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3rd
Nov
2021

‘Great oaks from little acorns’

Great oaks from little acorns

Sustainable (ESG) investing has experienced an astonishing level of interest and asset flows, particularly in the UK and Europe, in the past three years or so. It has become central to our investment proposition. Many of our clients increasingly want to reflect values and preferences that are important to them by allocating capital to firms with better ESG sustainable credentials, and in some cases, exclude the worst offenders. There is no doubt that this broad ‘movement’ has driven investment management firms to look hard at, and invest in, their stewardship capabilities. That includes engaging more intensely with portfolio companies to apply pressure to improve and using their fund clients’ proxy votes at AGMs to make a difference in sustainability matters.

That is all good. We have, however, identified a real risk that investors may believe that they are reflecting their values and truly making a direct impact on issues such as carbon emissions and climate change. The true impact that values-based investing can make is more secondary, nuanced and complex in its delivery than many investors might understand. That is not their fault, particularly given much of what is written in the media or delivered by fund management and marketing departments.

It is important that clients understand exactly what their values-based portfolios will and will not deliver—a mismatch between client understanding and reality risks the trust that sits at the heart of client-adviser relationships. Hopefully, the context, background, and ideas we provide will help build a more honest and open dialogue with those investors.

We believe that financial planning firms have a material opportunity to integrate sustainability into their financial planning process fully.

Our key findings are as follows:

• Sustainable development – balancing the needs of the present with those of future generations – has rightly become central to the world we live in and needs to become central to the way we act.

• The investment industry has seen the growth in interest in sustainable investing as a positive opportunity to deliver excess returns by accounting for ESG characteristics in their analysis and to do good in the world.

• Climate change is both real and startling. Our analysis illustrates that COP26 is a pivotal moment in trying to keep temperature rises to below 1.5oC above pre-industrial levels. We are already at 1.1oC above. At current rates of CO2e emissions, we will reach that point in less than ten years.

• Today, around 90% of energy consumption is powered by fossil fuels split pretty evenly between coal, oil and gas. It is evident that fossil fuels will be a significant part of a long transition to a net-zero world, and knee-jerk demonisation and divestment may be counterproductive.

• The top cumulative emitters since 1850 of CO2e are the US, China, Russia, Germany, Japan and the UK, who make up more than 50% of all-time emissions. Today, China is by far and away the largest emitter (around 30% of all emissions on its own) and broadly heading in the wrong direction. Along with the US, India and Russia, they account for around half of all emissions today. On a per-capita basis (of G20 countries), Australia, US and Canada have the highest emissions at around 20 tonnes per capita. The UK sits at around 7 tonnes per capita.

• The COP framework provides a global forum for addressing climate change. COP26 is looking like it will be a pivotal moment in whether the temperature target will be met. Talk and long-term pledges need to be turned into action. The latest UN report suggests that ‘time is running out’. With the pledges and targets in place to date, we are heading for a 2.7oC rise by 2100, which will have severe consequences for the world. It is depressing to note that the $100bn p.a. finance target to support less wealthy developing countries transition was not met last year and will not be met again this year. The UK has spent nearly £37 billion on track-and-trace alone in the past two years.

• Reporting standards, led by guidance bodies such as the TCFD, are driving greater reporting and transparency on corporate sustainability criteria. That can only be a good thing. Greater standardisation would be of benefit.

• Understanding emissions reporting requires a knowledge of the three key ‘scopes’. Scope 1 and 2 represent direct and indirect emissions directly related to the operations of a company. Scope 3 relates to the emissions from things like the use of products sold or the processing of sold products. The former is more easily calculated and reported than the latter.

• Carbon intensity appears to have become the measure of choice for company and portfolio analysis. It is a ratio of Scope 1&2 CO2e emissions per $1 million of revenue. It is relatively robust as its inputs can be defined, and it allows for comparability across sectors.

• Sustainable (ESG) investing means many things to many people but reflects the use and focus on ESG metrics in the investment process. We consider that dataset to be an additional tool in the armoury of investors to assess the strategy and risks of a firm, which can be accurately reflected in prices. We do not see it as a unique process, as some in the investment world appear to do.

• Investors may wish to reflect their values and preferences in portfolios, and sustainable investing is one example. That is entirely reasonable.

• There is, however, a wide gap between reflecting one’s values, e.g. by not owning oil companies, and making a difference to the problem that drives these values. Not owning oil companies does not reduce oil company emissions or the investor’s true carbon footprint. Such a win-win situation is a chimaera, given how markets work.

• A real danger exists that all that is happening in the investment world is a shuffling of the pack of cards with ‘values-based investors selling the non-values-based stocks to others who care less, by definition. This could be described as greenwashing. Marketing narratives, such as a ‘green’ investment portfolio is ‘27X more effective’ than other carbon savings like taking less flights or eating less meat are plain nonsense. Apart from being untrue, they risk investors believing that they are doing simply enough through their portfolios.

• ESG data sets are proliferating rapidly, and it is estimated that there are 600 different rating systems globally. Corporate sustainability reports are at risk of being measured by weight. Apple and Microsoft’s sustainability reports are around 100 pages long. BATs is half as long again!

• At WealthFlow, we believe that markets work pretty well and that risks are reflected in prices. Most of the world’s fund managers managing US$120 trillion, like WealthFlow, are signed up to the Principles of Responsible Investing. We believe it to be inconceivable that this sustainability-focused majority are not reflecting their views in prices, particularly with the greater ESG reporting data available.

• Buying and selling stocks in the secondary markets, as most ESG funds do, does not directly impact CO2e emissions, for example, or provide or denude funds to companies. At best, it may affect the cost of capital, making it more difficult for ‘bad’ companies to raise finance (if they need it) and resulting in fewer projects being undertaken and vice versa. Real-life impacts on the cost of capital attributable to sustainability risks are hard to measure.

• Sustainable investing has achieved a material upswing in the quality of stewardship that fund firms are now expected to undertake from engaging with portfolio clients to proxy voting for fund holders at AGMs. That is the good news. The irony though is that ‘bad’ excluded companies can only be engaged with using the shareholdings of non-ESG screened funds that hold its shares!

• Positive engagement through owing shares can be more powerful than divestment, as evidenced by the hedge fund Engine No 1’s nominees gaining three seats out of 12 on the board of ExxonMobil by co-opting major shareholders to vote with them. Most ESG- screened funds exclude Exxon.

• We understand that there are now over 3,000 different sustainable indices on Morningstar, with at least one common ESG theme in its name, such as ESG, SRI or ethical.

• Climate change solutions are complex. At a governmental level, we believe that some form of global carbon tax or pricing of carbon by the market is the preeminent solution. It is certainly worrying that dominant emitters have arrived at COP26 dragging their feet when handing in their late and potentially shoddy homework.

• At a corporate and individual level, we believe that the mantra of ‘reduce emissions where possible and offset the rest’ is a good rule-of-thumb.

• Unfortunately, carbon offsets are complex, opaque and hard to undertake due diligence on. Regulation and clarity would be welcome in this space.

• From a financial planner’s perspective, we see a real opportunity to embed sustainability analysis – particularly around carbon footprint of client choices – in the financial planning process. For those for whom values-based preferences are important, it will be particularly useful to integrate measurement into the choice trade-offs that clients face, not just from a financial perspective but a values-based perspective. Pricing the costs of these choices and providing advice around suitable offset opportunities will provide a far deeper trade-off resolution than at present. We believe that considerable value can be added in this space.

Great oaks from little acorns grow!

Duncan R Glassey
Managing Director – WealthFlow
[email protected]

 

This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Errors and omissions excepted.

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© 2021 WealthFlow Group Limited
All Rights Reserved | Privacy | Cookies Policy

Head Office & Consulting Rooms: 10 Charlotte Square, Edinburgh EH2 4DR.

Mail correspondence to our Central Scotland Admin Hub: WealthFlow Group Limited, PO Box 14947, Grangemouth FK3 3AU.

Authorised and regulated by the Financial Conduct Authority

For your protection, unresolved complaints can be referred to the Financial Ombudsman Service.

Registered in Scotland No SC635011. Registered Office: 10 Charlotte Square, Edinburgh EH2 4DR.