Anthony Bondain The problem (s) with sustainable finance

We've made progress, that's for sure. And then directing financial flows towards socially responsible investment seems like a good idea. That said, there are some misunderstandings, for example the difference between what ESG investments contain and what their investors think they contain. Or on the advisability, or not, of excluding certain sectors. I specify right now that this development is not exhaustive and that it is limited to asking a few questions by providing insights. The author alone is to blame for all approximations and errors, so feel free to correct him (without insulting him if possible).

Why is there (often) a misunderstanding about the content of the ESG?

Let's take an average investor whom we will call Emile (my grandfather and my neighbor are called Emile, so don't think that's pejorative). Emile decided to make responsible investments. As a modern man, Emile chooses two ESG ETFs from iShares, the world leader in passive management. The MSCI USA Select ESG, exposed to American stocks and the MSCI EMU Enhanced ESG, exposed to European stocks.

When Emile looks at the composition of his first ETF, he realizes that he has, in order, Microsoft, Apple, Alphabet, The Home Depot, Facebook and Tesla. Emile, who is not a partridge of the year, says to himself that it is all the same strange to end up with this stuff, when we know the planned obsolescence of some or the abuse of a dominant position by others. He figures he might as well have taken a Nasdaq ETF or S&P500, given the inbreeding. Note that the top lines of the ETF Lyxor S&P500 Paris-Aligne Climate (compliant with the Paris climate agreements) are Microsoft, Apple, Amazon, Facebook, Alphabet and Nvidia. Reminds you of something? And the Amundi MSCI World Climate Paris Aligned ETF? Apple, Microsoft, Tesla, Amazon, Alphabet, Facebook. Tech seems to go hand in hand with ESG, obviously. From there to explaining the outperformance of ESG in 2020… But shh, it's a secret.

In addition to being clever, he is a curious Emile. So he will see the composition of his ETF Enhanced ESG Europe. And there, he is a little puzzled. He does not know ASML, the first position of the fund. But the second, yes, is LVMH (leather bags). He also knows Sanofi "those who failed on vaccines" (Emile is teasing) or L'Oréal (lipstick and shampoo). Objectively, he does not really see the ESG dimension, but why not, after all. On the other hand, Total or BASF, it makes Emile a little weirder in the first positions of his ETF ESG (even if I have already seen Emile weeding with diesel, truthfully).

Well, there are not only ETFs in life, there is also active management and its hundreds of funds with slightly less mechanical selection criteria, like Pictet Global Environmental Opportunities, which " invests primarily in the shares of companies active in clean energy, water, agriculture, forestry and other areas of the environmental value chain". A little less general already. The first lines are Vestas, Applied Materials, ON Semiconductor, Synopsys, Orsted and Thermo Fisher. It looks a little more like the Epinal image of the specialty.

To give an overview of the offer, you should know that there are around 1,200 funds in Europe with the “sustainable finance” stamp, according to Novethic. This represents 2% of the 60,000 existing funds on the old continent, but they capture a much larger share of inflows than their number would suggest. They benefit from one of the labels that exist in Europe, in particular the main one, the ISR from the French government. Novethic identifies nine of these labels, which are either “ESG” as a whole, or more “environmentally” oriented. To qualify for SRI, for example, a fund must be certified on the basis of strict criteria by one of the three organizations recognized by Bercy (EY, Deloitte and AFNOR). The list of labeled funds is available here. There are also several other European labels, including the Belgian Towards Sustainability, with a list of products available via this link.

But as you will have understood, financial flows are not necessarily oriented specifically towards the sectors, professions and companies that are supposed to best embody ESG, at least in the eyes of the public. Let's see why.

Why having universal data is still an illusion

Dreyer’s English includes a footnote on how to type “en” dash on iPhone. Talk about a Modern Day–edit. https://t.co/wqa5dGknPW

— Andrew Drozdov Fri Mar 19 21:17:39 +0000 2021

As a preamble, and because we often forget, what we group under the umbrella of “sustainable finance” or “socially responsible investment” is based on environmental AND social AND governance criteria. We could debate the interest of the coexistence of the three criteria, but that risks taking too much time. As human beings love shortcuts, it is often the green dimension that is put forward because of the climate emergency, which is more meaningful for investors than the other two dimensions. In French, we also speak of "extra-financial rating" to qualify this data which does not come from the balance sheet or the income statement.

To form an opinion on a company, it is necessary to have precise information. They can come from a seasoned team of analysts, who sift through annual reports and overwhelm companies' investor relations departments with inquiries. It exists. But more often than not, you have to rely partially or totally on third-party providers. This is where things get tricky. Several providers offer ESG data, with more or less exhaustive coverage. This originally very fragmented market has become much less so since the major players in financial data have taken over the young shoots. For example, Moody's acquired Vigeo-Eiris, while Sustainalytics fell into the hands of Morningstar. Concentration also involves larger companies, such as the ongoing takeover of Refinitiv by the London Stock Exchange.

Despite these similarities, the results are still very disparate, due to multiple standards, different methods and asymmetry in corporate communication. Academic research is unanimous on this point, up to a recent often cited study (Berg, Kölbel and Rigobon, MIT / University of Zurich), which analyzes six specialists (KLD, Sustainalytics, Vigeo Eiris, RobecoSAM, Asset4 and MSCI IVA) to show that the correlation between their ratings only reaches 0.54 on average, and even drops to 0.30% for the "G" component. It is well known, the G-spot is often difficult to find.

To make matters worse, the requirements imposed on companies are very different in different regions of the world. In vain they multiply the criteria, the suppliers only obtain partial information, most of the time provided by the company itself. They also had to integrate a fourth dimension, which can take different forms. Some call it the controversy note. For example, such a company that produces electric vehicles (super wow!) regularly sits on labor law (less wow) or consumes rare materials supplied under questionable conditions (no wow). Or an oil producer who is converting to renewable energy by planning to invest $5 billion in this sector by 2023 (super wow!) and who is simultaneously devoting $20 billion to fossil fuel investments (less wow). In general, the controversies are about serious things, such as an accounting scandal, a tartiflette with a vacuum-packed Reblochon or an environmental disaster. In the two aforementioned examples, the companies – any resemblance to a real situation would be totally coincidental – suffer from a nasty note of controversy, which will affect their ESG score. We can almost speak of ESGC as this rating has weight with some suppliers.

Based on this information processed in a rather complex way, the extra-financial rating service provider offers synthetic ESG indicators, which allow, for example, to set up indices or create selection grids likely to be labeled by organizations. official, professional, not-for-profit, or industry-recognized. With recent consolidation, the data provider can also be the index provider. This is convenient but it raises other questions. But that's another subject.

These indicators are therefore used as filters, via several strategies.

What techniques are used to put together an ESG selection?

There are several approaches to creating a selection. In passive management, trackers can replicate indices or pre-existing selections. Active managers have a greater arsenal since they are able to add a human dimension to the mechanical dimension of models and algorithms. Let's look at some possibilities:

You can of course mix two or more approaches. Moreover, the most common way to build an ESG index or fund is to combine a positive approach (take the best of the class in each sector) and a negative approach (exclude certain sectors). To return to the first example mentioned above, the iShares USA ESG Select Index ETF replicates the MSCI USA ESG Select Index, which consists of over-representing the best-rated companies in each sector and under-representing the worst, while excluding tobacco and the most controversial companies.

Awful, dirty and mean

To conclude, it is impossible to escape the debate on the "irreconcilables", by barely caricaturing. Part of the population thinks that we must overturn the table and close overnight Total and The Boeing Company, Bayer and ArcelorMittal or the nuclear power plants of Electricité de France (but love Wish and buy SUVs). Another thinks that this kind of business should be given time to transform (and consumes organic tomatoes in winter because it's good for the planet). Here we find a bit of a misunderstanding between absolute ESG ("Total is a big polluter and has nothing to do with an ESG index") and relative ESG ("Total makes more effort than its sector and can therefore appear in an ESG index"). Or in a less trivial way: should we exclude such companies or ensure that they use their considerable resources to change more quickly? I lean towards the second option, reinforced by regulatory measures that put polluting, socially retrograde or opaque companies under pressure to accelerate their transformation, in order to avoid “greenwashing” as much as possible. This strategy seems more pragmatic and makes it possible to avoid burning the slats of the parquet floor for heating, ending up with 1 billion vehicles in car cemeteries overnight or with an unemployment rate of 32%. In reality, it is above all more likely to succeed because it is acceptable everywhere on the planet: local crusades only weaken the economies that launch them if the rest of the world doesn't care.

Finally, several criteria harmonization initiatives are underway. I am well aware that it is bordering on the oxymoron with such a sentence, but it takes a little time for everyone to agree. In Europe, for example, the Commission's offensive in favor of sustainable finance is reflected in the staggered arrival of new transparency rules. From March 10, management companies will have to classify their funds into three categories: in gray those who are content to take ESG risks into account in their investment process (or who do not care), in light green funds that promote ESG principles and dark green funds that have sustainable objectives. The opportunity, we can hope, to see things a little more clearly.

Among the resources used: