees, their Board’s diversity, etc. very well and yet produce a product that has very negative externalities for the environment.

A company can manage their material ESG issues very well but not be a sustainable company, and a company can be sustainable while still having low scores on ESG issues.

On the other hand, a company may be considered sustainable because of the product it produces and yet be a laggard when it comes to managing its ESG issues. We have seen this very situation with Tesla being removed from the S&P 500 ESG Index while Exxon remained.

Since ESG indices act as de facto ESG data providers, and it is important for investors to understand the specific requirements for inclusion in these indices.  ESG indices can also be sector neutral to their non-ESG counterparts so you will find sectors not traditionally associated to sustainability or ESG.

Bottom line: There is no such thing as an “ESG stock”, and there is no consensus on whether certain companies, products or industries qualify as sustainable or ESG friendly.  Investors need to determine the ESG characteristics or exposures (both positive and negative) that they want, or are comfortable with, in their portfolios. Industry materiality frameworks, standards, taxonomies, indices and data providers can help guide the conversation but given the subjectivities of sustainability, these are not the only solution.

The market has finally realized that not only do you not need to give up return to invest in a sustainable company (which was never a valid argument) but investing in sustainable firms will actually help you create alpha.

PG: Disclosures and audit are sacred territories. Who should be refereeing if there is greenwashing – before a regulator blows the whistle? DWS is neither the first nor the last?

TC: We have seen a huge upsurge in ESG labelled funds over the last few years. The positive side to this is that the market has finally realized that not only do you not need to give up return to invest in a sustainable company (which was never a valid argument) but investing in sustainable firms will actually help you create alpha.

Just like there is no definition of an ESG stock. There is no true definition of what constitutes an ESG fund. Many firms were happy to relabel funds as “ESG” without putting the required governance and oversight measures around this.  While firms like BNY Mellon and Goldman Sachs (currently being investigated) probably did not have an intent to mislead, regulators act to preserve investor interests, so they will crack down on any misstatement or omission of information. 

As to who should referee these managers before a regulator steps in? This falls squarely in the court of internal compliance and audit departments.

As to who should referee these managers before a regulator steps in? This falls squarely in the court of internal compliance and audit departments. An underlying issue and core challenge however is the understanding of what is ESG integration. This is not a binary process. There are many different ways of integrating ESG and many different levels of maturity for ESG practices. Fund managers need to understand where they fit on this maturity spectrum and they need to ensure there are governance and oversight practices that can be tracked and measured internally.

If a firm is investigated by a regulator for greenwashing, whether it’s a lack of internal governance and oversight or whether the firm intended to truly mislead investors probably won’t matter to clients or in the court of public opinion. This however can be positive for those fund managers that are truly integrating ESG authentically as it will help identify asset managers that “do” from managers that “say they do”.

PG: What are some issues that you think will next come under focus of regulators or industry watchdogs for investment funds?

TC: Getting to net zero global carbon emissions will require the “largest re-allocation of financial capital in human history” (McKinsey), and institutional investors are the critical lever to strategically drive that transformation to a net zero global economy. With this very real need to get global carbon emissions to net zero by 2050 and reduced by 50% by 2030, there has also been an upsurge in the number of Net Zero or Transition funds.

While there are some truly innovative investment strategies out there that will no doubt help with the transition to a low carbon economy by investing in those leading companies that are transitioning and transforming their business models and by investing in those companies that are creating solutions to get us there, this has also opened the debate about what is a true net zero portfolio.

There are many ways to get to a net zero portfolio but not all actually reduce emissions in the atmosphere, which is what is urgently required to get global emissions to net zero by 2050.

There are many ways to get to a net zero portfolio but not all actually reduce emissions in the atmosphere, which is what is urgently required to get global emissions to net zero by 2050. For instance, some funds will consider the shorting of high carbon companies as a way of reducing the carbon emissions in their long positions, although this does not actually reduce emissions in the atmosphere. Others will purchase offsets, although not all offsets are created equal. Offsets that only avoid emissions are not as impactful as offsets that remove carbon and have long lived storage capabilities.

Transparency is, therefore, key when assessing the carbon intensity of a portfolio. The goal should not be to have the lowest emissions, but rather the most accurate. With that as a starting point, the plan should then be to reduce emissions as much as possible through security selection and engagement, and then finally through offsets that remove emissions from the atmosphere. 

PG: Nothing, as of now (including the Paris Agreement) is mandatory. Would you not consider that as toothless?

TC: I think it will be difficult to make them mandatory, given that there is still so much political opposition. However, going forward these will probably become de facto mandatory as the world evolves and investors demand this. Countries that do not meet their Nationally Determined Contributions (NDCs) of the Paris Agreement, for instance, are already being scrutinized and this is becoming part of sovereign risk analysis. This will most probably start to affect countries’ credit ratings and hence their ability to raise debt, attract foreign capital and maintain a competitive market and foreign exchange rate.

PG: Many thanks Tamara for these brilliant insights into some very critical issues that tend to cause serious ambiguities in the world of ESG.