Cohesive Action Is Needed To Really Crack The ESG CodeCohesiveActionIsNeededToReallyCrackTheESGCode

As readers probably know, if like me, you are currently living in the UK, you have been in a complete lockdown since the start of 2021, going out only for essential shopping and local exercise.  So, I have found myself with plenty of time for contemplation, but at least events in the markets have been offering plenty of distractions!  For the first time in family history, I was alerted early to an investment issue by my children, in this case the GameStop saga (they are clearly much more in tune with the Reddit zeitgeist than I am).  More recently, the markets and particularly the bond markets have suddenly – arguably belatedly – woken to the possibility of inflation (see my Q3 letter for a slightly more forward-looking perspective).   

Indeed, while our investment teams have been poring over the projected timing and impact of inflation (reference Dr. Sushil Wadhwani’s recent commentary here), my focus is on the longer term and, in particular, I have been fascinated by the continuing acceleration of developments in the ESG space.  I would pick out three interwoven strands at this point in time: 

1. Global interest in ESG, and particularly the environmental “strand,” continues to accelerate.   

2. The new Biden administration in the US has seemingly set on a clean break from the policies of the previous administration.  We have already seen that with the US rejoining the Paris Agreement, and all the indications are that we are going to see a much more sympathetic approach to ESG than we had from the US Department of Labor (which “governs” pension plans) previously, which was seemingly putting hurdles in the way of those plans that did want to adopt an ESG approach. 

3. New European regulations around ESG disclosure in funds are coming into force this month, applying to funds that are used by non-European investors as well. 

I would summarize that we are seeing, simultaneously, an increasing convergence of direction globally and, at the same time, an increasing divergence of what that direction might mean in each region.  Now that can happen in any global enterprise, but I would argue that particularly in terms of ESG and climate, that divergence risks undermining the goals of what our clients, asset managers and our regulators are trying to achieve. 

To start to shine a light on the challenges, I would argue that the right starting place is to consider what our clients who are adopting ESG actually want.  This requires a high level of generalization, but in essence I would summarize that they want to see the behavior of corporations change, although the focus and direction of that change will potentially vary from client to client.  So, for example, if you as a client oppose global warming, your goal is either to get those corporations who emit carbon dioxide to reduce their emissions directly, or to get them to be transparent about their emission activities with sufficient clarity that either the capital allocation process or customer base skews against them to force them to change.  Now, you may also want to use your capital to accelerate development of alternative technologies that reduce CO2 emissions, e.g., hydrogen power or CO2 recapture, but the chain of cause and effect is much easier to influence here; subject to whatever legal and fiduciary constraints they operate under, a client is free to positively allocate capital to these new alternative technologies, should they so choose.  The challenge is how your ESG aspiration as a client works its way through the “system,” i.e., a company with managers on behalf of shareholders and an asset-management industry managing assets for clients, since the system creates a range of agency effects that can obscure your goals. 

What do I mean by “agency” effects?  As a general economic term, these arise when the will of the end user is enacted through agents of any sort and the interests of the agents and hence their potential actions diverge from those of the end user.  Where do I see agency effects in the ESG cycle? 

• One mode of putting pressure on corporations is via shareholder resolutions.  Management is likely to resist pressure to change strategy, and the fragmented nature of the voting process can make it easier for corporations to resist that pressure, e.g., resolutions need to be permitted to be tabulated, the voting is divided across all the shareholders, and the actual voting process may well be delegated to the investment managers rather than enacted by the asset owners, who moreover may find that rules on market collusion (seemingly not applicable to Reddit participants!) preclude their acting in concert. 
• If corporations are going to publish data, then, of course, they will naturally prefer to publish data that shows them in a good light. This may be via choosing different start dates, different reference points or focusing on partial disclosures, etc.  Thus, the collective desire to see more comprehensive, more standard data can end up being frustrated. 
• Managers themselves are in competition with one another, and so will naturally look to score competitive points irrespective of whether in aggregate this benefits our clients.  So, if individual managers choose to compete on having better “secret” data, then actually this can serve to reduce forces on companies to publish better public data. 

• Finally, we often look to regulators to lay out minimum standards on issues like data disclosure to prevent arbitrage and selectivity by companies.  For general financial reporting, this is underpinned by international accounting standards, for example.  However, if regulators see themselves as somehow in competition, that can create windows for global companies to both play the field in terms of which standards they adopt, and also use lobbying etc. to stoke that competition in a direction that suits them. 

So how can we, as an industry, try and counteract these agency effects to better increase the chances of achieving what both the clients and many, if not all, asset managers want?  Of course, because we are counteracting agency effects, it follows automatically that this may not suit every individual player, but the stakes are too high to let that be a deterrent.  Here is my manifesto! 

1. Let us, firstly, accept and embrace that ESG will mean different things to different end clients, both within an individual country and even more so globally.  Let us embrace that in our design of our strategies and products – even though it reduces our economies of scale – rather than trying to shoehorn everyone into the same label, which will actually serve to reduce cooperation and create more dissonance. 

2. Let us look for ways in which we can work together as an industry on issues like engagement and voting, which will help us mitigate the natural fragmentation in the system that serves to reduce our collective voice, and allow end companies to divide us. 

3. Let us work to avoid proliferation of initiatives, particularly around data, each of which is well-meaning in isolation, but which collectively serve to reduce the pressure on companies to publish abundant transparent data on a consistent basis.  For example, it’s been fascinating to observe the growth in the number of academic bodies that are tying to a particular owner or manager to launch a research initiative on some facet of ESG data and/or its significance.  Given the large number of universities, and large number of clients and managers who care passionately about the subject, this is of course not surprising at an individual level.  However, I would argue strongly that the industry is better served by having two or three such initiatives with multiple backers of each rather than 20 or 30, and certainly that the former is more likely to create effective pressure for changes in behavior, which is, after all, the goal here! 

4. In a similar vein, let us be careful and thoughtful as individual managers about proclaiming that we have some secretive data source that makes one of us a better ESG manager than another.  At its broadest level, I do not believe our clients are looking to use ESG as an opportunity for gaining alpha (presumably at the expense of someone else who must be “losing”); they literally want a better world for everyone.  Fragmentation of data, which by its nature is the opposite of transparency, only serves to reduce the pressure on companies to change. 

5. Finally, let us collectively try to increase the pressure on global regulators to find a common voice on and common approach to ESG.  This is an area where we want maximum convergence in terms of what is expected of investee companies, and minimum scope for interpretation and global divergence by those companies.  Again, there may be national fiefdoms in play, but we are generally all aligned here, and any rules that are enacted whether nationally or globally are presumably there to help protect the owners of the assets. Our collective voice surely has weight, if we can find a way to make it heard effectively. 

Of course, your manifesto may be different!  But I do hope you share my view that we should try and address these issues early and cohesively, before we all head off in different directions.  The further apart we allow ourselves to get, the harder it will be to get back together without perceptions of winners and losers.  The underlying paradox is that, potentially, this is an area where the greater the plethora of individual efforts that go in, the less effective we risk being at achieving what we all collectively want!