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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đ Sustainable fund flow data are in. Morningstar finds assets grew to $2.74T in Q4. Bloomberg predicts theyâll hit $50T by 2025. Different metrics beg the question: What is a sustainable asset? SFDRâs definitionâclaimed by 40% of European assets and a record 536 rebranded funds in 2021âisnât 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.
đ”ïž Reuters says 2022 hasnât 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 âbluntâ labels, CEO Patrick Wood Uribe told the FT.
đŠ Selectivity will be critical in the financial sector. As green bonds approach $1.5T, banks face opportunity and riskâas 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 â[long] time horizonâ of climate change. If you assume (b) to be true, so is (a) I guess? Unless youâre an insurer.
đ§ź 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 canât lean on the data-gap excuse or MSCIâs generous scores.) It could also address a problem in âself-defeatingâ 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.
đĄ 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 âinsufficient informationâ 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 donât hear the ESG tagline âdo well by doing goodâ 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 âgreenâ. 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 isnât 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 âviceâ 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 canât assume the same of the humans you knowâor worse, like. Â
Complex problems are doubly dangerous if thereâs 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 policyâand associated investment activityâthat penalises âbrownâ and rewards âgreenâ 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 donât work. Worse yet if theyâre ethically coded, because then you have the urge to opt for the complicated solutions to avoid being perceived as âbadââparticularly if youâre 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.
Itâs 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 metricsâparticularly wellbeing, health, peace and justiceâour 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.
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