Ethical Investors (ESG) have not weakened the west’s defences.

As we watch the human tragedy in Ukraine with profound shock and sadness, we are all questioning, searching for reasons of which there are many. Did the hubris of the West, or the millenarian ideology of the business and political class create this conflict? Has the subversion of statecraft by commerce and the desire for economic growth been the key distraction? Was it the expansion of NATO and the European Union? All are valid symptoms and will be discussed after the current human tragedy ends.

One suggestion from Matthew Lynn in the Spectator which asserts that ‘woke’ culture wars and ESG are responsible for the current crisis can be discarded. Lynn has argued that ESG being “self-righteous concentration on progressive causes like race and gender, and crucially its wishy-washy pacifism, have undermined the West’s ability to defend itself” . It is exciting to start a debate but hard to follow and on analysis, for me, has little or no merit.

What is environment social and governance investing (ESG)?

ESG is simply addressing the real and scientifically proven risks of planetary heating, climate, and carbon, impacting all our lives and economies. Allianz reported that climate change is one of the top risks to business in 2022. ESG is the financial and business way of ‘pricing in’ these current and future risks. It reflects a system change for businesses and economies to address the negative impacts of our past and future economic activities which pose a threat to capital and society.

Maybe Larry Fink and all the banks are wrong.

Blaming ESG for the current crisis brings into question the judgement of Larry Fink and Blackrock, Standard Chartered, HSBC, Goldman Sachs, JP Morgan and all the major banks who play a major part in the global economy. Investors and funds are now making climate and carbon (core to the ESG movement) are going long in the ESG market, inveting and hiring thousands of people to develop services in the sector to sell to business. Perhaps it’s a strategic misstep by these titans.

Perhaps investors who are ESG minded and seeking a return are also wrong. Two ETFs that adhered to environmental, social and governance (ESG) investing principles recorded returns over 200 per cent in 2020. The ESG ETF with the highest net return in that year was Invesco Solar ETF, with 221.2 per cent. Similarly, Invesco Wilder Hill Clean Energy ETF also recorded an annual net return of over 200 per cent for the year. Perhaps the drive for ‘woke’ ESG investments and business is being led by the financial institutions, who are interested in fees for advice and sale of financial instruments, rather than some cabal of ‘left wing’ activists.

Maybe its not ESG its the Alpha?

Hubris of the West and the ‘end of history

The fall of the Berlin wall and the collapse of the old Soviet Union was triumphantly greeted as the victory of the West and ‘western ideology’. But, instead of following the lessons of the Marshall Plan and the rebuilding of Germany, which included strengthening state institutions and the tools of democracy, the West sent in the ‘Chicago boys’ to restructure the economy.

This sowed the seeds for kleptocracy, the emergence of the oligarchs and the concentration of power and wealth. In the West, we looked on as we held our belief that we had ‘won’ and we were at the ‘end of history’. Politics and statecraft were subverted by commerce and the need for cheap energy, globalised markets, and the sale of cheap goods, which, as the OECD has noted, led to an increase of FDI into the Russian economy.

The inward FDI stock is the value of foreign investors’ equity in and net loans to enterprises resident in the reporting economy. The value of FDI inward stock in Russia fluctuated from approximately 471.5 billion U.S. dollars in 2013 to over 449 billion U.S. dollars in 2020. The thing is that we ‘the people’, business, politicians, investors let this happen in our pursuit of growth and markets.

Today there has been an active debate about the source of Russian money and how the financial taps can be turned off. With ESG investing, there is a more significant analysis of the ‘use of’ and ‘source of’ proceeds and supply chains. All which in the future will help solve this problem. In addition, the drive for disclosure leads to greater investor choice in which assets, companies, and regions they want their money to flow. All which make any future sanctions actions easier for governments and regulators to activate.

Screening as a practice is a core element of a ‘free market.’

Under the influence of left-wing activists, many investors decided that making weapons was wicked and destructive — Matthew Lynn

We have long declared our love of ‘democracy’ and our freedom of choice in the West. The principles of screening of capital and funds have long been in place. The individual’s freedom to choose how they want their capital and pension money is why screening is required. If they’re going to select responsible investments it is about choice.

It is the fiduciary duty of boards, asset, and fund managers to respond to shareholder pressure. If the shareholder does not want to invest in weapons or fossil fuel, or a country’s bonds, then that is their choice driving the market.

The growth of the European responsible investing market from 2012 to 2018 is a good measure of investors’ priority on screening (choice). In 2012, the total value of assets of Responsibility invested funds managed in Europe was approximately 252 billion euros. Within six years, it nearly doubled, reaching 496 billion euros in assets under management on the responsible investing market by the end of 2018. Today, 1/3 of investor capital is flowing to ESG funds that have such requirements. Financial institutions and asset managers would not provide the funds without market demand.

Growth of European Responsible Investment to 2018

Climate and carbon are not new — ESG is the financial sectors response.

Rewind just a few weeks, and much of the City was obsessing over ESG issues. — Mathew Lynn

The risk-return paradigm drives investing and finance. Analysts want to reduce short- and long-term risks to guarantee return and profit. Since 1970, the economic losses from climate disasters have risen steadily. It was the highest between 2010 and 2019 at about 1.3 trillion U.S. dollars, an increase of over 400 billion U.S. dollars from the previous decade.

Real Risk to investors

These translate into costs for economic activity and business. Instead of obsessing, investors and the global financial sector has recognised the science and are ‘pricing in’ the risk.

The publication of the IPCC report this week (28th February 2022) is stark and should help us get over any misgivings we may hold about ESG. We face the global impact of climate change in the north and the south; millions face food, water, and resource shortage. The collapse of biodiversity is well underway. Our world is a lot more fragile than we thought.

The indicators show that we have most likely blown past our 1.5 Paris target due to the energy and economic crisis. Due to the energy crisis and the slow pace of transition, the next decade is going to be tough to lower carbon. The questions that analysts and those constructing portfolios are obsessing over are:

1. Will this company manage its exposure to climate risk?

2. Can this company survive, be profitable and make new products in the low carbon economy?

3. Will this company enhance my fund in the low carbon economy when there might be real risks of carbon border taxation?

These are practical questions designed to protect those with pensions against value destruction and the inevitable market shocks which come with climate change of the next fifty years.

Failure of western policy and energy independence

Fund managers were harassing the oil companies to stop developing domestic supplies of gas, even though our failure to do so has increased our dependence on Russia — Matthew Lynn

Energy and fossil fuel are finite materials. Access to secure, low-cost, and reliable energy is one of the most basic needs of a growing economy. The price is dictated by market dynamics and the cost of production, which dictates the cost to the consumer. When gas and oil is cheaper to import than develop domestically, and without any government or regulatory mandate to create domestic energy supply, why would the market invest in the higher cost?

Our lack of independence is due to the lack of foresight and our unwillingness to invest in low carbon alternatives over the last two decades. The malaise started first with selling the U.K.’s oil and gas in the 1970s instead of using the capital for future energy and economic growth. At that exact moment in history the Norwegians and the Norway fund developed the correct strategy.

This misstep in the U.K. was compounded by the government’s failure to develop an alternative market for renewables and nuclear. The sale by the UK government of most of the energy and utility companies, something the rest of Europe did not do, took the generation and pricing capacity out of the hands of the UK. In market and capital terms, the transition to alternative sources should have been led at a UK sovereign level to de-risk low carbon sectors and the first investment phase to start the high-net-worth green tech energy revolution which would have boosted regional employment.

(BTW the UK insistence that only 5% of its gas comes from Russia is nonsense, Europe has one joined up gas network, it is impossible to make such an assertion).

As a result of these decisions and others the UK and Europe rely on high carbon fossil fuel from outside our borders, therefore ceding control of this vital economic asset. Energy is such a vital asset one needs to question if it should purely be left to market dynamics or if to correct the current crisis government needs to take the lead.

Figures from the IEA demonstrate the ‘woke’ fund managers, mentioned by Lynn, have failed to stop oil companies supplying oil. As a result, the total energy supply of oil worldwide amounted to 187.4 exajoules in 2019. This accounted for approximately 31 per cent of the total global energy supply, which was 606 exajoules worth. Coal followed, at 162.4 exajoules worth supplied all which underline the global challenges in transitioning to low carbon sources of energy.

IEA Global Source of energy

Defence Spending has not declined.

Critically, they were demonising defence companies on the basis that making weapons was immoral or wrong. Many companies had slowly started winding down their defence units. It was not worth the hassle of trying to justify them to woke fund managers, nor was it worth the damage done to the share price — Matthew Lynn.

It is the freedom of the investors in the market to choose where they want to put their money. For some, they will find investing in weapons and arms a good option. However, as part of the debt and equity raising process investors and investees go through the ‘due diligence and use of proceeds’ process. All institutional investors will ask if the money raised is for arms or weapons. The question is asked at this level because somewhere down the line, the fund or pension client will have indicated that they either do or do not want to invest in these assets.

The biggest client of defence companies are governments who have national armies. In July 2021, the U.K. Treasury analysed U.K. defence spending, demonstrating that actual expenditure has gone up.

In 2020/21, the United Kingdom spent approximately 44.6 billion British pounds on defence, an increase of two billion pounds when on the previous year. Compared with 1996/97, when the U.K. spent approximately 22.1 billion pounds on defence, there has been a net increase of 20.1 billion pounds. When adjusted for inflation, defence spending in 2019/20 is 8.5 billion pounds larger than it was in 1996/97.

If ‘woke’ fund managers were trying to thwart the U.K. or global defence spending, they failed. Compared with the rest of the world, the United Kingdom spent the eighth-most on defence, less than the United States, China, Saudi Arabia, India, France, Russia, and Germany. In terms of military spending as a share of GDP, the U.K. was behind ten other countries in 2019, especially Saudi Arabia, which spent 8 per cent of its GDP on defence. After the current crisis and geopolitical review, one would imagine these figures will increase.

UK Government Defence Spending

The ESG market is imperfect.

Despite all our rational analysis, markets generally act irrationally and rarely follow a straight line. The ESG market is imperfect and has followed a ‘laissez faire’ process. As such, there has been little government intervention, refereeing or regulation with ESG or decarbonisation. These factors result from the long history of politicising climate issues and economic ideology resulting in the erosion of government and regulation by political funders and actors calling for small government. Tariq Fancy was more eloquent with his metaphor of the ‘hockey game without a referee’ in his essay on the problems with ESG.

ESG is the financialisaton of climate and social issues, which has taken the debate a couple of steps away from the hard science and facts of the IPCC. The schools of thought include climate science, risk, accountancy, strategy, and finance which are very challenging disciplines to get talking in the same language and working together.

ESG is not working yet for carbon

Like all markets, there are still flaws. I fully agree with the Aswath Damodaran point “investing in a well-managed company or one with high growth does not translate into excess returns if the market already is pricing in the management and the growth”. I, however, view the higher disclosure of performance standards as being positive for a different reason. Boards and companies that must be fluent and focus on resource efficiency tend to be managed better. Why? Because they really must look at their business model in detail. Not just via the profit lens but also through the carbon and social impact lens.

The latest analysis from Majority Action in the US found that 23 out of 45 U.S. companies failed to fully comply with any of their net-zero company benchmarks. Specifically, with carbon measuring, companies are underestimating the level of carbon that can be reduced. Therefore industries, companies and governments will miss carbon targets and the climate pressures flagged by the IPCC, IEA. The pressure on business and finance is building up as inaction creates more risk to investment portfolios and pensions.

ESG, if successful, will help in the future.

As it stands, the ESG market and structures are only at the start. Much work is developed around key frameworks that measure a company’s climate risk and assets, how the company is impacting where it operates, the carbon measured by the company, and how accountants can measure and report ESG factors to which companies need to make capital allocation. The real work has yet to begin on biodiversity and the loss of nature.

For all its criticisms ESG does achieve one thing. It moves us away from the theoretical financial models developed analysts which at best are abstract. It forces the senior management to connect both the negative and the positive inputs and outputs a business is making. This is better for reducing risk in portfolios and funds. Investors and analysts get a better picture of the capital flow, resource, carbon impact to and companies are real, which just like the tragic events in Ukraine are real.



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Jonny Mulligan

Jonny Mulligan

I work with companies and investors responding to the ESG transition.