Do well by doing bad

18 Feb 2022 | A victory for vice sectors; climate stress tests create greenwash; regulation plays catch up. Plus, an appeal against complicated solutions to complex problems.

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📈 Sustainable fund flow data are in. Morningstar finds assets grew to $2.74T in Q4. Bloomberg predicts they’ll hit $50T by 2025. Different metrics beg the question: What is a sustainable asset? SFDR’s definition—claimed by 40% of European assets and a record 536 rebranded funds in 2021—isn’t enough for Morningstar, which cut 1,200 funds from its sustainable list (mostly Article 8) and reverted to pre-SFDR criteria. A better question: What is a sustainable asset not? Something ESMA plans to answer.

🕵️ Reuters says 2022 hasn’t derailed flows, but the value rotation is forcing ESG investors to think bigger than Big Tech for opportunities in new regions, sectors and sizes. Cue pivots to real estate, mining and financials, particularly in Europe, where valuations are attractive and policy supportive. As we wrote in Investment Week, volatility requires investors to be more selective. It should also dispel vague performance attribution and “blunt” labels, CEO Patrick Wood Uribe told the FT.

🏦 Selectivity will be critical in the financial sector. As green bonds approach $1.5T, banks face opportunity and risk—as do insurers, who picked up a $130B bill for natural disasters last year. Somewhere in America Gary Gensler is still shirking, but ECB + BOE climate stress tests are underway and herald higher capital requirements. US banks balk at the prospect, blaming a) data gaps, b) the “[long] time horizon” of climate change. If you assume (b) to be true, so is (a) I guess? Unless you’re an insurer.

🧮 Logical counter-counter step for regulators: Fix the data. ESMA wants to make ESG ratings more transparent, soon after OECD pushed for a focus on outcomes over risk. (Double whammy for banks if they can’t lean on the data-gap excuse or MSCI’s generous scores.) It could also address a problem in “self-defeating” EU Taxonomy alignment rules. In the absence of first-party data, cautious investors are reporting scores of zero; now, ICMA is pushing to permit third-party data and estimates.

💡 The idea is catching on that progress will emerge from more, rather than more distilled, information. Like US banks, Swiss Re says climate change is an uncertainty and not a risk, as “insufficient information” on real-world impact makes scenario analysis preferable to stress tests. Unlike US banks, however, it argues the uncertainty makes immediate (if iterative) analysis and action even more important. Only then will companies get to, instead of guessing at, the best data and thus decisions.

Do well by doing bad

You don’t hear the ESG tagline ‘do well by doing good’ much in 2022.

In the last few months, clean energy funds have suffered from sliding performance / too much demand / too little demand. ESG-friendly Big Tech is losing its decade-long dominance in the face of rising interest rates. But the real story is macro.

The EU, forerunner in green policy, is being sued for its decision to label gas and nuclear ‘green’. The relatively socially equitable West has ceded energy influence to China (renewables) and Saudi Arabia and Russia (oil & gas), ironically as a result of its green policies, which isn’t the least embarrassing thing to happen in the run-up to a Cold War.

Supported by macro and micro tailwinds, the investment case for traditional ‘vice’ sectors (military defence and fossil fuels, plus potentially alcohol, tobacco and gambling depending on the direction of geopolitics) looks pretty good right now.

Untangling complexity

With the benefit of hindsight, recent events are a consequence of trying to make the complex complicated.

Complicated problems are hard to solve, but they are solvable with the right playbook. Complex problems, on the other hand, contain too many variable, unknown and interrelated factors for most frameworks.

A complicated problem: launching a spacecraft. A complex problem: raising a child.

The spacecraft is more interesting and impressive. It demands more expertise. But the outcome is (somewhat) predictable. You can assume rockets will end up where they need to be. You can’t assume the same of the humans you know—or worse, like.  

Complex problems are doubly dangerous if there’s a vested interest in the outcome. Once cognitive biases enter the mix, well-meaning problem solvers are more likely to reject uncertainty and double down on a framework that worked in the past. Extra points if it promises immediate and irrefutable results.

In the context of a problem as complex as the energy transition, itself a product of another two complex systems (the globalised economy and climate change), that can be futile at best and catastrophic at worst.

Stress tests and disclosure rules are leading to misinformation, with data scarcity (the cornerstone of a complex problem) having created, inevitably, a situation where many organisations are either deliberately or accidentally misleading the market. Some are refusing to participate at all. National policy—and associated investment activity—that penalises ‘brown’ and rewards ‘green’ activities has, at least in the medium term, played out in favour of less responsible investors and management teams, not to mention authoritarian regimes. It may have driven up absolute emissions.

We touched on this paradox in January: In a complex system, labels and principles don’t work. Worse yet if they’re ethically coded, because then you have the urge to opt for the complicated solutions to avoid being perceived as ‘bad’—particularly if you’re a politician or investor or executive whose tenure, and so period of exposure, is minuscule relative to the complex problem at hand.

Virtue versus vice

Where some vice industries are disputed, defence invites almost universal condemnation.

It’s an industry to which the Vitium Global Fund, formerly known as the Vice Fund, naturally gravitates. While the Fund and its constituents might feel and be repugnant thanks to their impact on most metrics—particularly wellbeing, health, peace and justice—our morally agnostic machine-learning models reveal two areas on which the Fund performs well: SDGs 8 (Decent Work & Economic Growth) and 9 (Goal 9: Industry, Innovation & Infrastructure).

Biggest positive contributor? Defence.