Sustainability vs. ESG
Why ESG in its current form isn't driving enough climate action
A pair of Shaggy Manes on my land going through a typical 24-hour “self-digestion” phase.
Why isn’t ESG working?
Last month, an op-ed in the Financial Times boldly stated, “ESG as we know it is over”. Pointing to a recent paper on “competitive sustainability” by the University of Cambridge Institute for Sustainability Leadership, the article argued that ESG in its current form “will not deliver the necessary change” to address climate issues – an argument difficult to disagree with given the relentless upward trajectory of global greenhouse gas emissions.
I have said for a long time that real change can only happen if there is money to be made or saved. This is how capitalism works. The problem with ESG to date is that it has been used as a catch-all term for everyone’s beefs and hasn’t always demonstrated tangible value capture. It has generally been layered into businesses as an extra cost – for more reporting, extra hires, new technology, equipment retrofits – rather than boosting shareholder return.
As such, it might come as no surprise that U.S. corporate boards are dropping ESG issues from their agendas, with over 90% of directors believing that ESG is not the same thing as sustainability. Sustainability is simply about making plans today to create or protect company value far into the future, whether its by addressing physical climate risk, transition risk or a myriad of other factors. Competitive sustainability is about spotting these risks or opportunities earlier than others. ESG tends to be softer, hairier, more virtues based and more likely to evoke an emotional response – hence the intangibility. Whatever the term, the tug-of-war between long-term sustainability and short-term profitability is what has stalled progress on emissions reduction to date.
Where does sustainable finance come into play?
Sustainable investing blew up alongside the ESG “hype bubble”, but unlike ESG, hasn’t seen the same anti-woke backlash. In fact, global sustainable fund assets have stayed above $2 trillion since Q4 2022 (note that the EU makes up the bulk of it). This isn’t even including private equity capital, like Morgan Stanley’s new $750m 1GT Climate Fund to reduce one gigaton* of emissions by 2050.
*A gigaton is a billion metric tonnes. That’s about 5x more than the reported emissions from the entire Canadian oil & gas industry in 2021. Emphasis on reported.
Quarterly Global Sustainable Fund Assets (USD Billion)
Source: Morningstar Sustainalytics, Global Sustainable Fund Flows: Q2 2024 in Review
What is a sustainable investment?
The definition of what qualifies as a sustainable investment varies hugely. Over 40 sustainable finance taxonomies have emerged across the globe, acting as signposts for investors to direct capital toward “green” activities – but there is still some debate on what counts as “green” (after all, energy is still needed to meet AI demands and manufacture EVs). There is even more debate on whether this will help the world transition away from fossil fuels at all. If everyone piles their money into low-carbon sectors (communications, software, insurance), doesn’t that leave the high-carbon sectors (utilities, oil & gas, industrials) to keep emitting?
Even CDPQ, one of the “Maple 8” or largest public pension funds in Canada, is recognizing the need to be involved in real-world decarbonization. The capital allocator is focusing less on tightly-defined European taxonomies and more on finding “transition enablers” – leading companies in hard-to-abate sectors with robust emissions reduction plans. All while avoiding the regulatory crackdown on greenwashing – or marketing a fund as “green” when it really isn’t – as Vanguard recently paid a hefty $8.9 million fine for.
There needs to be a first-mover advantage
Real climate progress starts where investors and transition enablers meet. Strict portfolio exclusions, like divesting from oil & gas completely, have clearly not worked. Engagement with company decision-makers, while fuzzy, slow and hard to measure, is only the beginning. Directing the flow of capital to leading companies that can show measurable, impactful reductions on the back of announced pledges provides a crucial decarbonization tool that has thus far been missing: the first-mover advantage. Companies may face risks with inaction but are rarely rewarded for acting first. Uplifting the ESG scores of companies that demonstrably reduce emissions year-on-year, even in brown industries, has the potential to attract even more capital and spur more action. This is so much better than side-lining these companies completely.
To be clear, not all high ESG performers automatically get added to investor “buy” lists. A recent academic survey of 509 equity portfolio managers in the US, EU and UK showed that very few are willing to sacrifice financial returns for environmental or social performance, across both sustainable and traditional funds. As someone who relies on solid investment performance to comfortably retire, I think this is perfectly OK. But I also see that emissions are becoming more material as more jurisdictions attach a price tag to them (see Europe’s CBAM). Indeed, the study showed that many investors associate higher emissions with higher downside risk, with 26% viewing them as highly material or having a direct impact on financial returns. So, take the report with a pinch of salt. Materiality is very sector- and policy-dependent, especially when it comes to carbon pricing.
What makes a sustainable asset manager?
Lastly, if you’re still not sure what a sustainable asset manager looks like, fret not – the Nordic godfathers of ESG recently put together a league table of the “best” sustainable asset managers in the world. Only one Canadian firm made the list – Mackenzie Investments, with their niche focus on electricity grids as part of the energy transition. Proof, once again, that energy transition themes are overtaking ESG in the name of climate mitigation.
