ESG and the Communications Imperative: part two of an interview with Amin Rajan of CREATE-Research
Our series ‘ESG and the Communications Imperative’ interviews leaders across a range of industries, exploring how ESG strategies are reshaping communications, and what companies can do to maximise the impact.
In part two of our fifth interview, Prof. Amin Rajan, CEO of CREATE-Research, shares his insights on the challenges facing ESG communications and view on the way forward.
Do ESG communications largely fall on deaf ears?
Yes. Communication has had two negative dimensions: clever marketing gobbledygook and technical jargon. Neither was designed to inform or educate investors.
First, communication to investors was hyped up to the sky, using clever words to say a lot about nothing. The language used was suffocating in the extreme. It aimed to exploit the so-called ‘bandwagon effect’: riding the ESG wave because it was hyped up in the media as the next ‘Eldorado’. It sought to exploit the greed-fear dynamics inherent in the investor psyche that often prompts investors to act in ways contrary to their best interests. ESG investing was presented as an opportunity too good to miss.
The key reason was that the required template of taxonomy and data essential for ESG investing was evolving gradually, while investors’ interest in products focused on ESG practices had skyrocketed. Hopes have run ahead of expectations.Looking ahead, we can expect more stringent corporate laws on climate change in China, and the implementation of a carbon emissions trading scheme, which will put climate change further into the spotlight.
Second, the crux of the problem is that there is, in practice, no universal agreement on what constitutes a ‘good’ company. Hence, with few exceptions, governments worldwide do not mandate companies to provide data on their ESG practices within a consistent framework.
Fund managers have thus been forced to use the different definitions adopted by around 130 separate data compilers, using proprietary scoring methods that often yield radically different assessments for the same company. The most widely used data come from MSCI and Sustainalytics. A comparison of their respective scores reveals consistency in only about half of their coverage universe, according to research done at State Street Global Advisors.
As a result, client communication has been full of fine print, with technical details described in ways that few investors bother to read or understand.
What are the challenges around communicating ESG that you find when working with investors? How do you see the way forward?
The biggest challenge stems from the fact that capital markets are slow to price in ESG risks. Hence investors in various parts of the world – especially America and Asia – remain unsure whether ESG investing can generate its targeted double bottom line: doing well financially and doing good socially.
Three forces inherent in capital markets are slowing progress. Each is expected to weaken over time, as ever more investors switch from the old ways of investing that solely targeted financial returns.
a. Steep learning curve for data
Currently, investors are faced with a steep learning curve because of a lack of the requisite data on three foundational concepts in ESG investing: materiality, intentionality and additionality.
Respectively, they seek to assess:
Materiality - how material various ESG factors are to a company’s financial performance;
Intentionality - whether the company intends to take action and ‘do good’ via its products, services and interactions with wider society
Additionality - whether ESG investing generates societal benefits, in addition to financial ones.
The ESG strategies of asset managers are evolving rapidly, but the requisite infrastructure of data, skills and technology has yet to catch up. The problem is exacerbated by the fact that there are no generally agreed guidelines on what constitutes a ‘good’ or ‘bad’ company.
The result is two-fold: ‘greenwashing’, as asset managers repurpose their old funds with ESG labels, without rejigging their underlying investment process; and ‘whitewashing’, as investee companies overstate their green credentials in the absence of externally audited data.
b. Quarterly capitalism
The second force slowing down progress is the rise of short-termism – especially over the past two decades – under the guise of ‘quarterly capitalism’.
This sees listed companies incentivised to produce short-term profits at the expense of long-term growth.
Equity markets have, as a result, morphed from being a source for raising investment capital for growing companies to a vehicle for cash distribution and balance sheet management; as shown by massive share buybacks on both sides of the Atlantic.
Markets are no longer effective conduits between savers planning for a decent retirement nest egg and borrowers deploying savings to create wealth, jobs, skills and innovation.
c. Tentative evidence of success so far
Evidence suggests that early ESG investors are satisfied with their returns so far. But as the new wall of money has arrived, a critical question has come to the fore: is ESG a risk factor which, like other traditional risk factors, generates returns? Early adopters fall into two camps: believers and pragmatists.
Believers advance three arguments:
ESG is certainly a risk factor; except that, so far, it has rewarded investors in Europe, although far less so in the US and Asia Pacific.
The reward has varied over time and between the three individual components: environmental, social and governance.
The huge collective push from governments, international agencies and investors worldwide will reshape investor behaviours over time. It is hard to believe that, given this, nothing will change.
Pragmatists hold that it is too early to say because:
For any return driver to be treated as a risk factor, it needs long performance history over multiple cycles in multiple regions, within a replicable investment process. ESG investing data thus far fall short of these criteria.
Capital markets enjoyed the longest bull run in history in the last decade, thanks to the easy money policies of central banks. Asset valuations have been lifted indiscriminately. Hence, the true test of ESG investing should not be judged by the assets it has attracted so far, but by how resilient these flows will be when the next downturn comes.
Well, the naysayers were finally confounded by the market rout in March 2020. Published data by Morningstar showed that the long-term performance of the majority of a sample of 745 Europe-based sustainable funds was better than that of non-ESG funds over periods of one, three, five and ten years. Most notably, they did better during periods of big drawdowns. Thus, they are winning more by losing less.
Both camps agree on one point, though: given the powerful tailwinds from institutional investors, ESG will become the gold standard of investing and the new frontier of industry innovation in the 2020s.
When considering investment, what do the asset owners you work with want to see from companies regarding their ESG credentials?
First, they want their investee companies to compile data on the three foundational concepts in ESG: materiality, intentionality and additionality. They also want these data sets to be independently audited by external professional agencies.
Second, they want their asset managers to complement these data sets with shareholder activism that targets real-world outcomes at scale. The principal tool for doing so is direct engagement between asset managers and their investee companies under the more muscular model of Activism 2.0.
This approach rests on the belief that ESG investing only works if company boards are not just called to account, but also held accountable for their actions. It enjoins asset managers to:
Create an agenda for change and acceptable standards that are consistent with its delivery
Engage in proxy voting to ensure that investors’ voices are heard on board-level deliberations
Foster year-round dialogue with investee companies beyond shareholder meetings.
Asset managers are increasingly expected to act as agents of change by seeking progress in three related areas: communication, learning and internal politics. These approaches aim to promote new learning in the belief that ideas breed ideas and only improved collaboration can deliver the goals of all stakeholders.
Indeed, some investors believe that engagement enables them to develop structural capital that offers an informational edge: the ever-deepening knowledge about how sustainability is actually being implemented on the ground via a positive feedback loop.
Finally, investors also want business leaders at asset management firms to set the ‘tone at the top’ by:
Creating a culture and belief that ESG is not just another fad, but a sea-change in the way investing is to be done
Harnessing the collective memory of the business via joined-up thinking between the investment team and the stewardship team
Ensuring that their portfolio managers and research analysts develop the requisite expertise into the dynamics of ESG factors and are incentivised accordingly
Encouraging regular engagement with investee companies, setting realistic expectations and monitoring progress regularly.
If you would like a copy of Prof Rajan’s latest ESG report, please contact us.
For more insights, you can find CREATE-Research's collection of reports here.