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L’Aparté N°3, the Amiral Gestion Newsletter

ESG and its challenges: lessons from History

ESG and its challenges: lessons from History

Thousands of billions of euros. This is the size of assets managed by “responsible investing” funds. Globally. They are mainly concentrated in Europe, where regulation provided additional impetus to responsible investing. In France alone, a study by the French Asset Management Association (AFG) dating from May 2020 estimated the amount invested in responsible investing at 1,861 billion euros(1). No doubt this figure has been exceeded by far since. The number of certified funds is setting records year after year. Inflows into “green” stocks have pushed valuations so high that analysts are appealing to ever more creative approaches to justify them based on classical economic theories. Companies are adjusting their speech to capture this SRI windfall, hoping to see their shares carried along by this wave of buyers. It’s true that between E, S, and G, there are few companies that don’t have a story to tell.

Some observers are sceptical, or even critical, of this mass phenomenon. Big investors, who have built their success on a deeply rooted wariness of the crowd, reject what they see as vagueness deliberately maintained by both companies and the asset management industry, a smoke screen facilitated by a multitude of concepts. Instead, they are calling for a level playing field, with regulations applying to all companies that would be far more effective than merely counting on companies’ goodwill. They don’t believe a “green” label is enough to combat climate change; they’re calling for a carbon tax. To combat digital addictions, they demand for application design to be regulated. And, more broadly, they point out the conflict between big words full of good intentions, and companies’ imperative need to generate profits in a competitive world.

Tariq Fancy, who recently resigned as head of sustainable investment at BlackRock, added fuel to the fire this summer when he called ESG a “dangerous placebo” or a “mortal distraction”. Honest ESG practitioners themselves are very conscious of the difficulty of their job. A major hurdle they see is the lack of standardisation in company disclosures, resulting from various methods and perimeters; a weak correlation between ratings provided by external agencies because of methodological biases (company ratings depend a lot on who issues them); misrepresentations of the company’s business (a steelmaker will always have a larger carbon footprint than its distributor, but they are often compared in the same way); a disclosure bias in evaluations (they don’t all have the same resources for responding to the many questionnaires sent to them by ratings agencies, and small companies are routinely underrated vs. large ones); and so on. Rather than undertaking a full and painstaking inventory here of the charges often levelled against responsible investing, we prefer to send the reader to the 214-page study released by the European Commission in November 2020, which is fully aware of the challenges(2). On this basis, we may conclude that the authorities are well aware of the challenges. In the midst of this flood of criticism and often intractable problems, it is worth asking whether it is all really worth it. In reality, and as is often the case in dealing with uncertainty, delving into history shows that we faced similar situations in the past and yet we managed to gradually overcome all obstacles in our endless quest for meaning.

« In dealing with uncertainty, delving into history shows that we faced similar situations in the past and yet we managed to gradually overcome all obstacles.»

A history of accounting standards, an insightful guide in meeting the challenges of ESG accounting

The fact that companies release their accounts publicly is now regarded as something obvious for any investor. It would be unimaginable to invest in a company’s shares nowadays with no idea of how profitable it is, with no view of its cashflows or balance sheet. And yet, public disclosure of accounts is a relatively recent development, one that has come about mainly over the past 100 years.

Not until late 19th century did the need arise to share financial information with outside parties, starting with the community of investors. Building US railways required so much capital that even the country’s richest families couldn’t undertake it without calling in outside capital. For the first time on such a scale, an industry was headed by professionals who had to report to investors (who were often British and therefore faraway). This laid the foundation of modern accounting. Even so, the information provided was often fragmentary and dependent on companies’ goodwill.

Moreover, companies often saw no reason to disclose it, including information as basic as revenues, out of fear that it would help competition! With no visibility at all, investors trusted, above all, their bankers’ good judgement rather than analysing the financial statements in detail. In most cases, a dividend coupon alone provided proof that the company was profitable. But this was not an infallible measure, as some companies managed to pay out dividends by simply drawing on what today we would call share premiums – in other words, the money that shareholders had themselves injected – and not on profits, which often did not exist.

For several decades in the 20th century, the accounting profession was shaped by enflamed debates and arcane quarrels until a regulating body was born to establish some order and facilitate comparisons. And even the term US GAAP, for Generally Accepted Accounting Principles, which lays down a common language for US accounting practices, illustrates how rules were borne of custom, and how the law was borne of practice. The concept of depreciation, for example, is now universally accepted as a smart way to spread out an asset’s cost over its useful life. And yet, it was often mocked and criticised as a trick for spreading out company profits! And, it’s true that many companies did amortise assets on the basis of their profits and not the asset’s estimated material depreciation. Such concepts have been refined over time, but not until the Great Depression was compliance with certain accounting principles entrusted to the Securities and Exchange Commission (SEC), which was established in 1934. And it was not until 1973, after several unsuccessful attempts, that the current Financial Accounting Standards Board (FASB) truly codified accounting rules. Some ambitious attempts, such as inflation-based restating of balancesheets, fell short. Other innovations made it possible to express in figures realities that had previously been beyond the pale of accounting. One example of this was the Black & Sholes optionspricing formula in 1973.

Accounting as a discipline has thus become considerably richer over time and has evolved into at least four branches: 1/ financial accounting for providers of capital; 2/ managerial accounting, which is essential in allowing managers to identify and operate the company’s internal levers; 3/ tax accounting, which is separate from the financial statements and resulted from governments’ decision to tax companies. This could no longer be arbitrary or dependent on managers’ goodwill; and 4/ prudential standards, which are used by highly regulated sectors, such as banking and insurance, that must demonstrate their solvency in order to be authorised to maintain their activity. None of these rules is set in stone. They continue to evolve on the basis of accounting practices, shifts in business models and policy-making choices. The goal of accounting rules is to summarise extremely complex situations by expressing them in quantifiable data. ESG is a new field that is only starting to emerge.

« For several decades in the 20th century, the accounting profession was shaped by enflamed debates and arcane quarrels until a regulating body was born to establish some order and facilitate comparisons.»

A fifht branch of accounting?

Disclosure of ESG information, which is required by investors and by agencies specialising in rating the various ESG pillars, could become an entirely new branch of accounting, this time meant for society at large. Necessary to compare companies, ESG data brings heterogeneous realities down to a figure, making it possible to objectify reality better than long speeches. However, there is no supervisory body to define and organise all of this. Companies are besieged with requests for information and are exhausted from filling out questionnaires, all with different angles of analysis. ESG data is today probably at the same stage that financial accounting was in the first half of the 20th century.

Today, as with accounting information one century ago, ESG data is self-reported and, hence, essentially a self-evaluation whose relevance is debatable and which is fraught with methodological errors or even outright cheating. Some initial efforts at standardisation had already been made by the European Commission via the Non-Financial Reporting Directive (NFRD), which aimed to better supervise company disclosure. However, this text contained one major flaw – its indicators were not standardised enough. Each company was free to select the information and calculation methodologies of each regulatory theme. The NFRD will soon give way to the Corporate Sustainability Reporting Directive (CSRD), which in 2023 will begin applying to a large number of companies(3) and will standardise data further, making audits more systematic.

Other requirements will no doubt strengthen the mechanism further. ESG will become a fantastic business opportunity for auditing firms, as well as for groups like Bureau Veritas and other TIC companies (Testing, Inspection, Certification), whose engineers are uniquely qualified to draw up all types of environmental balance sheets. PWC, an auditing firm, like the other Big Four, is laying the groundwork and plans to expand its staff by 100,000 people in the next five years to build up its capabilities in this field. The wave of data harmonisation and optimisation is only starting.

« ESG data is today probably at the same stage that financial accounting was in the first half of the 20th century.»

Can capitalism reward virtue?

Meanwhile, the European regulator is pressuring the asset management industry into standardising its practices and enhancing its transparency, and has adopted a common language in the form of the Sustainable Finance Disclosure Regulation (SFDR), Taxonomy, the Task Force on Climaterelated Financial Disclosures (TCFD), and others. This wave of regulations, with ever denser disclosures mustn’t allow us to lose sight of the regulator’s main objective – to urge capitalists to steer their capital towards virtuous companies. In financial terms, this means lowering companies’ cost of capital. In simpler terms, it means raising the price of well-performing companies, lowering their cost of financing and, hence, rewarding virtue.

In short, through these three letters – E, S, and G – public authorities are asking companies to selfregulate in areas such as: 1/ environmental risks, climate change in particular, which are everyone’s concern; 2/ the fate of those who have missed out on incredible, innovation-driven economic growth in which not everyone is a winner; and 3/ the disgust felt by people regarding certain executive remunerations deemed shocking or even immoral. The goal is to save each pillar upon which it rests and without which the system cannot endure. And what could do that better than regulating capitalism by designing a system enriching those regarded as the most virtuous and penalising those who act as if nothing was going on?

« In short, through these three letters – E, S, and G – public authorities are asking companies to self-regulate.»

This is a good idea, but it’s easy to see why some are frustrated. The situation is indeed uncomfortable for the financial world, whose mission is to finance the economy, but which is being asked to finance only a portion of it. In real life, heavy CO2- polluting sectors are still allowed. Aggressive social and governance practices are still legal as long as they comply with a certain regulatory framework, which varies from country to country. Do public authorities lack the courage to ask the financial world to play a role which it was not designed for? Obviously, finance alone cannot bring about an ideal society, and regulators must tackle essential societal issues one by one. And yet, finance does have an essential role to play, as it has always shaped reality through business models and has always steered research and development spending(4). Responsible finance can serve ably as an anteroom of a more extensive regulatory movement. Although frustrating for many, legislators – at least in Europe – often take an indirect approach in meeting their objective. Among several imperfect methods, it is perhaps the best approach. First of all, because it is sometimes difficult to agree on what is positive or harmful behaviour. Take the debate on nuclear energy within the European green taxonomy (which consists in identifying which activities are clean or not). The French support decarbonized energy, while the Germans are opposed to it on the grounds that it generates hazardous waste that currently cannot be fully processed. Conversely, natural gas is welcome in Germany, as it fits well with intermittent renewable energies and emits less CO2 than coal.

« China has already understood this. The world’s shop floor is aware that it will be cut off from many markets in a few years if it does not significantly improve its CO2 emissions.»

Another complication arises from the commitments that certain countries have made to others in the form of treaties. In the absence of global governance, the need to coordinate between states slows down reform initiatives where they exist. For example, if one area decides to tax carbon, will it be able to protect itself under WTO rules by taxing imports in the same way? One can understand the hesitation to reform when it is impossible to do it alone without the risk of destroying one’s own competitiveness. Even if it has had undeniable positive effects, the European carbon market within the EU has also hit domestic industries hard and promoted investments outside the EU (a phenomenon deemed “carbon flight”). Fortunately, there is now a strong desire to take this issue one step further. The change of leadership in Washington could also drastically accelerate the situation. China has already understood this. The world’s shop floor is aware that it will be cut off from many markets in a few years if it does not significantly improve its CO2 emissions. Regulation is not always well equipped to deal with a flagrant social problem, as no solution yet exists. Much innovation must be stimulated to bring about tomorrow’s solutions, but it is impossible to figure out ex-ante what willwork and what will not. Ban plastic? Today, it is impossible and even counterproductive for most applications, but authorities have various ways of rewarding actors who take on this issue by inventing new materials, by working on recycling and eco-design, by encouraging the reuse of containers, by expanding bulk unpackaged sales, and so on. There are many initiatives requiring lots of collective intelligence that will ultimately lead to improvements, but overly rigid rules and excessive regulatory control would kill the creativity needed for technological and scientific discovery. The legislator is doing its part through a carrot-and-stick approach. On one hand, it creates fear by threatening to ban certain practices, which pushes manufacturers throughout the value chain to innovate or die. On the other hand, it encourages a system that compensates those who are part of the solution by pushing their valuations to stratospheric levels (Tomra, a Norwegian plastic sorting company, is trading at 70x its 2021 earnings). Solutions will emerge from this, leading to regulations suited to this new state of affairs. Will bulk unpackaged products manage to resolve the many challenges it faces? will innovation in eco-design, materials, and chemical recycling, be enough to make plastics widely acceptable again? Nobody knows the answer, and at this point, the regulator is merely sending out urgent calls for action.

Lastly, ESG is an effective soft power and in some areas is more relevant than regulation, since it encourages companies to adopt good practices everywhere, including far from their country of origin. In the age of globalisation, of fiscal, social and environmental dumping, ESG is a reminder against toxic behaviour abroad, where home country regulation has little say in the matter. When an environmental or human rights controversy erupts halfway around the globe, the market imposes a serious penalty on the valuation of the company involved. With more than one third of the global responsible investing market, Europe is in a position to demand data from companies worldwide. This makes the European Union’s lead in setting ESG standards an important political asset, as it has the potential to lay down practices and the regulatory framework that will soon be required across borders. Hence, whether we regret or understand the legislator’s overly cautious approach, one thing looks certain: on basic issues, starting with greenhouse gases, regulation will continue to emerge and be more firmly structured. It will take various forms (acceleration of bans, taxations, etc.) with a scope and timeline that no one yet knows. For investors, addressing these major ESG challenges is a way to contribute to desirable societal trends, but it is also a way to prepare for inevitable social changes, which in some cases will be brutal. They must stay ahead of the curve and invest in companies that are pioneers in transforming their own sectors. Just as accounting made a great leap forward when governments decided to tax companies, investing through an ESG angle will matter even more once companies’ profits are financially impacted by sustainability requirements. There is little doubt that data reliability – which is being worked on and which everyone is calling for, starting with the companies themselves, will also be the starting point for tax innovation that penalises those who are late to the game. CO2 taxation is a model that could be replicated in many other areas, i.e. first, increasing data disclosure followed by a taxation system that is increasingly coercive, then extended to more sectors and taken up in more countries. ESG and economic reality will necessarily converge and will no longer be two worlds that currently co-exist.

« ESG is a long journey, and the world of asset management is only taking its first steps in that direction.»

As we have seen, responsible investing is far more complex than it seems, and we are only at the beginning. As in accounting, mistakes will be made and analysed after the fact as dead-ends. Simplistic approaches will be referred to as youthful errors. On the other hand, innovations will emerge and will move the discipline forward in the right direction. ESG is a long journey, and the world of asset management is only taking its first steps in that direction.

Faced with the risk of false leads, what is the right approach for the responsible investor?

Pragmatic contact with companies and their reality is the best antidote to a groundless and slightly idealistic way of investing only in what pleases the eye. Today, in order to please rating agencies, one should not emit CO2. Accordingly, many groups are selling off their problem assets, such as oil fields and coal-fired power plants, in order to regain investor favour. But in reality, nothing has changed – the asset changed owners but continues to emit CO2; the buyer has got a bargain by exploiting a fire-sale situation. The system, in spite of itself, rewards vice, not virtue. Some companies even push the vice to the limit and have made this power relationship their business model . The pressure on a company to sell its polluting assets obviously facilitates its marketing message and perhaps gives it a clear conscience, but it also steers it down the wrong path. A more subtle practice, albeit less spectacular but more effective, would be to look not only at a snapshot of the company but also, and more importantly, at the improvements it has made in its investments. Don’t just look at its balance sheet, but also at its investment flows. Who does more for the planet: the oil group that sells its problem assets on the cheap to an unlisted company that is off the SRI radar, or the oil company that holds onto its legacy assets, but steers most of its investments into renewable energies and green chemicals? The answer goes without saying, and yet this approach is now invisible to SRI funds. In this area, the industry overpromises, underdelivers and wastes time.

« In the future, a customer who is inevitably concerned about their carbon footprint will switch to a new supplier that meets their criteria.»

In contrast, other innovations will revolutionise some practices. The financial world is increasingly indexing lending rates to certain SRI criteria in the form of green or social bonds. This is a remarkable invention with tangible improvements as long as criteria are sufficiently rigorous and demanding, that could be widened or even rolled out systematically. Imagine the interest rate on your mortgage varying with energy efficiency works done at your home. The calculation of CO2 emissions defined by the GHG Protocol is hard to use, as it consists of analysing a product’s entire value chain, upstream and downstream, through the well-known Scope 1 to 3 calculations. Even so, it is a huge source of leverage for general improvement – in the future, a customer who is inevitably concerned about their carbon footprint will switch to a new supplier that meets their criteria. Leverage is global in scale, with a potential to create a generalised knock-on effect. Increasingly, executives are seeing a portion of their compensation tied to the improvement in their organisation’s ESG criteria. Knowing that managers of small and large companies wake up in the morning taking ESG performance into account is a step in the right direction. Perhaps one day the media will report on companies’ ESG performance in the same way they report on their financial results. Which ESG indicator will be the equivalent of EPS (earnings per share)?

We believe that an ongoing process, combining progress and training, is the right approach to take this discipline forward. The ease with which the industry has designed funds that offer attractive marketing pitches which focus on the most fashionable issues while overlooking the quality of their business models and valuation, will probably one day be regarded as the wrong path, especially if the financial results do not meet the current very high expectations.

Alongside the “Happy Few” companies (renewable energy pure players come immediately to mind), most sectors, and the companies that make them up, need to be transformed inside out and, hence, need to innovate. They therefore need support from investors. The smallest of them, for whom “responsible finance” is sometimes far from their main concerns, must become aware of how much disclosing their ESG data matters. They must integrate the idea that ESG reporting is inevitable and not a passing fashion, quite the contrary. At Amiral Gestion, we believe it is also investors’ role to engage with issuers on subjects material to their businesses, to understand key drivers at stake, in order to encourage them both to take leadership in transforming their sector, and make them aware of the risk of failing to act with conviction. They must encourage companies to undertake meaningful action in a concrete way and, unlike current practice, to refrain from covering up difficult issues. They must make them aware the extent to which a controversy can cause reputational harm and encourage them to implement all mechanisms for mitigating this risk, such as business conduct policies, whistleblowing mechanisms, etc., and incorporate the findings of these discussions in their research, as they already do with numerous financial criteria. They must be wary of, and even steer clear of, companies that practice tax avoidance, whose harmful impacts will, hopefully, one day disappear. They must play their role as a responsible shareholder at general meetings. They must also help build up a relevant standards-based framework for the ESG of tomorrow. Finally, they must incorporate all these angles of understanding into their overall assessment of companies, in order to make informed management choices that combine responsibility and investment and not regard them as separate issues. It is under these conditions that responsible investment makes sense.