If ESG funds only talk the talk, it is because investors, legislators and regulators don’t walk the walk

Duncan Sankey

Portfolio director and head of credit research Cheyne Capital

Whatever an ESG fund means to you, it probably means something different to the next investor

In 1964, US Justice Potter Stewart was flummoxed by the need to define hardcore pornography in an obscenity case and simply concluded: “I shall not… attempt further to define the kinds of material I understand to be embraced… [but] I know it when I see it.” Sadly, the same definitional problem plagues ESG funds and their regulation.

Investors can pick and choose from responsible/sustainable/green/impact investment options, but what should they select if they really want to promote ESG? Should they opt for an integrationist approach, with a view to fostering good behaviour rather than just sanctioning bad behaviour on the grounds that you cannot improve a company with which you do not engage? If, as a result, you end up investing in an oil major that meets the net-zero challenge by flogging its dirty assets to a privately-owned entity free from market scrutiny, should that not elicit just a little cognitive dissonance?

Exclusion: where do we draw the line?

If integration does not suit, there is always the exclusion model. But what to exclude? Coal? Tobacco? No brainer. But what about alcohol, which is also addictive, unsafe at any level and associated with a range of social ills that tobacco simply does not engender? Pornography? Ask Justice Stewart what that constitutes. And what about materiality? What is the appropriate metric to use? Revenues? Ebitda? Assets? And how meaningful is materiality in this context, anyway? If a company engages in an excluded activity at any level, surely it should be excluded: you cannot be 25% pregnant.

Even the entry-level of ESG — responsible investing — is bewilderingly nebulous. Principle one of the United Nations’ Principles for Responsible Investment commits signatories to “incorporate ESG issues into investment analysis and decision-making processes”.

However, the possible implementation measures it suggests — addressing ESG in policy statements, supporting the development of ESG metrics and analysis, encouraging research and advocating ESG training — fail to set clear and measurable objectives for what a responsible investment should be.

EU guidance is little better. Article 8 of its Sustainable Finance Disclosure Regulation (SFDR), which sets the criteria for “light green” funds, merely requires the promotion of environmental or social characteristics (possibly although not exclusively through the inclusion of principal adverse sustainability indicators) and explicitly does not require sustainable investment as an objective. Nobody says what should happen if responsible investing results in concessionary financing (producing a lower return than a comparable non-ESG fund would yield).

Unsurprisingly, in a Morningstar survey of prospectuses for about 4/5 of funds on sale in the EU (excluding money market, feeder funds and funds of funds), which was taken four months after the implementation of SFDR, almost 22% had earned Article 8 classification. This opens up the investment community to accusations of green-washing. But this seems unfair. The community is merely providing what investors want. If funds only talk the talk, it is because investors, legislators and regulators don’t walk the walk.

As laudable as the motives of ESG investing might be, there is an element of virtue-signalling. If the activities that ESG seeks to restrict or promote are that important, why not simply legislate change? Don’t like fossil fuels? Pass a carbon tax. Alcohol consumption was once unconstitutional in the US. Gambling could be abolished at the stroke of a pen.

However, this will not deter regulators from cracking down on ESG funds. The SEC has established a climate and ESG task force within its Division of Enforcement to “evaluate tips, referrals, and whistle-blower complaints on ESG-related issues”, with an initial focus on climate risks.

Its highest-profile sting to date is a probe into DWS, which was allegedly shopped by its own former head of sustainability. (DWS characterises this as “unfounded allegations”.) Yet the SEC’s own investor bulletin on ESG funds is a testament to the elusive nature of the concept. This will not prevent it from hunting down green-washing. Doubtless it’ll know it when it sees it.

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Global credit funds & CLO's

October 2021 | Issue 239

Published in London & New York.