The diverging future of ESG

The outlook for sustainable investment is diverging globally, simultaneously being propelled forward by regulation in Europe and parts of Asia, most notably in China, and being significantly challenged by growing politicisation and controversy in America.

In Europe the regulation is adjusting

The end of 2022 marked the implementation of SFDR Level 2, and with it, significant disclosures about ESG objectives, processes, monitoring commitments and data sources. The regulation has continued to evolve and there are important outstanding questions sent to the European Commission by country regulators. This uncertainty has led to a wave of fund downgrades, mostly from article 9 to article 8, from many fund managers including Blackrock, Invesco, BNP Paribas, Robeco and Amundi. Many of these are ETFs that manage the carbon emissions of their portfolios to reduce annually in line with specific climate benchmarks designed by the European Commission. After the European Commission specified that Article 9 funds should be invested only in ‘sustainable investments’, it became clear these funds could not defend disclosure in line with article 9. Other funds have also downgraded, including thematic funds at Pictet such as their SmartCity and Human funds. Most article 9 funds remaining are very clearly driven to invest in companies or assets that contribute to sustainability objectives.

Looking forward, this year we’ll see annual reporting from all article 8 and 9 funds before the end of June; funds will be required to report the sustainability indicators outlined in the documents provided in 2022. The idea is that there will be nowhere to hide – if the indicators do not align with the strategy presented in the prospectus, investors will quickly be able to identify funds that ‘walk the walk and not just talk the talk.’ The big question for 2023 will be how investors use these new disclosures, and whether capital does flow towards funds with more serious approaches to ESG and impact, as generally expected. Further evolutions in the regulation will be designed to continue to deflate greenwashing in the market, including a proposed name rule that will impose strict rules on funds with ESG-related terms in the name.

Clear messages have been sent out in China

In recent months, the banking and insurance regulator sent its strongest signal yet that banks and insurers will have to support the green economy with a new set of guidelines which require banking and insurance companies to establish strategies, processes and capacity to support the transition to a sustainable future. This includes the incorporation of ESG factors into risk management and investment decisions and the requirement for stewardship support and to enable the green transition. As of the start of 2022, listed Chinese companies are required to report a range of environmental information on an annual basis, including carbon emissions. Last month the asset management regulator the Asset Management Association of China (AMAC) published draft regulation that will require at least 60% of investments in funds promoting themselves as green to be aligned with the green description. They too are looking to deflate a greenwashing bubble in the industry. At least on the environmental side, there is clear progress.

ESG becomes a political argument in the US

Meanwhile in the US, a very different picture is unfolding with parts of the Republican party taking on ESG and sustainable investment as a highly bipartisan issue. Republican staff of the US Senate Banking Committee released a report last month alleging that the big three asset managers – BlackRock, State Street and Vanguard – were using voting power to advance a liberal political agenda. At the committee hearing, a Republican Senator stated, “What these activists have figured out is that any radical policy that they can’t get enacted through government can be advanced through corporate America by hijacking trillions of dollars in voting rights from everyday Americans’ retirement accounts.”

At least seven Republican controlled states such as Arizona and North Carolina pledged to pull billions from these asset managers as a result of their sustainability policies, and 23 states have been involved in some way including a motion signed by 14 Attorney Generals to prevent Vanguard from being authorised to purchase shares in energy companies due to the pressure they might apply on these companies to reduce emissions. Conservative groups such as Consumers’ Research are publishing aggressive campaigns to tarnish ‘woke’ companies including BlackRock and corporations such as Coca-Cola.

Certain asset managers are responding by reducing their public commitments, such as the decision by Vanguard to stand down from their commitment to the Net Zero Asset Manager Initiative. Others are pumping significant amounts of money into advertising campaigns and lobbying to try and defend their reputation. Ron O’Hanley, State Street chief executive, told the Financial Times in an interview “Everybody seems to have left facts aside, it’s become a convenient way to distort the facts and win votes.” “For us it is not a political issue. It is nothing more than the proposition that climate needs to be incorporated into our investment risk framework,” O’Hanley said.

Despite these very different environments globally, we expect at least some of the consequences to be similar; CEOs and asset managers may take caution with their messaging and are likely to focus more on the business case of sustainability. Rather than ‘greenwashing’, we may see ‘greenhushing’ as the Financial Times described it – keeping quiet about environmental and social efforts.

As the CEO of Coca-Cola speaking at Davos last January said “If ESG becomes toxic as a phrase, which it basically has in the US, it doesn’t matter to me. I’m just going to stop saying ‘ESG.’ But the idea that for my basic product, I want to be water positive, I want to have a circular economy on my packaging, and I want to grow our business with less sugar—you can call it anything you like, but no one with common sense says those are bad ideas.”

Perhaps ESG will become a term of the past; it was always an oversimplified description of a hugely complex range of issues and impacts and misunderstood by many. But the environmental and social issues have never been more significant and pressing, as evidenced by the annual World Economic Forum risk survey of global leaders, which put environmental and social issues as 8 of the top 10 risks in both the short term and long term. We will just have to find more sophisticated ways to talk about it.