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ESG will be upstaged by low cost, climate-based investing post COP-26

  • COP26 is unlikely see much global diplomatic progress, but many people and firms want to make better climate choices

  • ESG funds promise ethical investing, but their complexity and opacity make them poor (and expensive) choices for many

  • Expect a post-Glasgow reconfiguration of ethical investing, with climate-based becoming the default ethical choice

ESG will be upstaged by low cost, climate-based investing post COP-26
Paul Domjan
Paul Domjan

Senior Contributing Analyst

Tellimer Research
6 November 2021
Published byTellimer Research

COP26 is barely halfway through, but I can already tell you what happened at it. It was a really exciting couple of weeks, with loads of great side events put together by activists. And there was plenty of discussion about how Glasgow will deliver on the promises of Paris (and Kyoto and Rio), and be the last, best hope for the planet. [We should leave aside the arrogance – the planet will recover over geological time regardless of what we do. This is really about the last, best hope for mankind, or at least human civilisation in its current form.]

But, at the end of the day, COP will produce relatively little progress towards a coherent global framework. There will be notional commitments with big numbers attached, promises of action and renewed focus on the so-called nationally determined contributions, a framework that seems designed to encourage freeriding on least common denominator efforts to preserve the global commons. Indeed, backsliding from big commitments is already happening.

On the other hand, something important is happening that will help to address climate change, it’s just happening from the bottom up, rather than from the top down. Even though the UN Framework Convention on Climate Change has not delivered top-down, globally coordinated action on the scale that was expected at Rio 29 years ago, at Kyoto 23 years ago, or even at Paris 6 years ago, it has helped to galvanise society at many levels, including individuals, local community leaders, companies and the financial community, to seek to take action independently of governments.

I want to explore how this bottom-up action is likely to affect the expectations that companies have of themselves and that investors have of companies. Two decades ago, when we finished our master’s programmes, one of my friends took a job at a niche consulting firm, doing what at the time was called socially responsible investing (SRI) advisory. The work was complex because there were so many aspects to SRI, and no clear standard for measuring them. Moreover, different companies and investors cared about different aspects of being socially responsible.

ESG’s necessary complexity risks holding it back

SRI has now become ESG, and millions of pages of ink have been virtually spilt over defining ESG and introducing metrics, but the reality remains that is a necessarily complex concept. How does one weight environmental stewardship against human rights abuses? And how should we judge oil companies and others in the fossil fuel industry that pay scrupulous attention to ESG metrics, but whose business is fundamentally antithetical to the energy transition that we need to address climate change? The breadth of ESG and its different implications for different industries means that it is necessarily complicated and involves sophisticated judgements.

The sophistication of ESG is about to run headfirst into widespread, growing public concern about climate change. On the one hand, ESG is not going to get any simpler; indeed, developments like potential investor culpability for human rights abuses in China will only make ESG judgement more complex. On the other hand, I firmly believe that more and more people globally will want easy ways to make environmentally sound choices a core part of how they live their lives. They are unlikely to care about, or necessarily understand, the complexities of how companies are governed, but they will want to make the right choice for the environment.

The UK Sustainable Investment and Finance Association’s Public and Investor Attitudes Study, which focuses on the attitudes of British retail investors, provides a useful lens through which to see how this tension will unfold. People clearly care about the environment, but they aren’t convinced that the ESG products that are currently available will meet their needs, if they even understand them. When asked whose values they would like to see drive Britain’s post-Covid recovery spending, David Attenborough and Greta Thunberg topped the list by a wide margin. Not only did they want to see the government spend its money in line with Attenborough’s and Thunberg’s values, but 49% of Britons, and a large majority of those who already invest or have the income to do so, would like to see a government green bond offered to the public that would fund net zero housing, infrastructure and transport.

Despite the fact that 30% said that they were much more likely in 2020 to choose products and services based on their environmental and social impact than they had been in 2019, and presumably quite a few were already ethically motivated back in 2019, only 5% of those who saved or invested said they would consider using an ethical investment platform. This seeming contradiction is explained by the complexity of ESG and ethical investing. Although 70% said that they had thought about ethical investing, 75% still said that they did not know what ethical investing actually means. Two specific comments from private investors who participated in the survey summarise the problem:

  • “My complaint with the ‘ethical/socially responsible’ ETFs is that every single person has a different notion of what that means and those ETFs often don't coincide with what you typically hear from people. A lot of people would say they don't want any oil and gas companies in their socially responsible fund, for instance.”

  • “To me, highly active ESG makes sense. Deeply, deeply sceptical about passive index constructions. Just look at how consistent definitions are. Things are rarely easy and worthwhile.”

Climate-based investing will become the default ethical choice

What this tells me is that while ESG will continue to grow as an important, and sophisticated niche, climate-based investing will become the default ethical investment choice. I expect that there will be three different metrics, all of which have merit. Some funds will use a single metric, while others will combine the three and perhaps others:

  1. Scope Three emissions: This includes the company’s direct emissions, the emissions made on its behalf (eg emissions related to generating the power it uses) and the emissions of its full value chain, including its supply chain and the use and disposal (or recycling) of its products. Funds focused on Scope Three will tend to tilt toward low carbon sectors, not low carbon leaders. Their sectoral allocation skew relative to the index will increase these funds’ tracking error.

  2. Scope Three emissions versus peers: These funds will choose the low carbon leaders in each sector and may exclude some sectors, such as oil and gas. By maintaining the same sector weighting as the index, they will have lower tracking error than those that use Scope Three emissions.

  3. Science-based targets: These funds will allocate to companies that have established science-based targets for their business that are consistent with keeping the global temperature increase below 2°C. These funds will have higher fees, due to the need to validate the science-based targets, and they will have the highest tracking error, at least initially, as they will hold a more concentrated portfolio of true climate leaders.

Additionally, funds will need to decide how to treat offsets and credits, both nature-based (eg forestry credits) and industrial (eg funding LED lighting in developing countries). It sounds complicated, but I just outlined the framework in less than 250 words – far simpler than ESG, and far easier to implement passively.

2022 will be the year of the post-Glasgow reconfiguration of ethical investing

I expect that the momentum of Glasgow will drive a wide reconfiguration of ethical investing at three levels:

At the sophisticated end of the spectrum, there will still be plenty of growth in ESG investing, but it will be dominated by actively managed funds with higher fees. Growth in passive ESG will slow as investors question complex models that are displaced by simple, climate-driven metrics.

In the mainstream, many funds will use a climate factor, like those mentioned above, to provide a low-cost and transparent ethical choice that addresses the primary ethical concern of most investors: climate.

At the most basic level, most funds across the industry will adopt some environmental aspects, often chosen not at the level of the fund but at the level of the asset manager, many of whom will sign up to green industry initiatives.

COP26 may not lead to the binding top-down commitment many hope for, but it will reconfigure many industries from the bottom up, including asset management.