Too Green or Not Too Green

Without question the two most asked client questions we at Chadwicks have had to address in the past 8-9 months have been 1) “How do I best pass assets to my family and children?” and 2) “Can we please invest in Socially Responsible Investments?”. Often in the aftermath of question 1, once the assets are passed to said family and children, question 2 follows on shortly as the cliche of younger investors being more socially minded soon materialises.

Even before the start of the pandemic Socially Responsible investing was gaining significant traction – it appears now it is becoming mainstream. As with any investments that become “trendy”, we have to dig deeper underneath the surface. While the reasons and concept of it, we think, are fantastic, since we all know where the roads paved with good intentions go, a reasonable distinguishment of the various Environmental and Social Governance aspects is overdue.

ESG is in essence a compilation of non-financial factors that investments are assessed against to qualify where they sit on the green and socially responsible spectrum. All of these assessment results are typically combined into a single ESG score that can often vary significantly across ESG ratings agencies based on different methodologies. In fact, when compared to other types of company ratings, such as credit ratings, ESG scores tend to be much more inconsistent and uncorrelated.

esg-ratings

Most major ESG rating agencies seek to track 20 or 30 ESG issues and measure hundreds of individual indicators. Individual company ratings may then be aggregated into fund and index ratings or scores, being heavily relied upon by the multi-trillion Socially Responsible Investment industry.

You can probably sense how fragile the link of good intentions and good outcomes may be and you won’t be wrong to think “Rating agencies, were their methodologies not a catalyst for the 2007/08 financial crisis?”.

In reality, methodology in ESG can sometimes mean that a fund or stock can have a high ESG score by being in an industry with a low carbon footprint (finance for example), or simply by way of reporting on a lot of different metrics that ESG ratings agencies score on. Some large oil companies, for example, score well on transparency, compensating low E with high G.

To go a step further, funds and indices based on ESG ratings may deviate significantly from natural market weights. As at end of Quarter 1 2021 a popular global equity index designed to achieve strong ESG ratings had a weight of more than 12% to Microsoft (almost four times its market capitalization weight in a standard index) — but excluded Apple and Alphabet (Google). In a competing ESG index from a different provider, all three companies were overweighted.

More recently, a small number of ESG funds have begun removing Microsoft from their holdings based on concerns that they are currently growing an augmented reality product for use in the military sector. For the funds holding large allocations in Microsoft, this means a significant reshuffle behind the scenes. It’s also not uncommon for ESG rating providers to amend their methodology once or several times in the past few years, even retrospectively. Therefore, the opacity, complexity, and subjectivity of ESG ratings methodologies is still something that needs to be tackled before the sector can graduate to next level.

Another practical hiccup in the sector may be the run and overprice effect on ESG funds – if too much money is chasing too few assets, would a high ESG rating generate uplift in the intrinsic value of companies or would it run too far and create a bubble for a small number of firms. We’re already observing the business models of highly coveted ESG firms being tweaked to capitalise on the green rush and legislation. Tesla, whose main business one may ostensibly view as building and selling cars, actually has two other main sources to thank for its Q1 profits – crypto sales (which is a topic for another day) and sales of emissions credits to other automakers. The way this works is that Tesla accumulates free regulatory credits because it produces only EVs and sells them for a 100% profit to other automakers that are short of these credits. In fact this represented almost all of Tesla’s profit for this quarter and has been a long-standing income stream. It wouldn’t be surprising to see other ESG aspects adding goodwill and value to a small circle of companies, causing them to gain market share. But the big question is whether their standout ESG practices will still stand as such when the companies gain traction and size.

The good news? There are many. The SRI sector is directly and indirectly causing ripples in all other investment areas. Listed companies are being heavily influenced to focus on improving ESG or risk losing investor capital of SRI funds.

Index trackers, which are practically permanent owners of a significant number of companies on the market (relative to active funds who may often trade in and out of different companies) have begun to resume the role of governance on capital and influence on their underlying companies. The big names such as Vanguard and Fidelity are putting increasing pressure on Big Oil and other businesses in an attempt to speed up transition from the brown to green economy. This kind of pressure is not something that can be achieved by a very strict SRI screening fund, that chooses to exclude and avoid holdings in ESG offenders. Furthermore, increased demand for socially responsible companies will likely naturally over time increase their price and proportion in index trackers, making them cleaner and greener. 

The more one looks into Socially Responsible Investing, the more and more nuances appear. That’s the natural course of development of a sector that, if forces align, can become the standard of investing in the decades to come. However, it’s important to retain a sense of rationality when making these choices for ourselves and our investments and as much as we want to be part of the change to be careful not to fall victim of some of the hidden ESG traps. This can mean taking the SRI route but not taking eyes off the basic investment principles of diversification, cost and management, and trying to strike a balance between all.

The grass isn’t always greener in the land of green investments, but the organised chaos you may find there is a necessary stage that the sector needs to go through before it develops further and into, hopefully, the next iteration of capitalism.

Radostina Dencheva BSc (Hons), MA (Dist), Chartered FCSI Chartered FCSI, Investment Analyst

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