By Simon Cawdery
ESG. Three little letters that have increasingly become part of everyday investor vernacular while also generating a huge volume of opinion on both sides of the debate. How did we get here and what exactly is ESG?
Let’s start with the basics: What is ESG? To answer this, I turned to the CFA Institute which says that ESG stands for ‘Environmental, Social and Governance’ and goes on to explain that “investors are increasingly applying these non-financial factors as part of their analysis process to identify material risks and growth opportunities”.
On the face of it, this seems rather harmless. Investors are applying non-financial factors as part of their analysis. There’s no implication of obligation, no suggestion of expectation and no statement of prudence. It’s just a factor that can be considered.
Using ESG to evaluate companies
Therein, though, lies the rub of the problem. The history of ESG is in some ways no different to the history of any other factor that investors use in evaluating companies; many investors, for instance, will evaluate the quality of the CEO and decide if she ‘has what it takes’ and ‘has a positive vision’ in their analysis of a company.
Or some investors may do some research and consider that the diversity of an organisation is a good signal for future success. To take a somewhat simple example, imagine an organisation staffed just by 60-year-old white men. It may not be best placed to take the business into the Tik Tok generation and, thus, may be less successful than a more diversified workforce encompassing people of various backgrounds, ethnicity, age and experience.
So it is with the other elements of ESG. Many investors, for instance, consider environmental factors extremely important in their analysis. Companies that pollute are at risk of fines and punishments from increasingly concerned governments (who in turn are responding to societal pressures), and massive fines or taxes are detrimental to the longer-term health of companies.
So far, still nothing seemingly problematic. ESG is just a label that describes factors that some managers use in their investment analysis. Investment managers have a fiduciary obligation to use what they consider to be the most important factors in evaluating investments before they make them.
For some managers, certain factors are more important than others. Some managers consider financials crucial, other consider technical factors, others focus on leadership, while others can use ESG. Arguably, any manager should be able to use whatever factors they can justify in evaluating investments they make. They are also free to not use factors if they consider them to be less impactful.
On the flip side of this are the investors themselves, those persons who give investment managers their money to invest. If they consider that tech companies are the future, they will typically invest in managers who share that philosophy. Similarly, if an investor considers ESG critical, there are managers who focus on those factors. In a competitive market, if ESG or tech is the right factor, the value of money managed by those managers will increase and more investors will, usually, be attracted to it, thus justifying their hypotheses. Those managers that select bad factors will see their assets decline and probably fail; such is the intended mechanism of the free market.
Why the fuss with ESG then?
The fuss, from my perspective, has arisen because politics has become involved. If every factor is optional and at the discretion of the investment manager to use, or not, then it’s difficult to imagine any possible controversy. However, in the current political system that exists in the US (and other countries), compromise and accommodation are lacking, meaning positions have become extremely entrenched and increasingly extreme.
Advocates for climate change, for instance, who argue passionately for their cause, often struggle to find sufficient political support to pass policies designed to deal with that issue. Feeling that the political system is non-responsive, they look elsewhere to get their wishes actioned.
‘I rob banks because that’s where the money is’
As this quote from bank robber Willie Sutton suggests, certain activists have co-opted the ESG label as a tool to achieve political means. They have realised that if they can pass administrative rules that force those who manage money to consider ESG factors, then ESG actions will happen. The political system has failed, so they target the financial system. That is where the money is, and if those with all the money can be persuaded of the virtues of ESG then companies will be forced down a path that is favourable (in the activists’s minds).
Let’s take an extreme example. If every investment manager is required to consider carbon emissions of every company they invest in and high carbon emissions are considered bad, then investors will be forced to exit oil and gas companies and invest instead in renewable energy. In a sense, this is what is happening today. Politicians can’t agree on the right path for environmental protection and yet investment managers are pressured to consider ESG and give those factors top priority.
There are some obvious problems with this sort of approach. For one, it’s incredibly inefficient. If carbon emissions are a problem, fix the problem. Tax carbon emissions. It’s simple, it’s straightforward and it would immediately impact carbon emissions. On the other hand, encouraging investment managers to invest in renewables versus fossil fuel will take years to have any impact and there’s no certainty it will work. It’s at most a second-best solution.
The cost of ESG stewardship
And this, in a sense, is why this topic has become so emotive – it doesn’t necessarily deliver the optimal ESG outcome. Added to which, financial regulators are taking on the role of environmental stewards. They are requiring, in some countries, managers to publish ESG data and report to investors on the ESG costs of the companies they invest in. This all seems harmless until you realise that this has real costs for managers, and those costs will be passed on to investors in the form of lower returns. It also begs the question of why financial regulators are appropriate stewards of the environment or other social causes.
In a free market, investors can choose whether to invest with firms that publish such numbers and data, but in some countries all managers are forced to publish their ESG credentials. In effect, the argument that’s made is that financial regulation is pursuing a political agenda, potentially at the expense of investors.
But is that right?
Proponents will point to some compelling statistical data that evidences the benefits of ESG and say “all investors will be better off if companies are forced to focus on ESG factors”. The question, though, is what are those factors? Imagine we can agree that carbon is a bad thing and should be discouraged. Then perhaps it may make sense to force financial disclosure of carbon emissions. It won’t stop carbon emissions as quickly as taxing carbon would, but if we all agreed this was the only workable solution, at least it’s a step.
What about, though, to use a germane example – tax neutral jurisdictions?
Some Canadian entities evaluate Cayman on a ‘social factor scale’ and consider that it is an abusive environment and therefore prohibit making investments in funds that don’t tick a particular social factor. Is that fair or reasonable? If politicians find the topic hopelessly difficult to solve and are too hesitant to regulate through policies, how can we be sure the financial regulatory system’s attempts won’t fail or have unintended consequences?
What is Cayman doing?
Before answering that, let’s just set the scene. In Europe, almost all managers are now required to publish information on the ESG ratings of their investments and their funds. Many investors value this information, some do not. Many managers want to publish this information and consider it a competitive advantage to do so. Some do not and consider it a waste of time, but yet are forced to do so at the expense of costing their investors (the general public, remember) money in extra fees.
In the US, the debate is a few steps behind. There are fiery arguments about mandating additional disclosure and the topic is far from resolved. In essence, there is hardly any requirement or expectation to publish anything.
Cayman stands in an interesting position. Not much money is managed from Cayman. Rather, it is the fund vehicles that operate here. Cayman has no codified rules on what must be disclosed to investors, and yet many funds, entirely voluntarily, produce substantive information to their investors. Other funds do not.
What should Cayman do?
The answer isn’t entirely clear. What if Cayman did nothing? Then, the argument goes, the free market would take over and managers and funds would produce that which they think gives them a competitive advantage.
What if Cayman mandated rules of disclosure? What would those rules be?
Who in Cayman has the capability to write regulations, let alone enforce or supervise, on a topic as diverse as environmental through to societal and governance? Cayman could simply copy what Europe does… but then, very few European investors invest in Cayman funds and so what would be the point?
Passing rules will increase costs, and costs in Cayman are already high and often discussed as a competitive problem for the jurisdiction. Perhaps the best solution might be to adopt an internationally recognised voluntary code and enable funds to adopt it if they wish. If they do, then they can pay the costs of so doing, with the expectation that this will put them at an advantage with investors. Those who don’t agree don’t need to pay for the audits and the reporting. After all, investors will know whether a fund has adopted a code of standards or not. The best solution for Cayman might simply be to let investors decide what it is that they want, rather than regulators telling them what’s best for them.
ESG is a welcome addition to the toolkit of investors and investment managers. The problem is its politicisation and supervision. There are already multiple stories of greenwashing (that is, companies pretending to do something ‘green’ but really not). Is the best solution to enforce rules on something so emotive or to permit and encourage transparency and disclosure?
Simon Cawdery, CFA, is an investment manager and governance professional who lives and works in the Cayman Islands. He will be writing regularly for the Compass on business and finance matters.
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