How will ESG drive product innovation?

ESG is in the spotlight and, in many instances, for all the wrong reasons, with some vilifying it as a marketing exercise.

In the US, anti-ESG rhetoric accelerated after Texas passed a law in 2021 preventing the state from doing business with companies found to be boycotting fossil fuel-based energy companies. Since then, officials of 19 states have publicly criticized ESG-focused investment and engagement activities of prominent investment managers with respect to fossil fuels.

In the UK, the appointment of Liz Truss as new prime minister may bode ill for the near-term environmental agenda, with the government needing to prioritise the cost-of-living crisis and spiralling energy costs, thus delaying delivery on the UK’s legally enshrined net zero target.

So, is this the end for ESG? No, we think it marks a new evolution for investing, as the market starts to sharpen definitions and professionals start to refine the products and strategies which best fit clients’ changing needs.

A key issue with ESG is that the term is used to cover a broad range of investing strategies. ESG is a tool, not an investment style. At BNY Mellon Investment Management, we use Responsible Investment (RI) as the umbrella term. RI covers a spectrum of styles: exclusionary, ESG-integration, best-in-class, sustainable, thematic and impact investing. ESG-integration describes the input of environmental, social and governance factors into financial analysis and investment decisions.

ESG-integrated funds may be responsible by outcome, but will always prioritise financial objectives. Other RI investing styles, such as sustainable and impact investing, have objectives to be responsible, benefit stakeholders and a dual intent to deliver environmental and social returns, as well as financial performance. Because these ESG terms are not clearly defined in global regulations, there is heightened potential for client confusion.

Recent underperformance of exclusionary ESG funds has stoked more backlash. Rising inflationary pressures, the Ukraine war and the resultant energy crisis have caused exclusionary ESG funds, which are typically underweight energy and overweight the more ESG-metric-friendly tech sector to underperform. But we still see growing appetite for products in the RI space.

A review by Morningstar found sustainable funds performed better than the broader market in the second quarter and a recent Barclays survey highlights only 5% of respondents agreed that “ESG is a fad and will decline in popularity/importance in the coming years”.

We are seeing a shift towards best-in-class investing and funds with an environmental and/or social objective, i.e., those that report under Article 9 of the European Sustainable Finance Disclosure Regulation (SFDR). Investors are demanding greater attention to reporting of sustainability metrics and impact, bringing into focus the need for harmonised regulation of ESG data providers.

To date, most corporate disclosures on key sustainability metrics have been voluntary, sometimes leading to lack of consistency and decision-useful information, and a focus on backward-looking metrics, over forward-looking ones.

Asset managers are now better positioned to report on RI portfolios with the regulatory environment tightening globally, continued focus on preventing greenwashing, and the increase in corporate sustainability reporting. Clients are increasingly demanding funds report on the outcomes of engagement and formulate formal escalation processes (ultimately divestment) when engagement is unsuccessful.

Another area of focus is the inclusion of transitioning industries in sustainable investing portfolios. SFDR regulations are supportive of exclusionary investing and sustainably aligned strategies but there is less clarity on how to position transitioning companies. There is increasing scrutiny on the definition of sustainable investment (SI), after guidance from the European Commission (EC) indicated Article 9 funds should be made up entirely of SI (except for hedging and liquidity purposes).

Where does this leave high-emitting companies, which may be vital for future economic growth but most urgently require capital to decarbonise? Investors must assess the credibility of companies’ transition plans, but should sustainable funds be precluded from investing in sectors which are vital to a successful transition? In the UK, the Financial Conduct Authority and the UK government are leading the work on sustainability disclosures and have included transitioning industries in their regulatory focus.

By mandating disclosures aligned to the Taskforce on Climate-related Financial Disclosures (TCFD), proposing the introduction of sustainable investment labels and working on gold standard net zero transition plans (via the Transition Plan Taskforce), UK regulations look set to support investors identify credible transition plans.

This must be set in the context of enabling a just transition that is fair and creates better social and economic opportunities for all. Energy affordability and security are key priorities, which may mean further short-term underperformance of ESG funds which exclude the energy sector.

We also risk losing the momentum and commitments built at COP26. Despite Mark Carney’s pledge to “build a financial system entirely focused on net zero”, legal action has been brought in the UK demanding a more robust net zero strategy. One of Truss’ government’s first announcements was the extension of fossil fuel licenses in the UK, including North Sea fracking.

We do not expect governments to roll back net zero targets, but climate may drop down the priority list on near-term agendas, likely causing the private sector to bear more of the strain. This places even greater urgency on ramping up sustainable investment flows, identifying the best RI opportunities and delivering a greater range of RI products to clients.

This article is also published in Money Marketing. Illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.