Week in Impact

ESG self sabotage

21 May 2022 | Republicans love to hate ESG, Elon wants attention, crypto needs risk management.

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🚘 Republicans don’t like whatever ESG is. Mike Pence is mad at “leftwing radicals” for forcing companies like Exxon to “elevate left-wing goals” over “the interests of employees and consumers.” Elon Musk is also upset with the “leftwing agenda,” for “[rating Exxon] top ten best in world for ESG by S&P 500, while Tesla didn't make the list!” To recap: Exxon (and other automakers) got S&P’s ESG stamp of approval because they ‘elevate the interests’ of employees and consumers, and Tesla was dropped because of poor working conditions, racial discrimination, and vehicle injuries—which sound like things that are very much not in the interest of employees and consumers. Pence should be raving about the “radical ESG agenda”! While it makes for a less exciting read, Pence, Musk, et al could at least reacquaint themselves with S&P’s methodology, widely available on its website. ‘Criteria’ begin on page 7.

🛢️ The GOP missed the memo about the new ESG realpolitik. BlackRock, not S&P, was the target of ire in Pence’s energy policy speech to Houston. The BlackRock that just promised to keep nurturing $115B in Texan oil & gas companies? The BlackRock planning to vote against more “prescriptive and constraining” climate resolutions at odds with shareholder value? That BlackRock? Even Larry Fink’s bullish position on the long-term outlook for renewables is straightforward pragmatic capitalism: The green tech market is predicted to rise to $74B in 2030, from $10B in 2020. In the meantime, Fink has added his voice to what the FT’s Patrick Jenkins calls “the new ESG realpolitik,” which manifests as a “frankness” about the need for transitional fossil fuels. That frankness, says Jenkins, “is as important for the reputation of ESG as it is for the future of the planet.” Less catchy as a midterm soundbite, though.

🌳 The radical woke hedge funds are at it again! AQR’s Sustainable Long-Short Equity-Carbon Aware Fund is up c.20% this year, beating 94% of its peers. Bloomberg credits its success to a unique hedging strategy, via which it shorts companies unprepared for the ramifications of global warming. CIO Cliff Asness has long (and passionately) championed the financial, social and environmental benefits of ESG hedging. Now the UK’s FCA is taking notes, having “sought feedback on the role of derivatives, short-selling and securities lending in sustainable investing,” to ensure its regulatory framework can “accommodate the breadth of ESG strategies observed in the market.” The move would give UK hedge funds a competitive edge against their EU peers. Despite an early surge in sustainable index funds, the green tide is turning: Capital Group finds 63% of investors think ESG is best managed in active strategies.

ESG self sabotage

‘The higher you climb, the harder you fall’ is a sentiment felt—perhaps for the first time—by both ESG and crypto tribes this month.

Ten years ago, the terms were relatively new. Despite little overlap, their early advocates shared similar views about the post-crash direction of finance, the inextricable influence of society, and the potential for better accounting.

From 2016 to 2021, digital assets rose from $14B to $3T (depending on who you ask); ESG assets, from $23T to $35T (depending on who you ask). Tides turned in 2022, as markets sank and pulled down ESG and digital assets with them.

And then, last week, the richest man in the world lost all of his gains on both and made it everyone else’s problem.

Elon Musk is mad.

Musk made two claims in his Twitter tantrum. One, Tesla “has done more for climate than any company ever,” and two, “ESG is a scam.”

On the first, he’s not wrong. Tesla has electrified the auto industry and made the energy transition look cool. But it doesn’t follow that ESG is a scam, and that’s because ESG doesn’t care what Tesla does for the environment.

The scam is that so many people think it does.

Like ratings agencies, index providers, and asset managers, Musk understands there’s a distinction between ESG and impact. Like ratings agencies, index providers, and asset managers, Musk has capitalised on the opportunity to pretend it doesn’t exist.

It’s easier to claim the system is broken than to accept S&P’s justification (racial discrimination, poor working conditions, and handling of deaths and injuries linked to autopilot vehicles). Even better if, in doing so, he can turn public opinion against the system that spurned him.

Here’s the thing: The backlash is a beast of the ESG industry’s making. MSCI’s “better portfolios for a better world” walked so that Musk’s “ESG ratings make no sense” could drive.

Sustainable cashflow or sustainable world?

ESG is not environmental and social impact. ESG. Is. Financial. Risk. And that’s OK! In fact, it’s great!

ESG is brilliant not as a catchall strategy to maximise returns and save the world, but as a form of financial analysis befitting an economy of burgeoning integration and information. It’s a wider lens, broader scope. And if you want to capture a company’s context, the society and environment in which it operates are two key datapoints.

To be clear, however, the E and an S in the acronym are inputs—not outputs.

What ESG is not is a lever with which to improve society and environment (see: impact). In fairness, neither the ESG ratings agencies, nor index providers, nor asset managers claim otherwise—at least not explicitly. But it’s also fair to say they haven’t gone out of their way to dispel the myth, into which it’s tempting to lean. People like to make a difference. As myths go, it’s lucrative.

Now, it’s coming back to bite them. Postscript ed.: Matt Levine detailed this landscape in his newsletter, published a couple of days after our own:

There have been various backlashes [to ESG]. One sort of backlash is along the lines of: No, ESG is bad. (And so various US politicians try to make it illegal for investors to consider environmental or social impact in making investments, etc.) Another is along the lines of: Sure, ESG is good, but ESG as practiced is often fake. The theory here is that people who call themselves investment managers do not really care about ESG factors, and ESG is a marketing term rather than a real commitment.

Both backlashes are direct consequences of the ESG marketing machine, which, in positioning ESG risk management as positive impact, has made it an easy target for people who a) don’t want positive impact anywhere near capital markets, and b) don’t understand why ESG doesn’t look like impact in practice.

This is bad for ESG, and by extension, all the corners of the market that could benefit from a healthy dose of 21st Century risk management.

Like, say, crypto.

An existential threat with exponential damage.

Both blockchain technology and crypto have huge potential in terms of positive impact. According to our source texts, crypto facilitates better financial access and inclusion, alleviating poverty and increasing global innovation. The notorious climate footprint of blockchain is, at least partially, offset by its potential in efficient supply chain management, with big gains in social security.

The SDG impact of cryptocurrency, Util data

But the concept’s potential is undercut by its reality. Today’s market is very different from the decentralised, democratised image it projects. With just a handful of people and centralised exchanges pulling the strings, and evading accountability, it’s the type of market begging for ESG—sorry, risk—oversight to keep it on course.

Yet: Accountability is counter to the culture of crypto, which spawned from a deep distrust of a financial system that, in the aftermath of the financial crash, looked very dishonest and very out of touch. Patching up that reputation requires a healthy dose of honesty and authenticity. Pretending ESG = ethics is not honest or authentic. And that can, has, and will be used against perfectly sensible risk management.

Tesla is the perennial ESG paradox because it’s great for the energy transition and a nightmare for shareholders. By conflating the two, Musk can obfuscate his serious governance issues by accusing ESG of being devoid of substance. Those at the helm of influential crypto companies and exchanges can poison perceptions of risk management in a similar way, weaponising the idea that it’s a useless, if not nefarious, moral interference. (See: Peter Thiel calling ESG a “hate factory for naming enemies” in a speech at a Bitcoin conference in April.)

That crypto culture, to which $3T in digital assets are tied, is vehemently anti regulation and anti risk management. Unfortunately, one result is there’s little by way of a) scrutiny to prevent the type of apocalyptic crash that hit Terra Luna this month, and b) safety net to protect those left holding the bag.

If there are more Terra Lunas—and judging by the transparency of certain exchanges and their supposed reserves, it’s only a matter of time—it could prove to be a smear campaign with multi-billion dollar ramifications.

Util is an impact data provider. We’ve railed against the conflation of ESG and impact many times before, because it cannibalises progress in the impact space. Ironically, and worryingly, it now threatens to cannibalise ESG.

With the backing of institutional investors and regulators, the sustainable finance industry will weather the latest spate of criticism just fine. But hopefully, ratings agencies, index providers, and asset managers emerge with more interest in communicating exactly what it is they do—and, more importantly, exactly what it is they don’t do. The implications go far beyond the fund management industry.

Both ESG and impact have merit. Time to be honest about what those merits entail.