Nobody wants to do harm

13 Nov 2022 | Paris Agreement obituary. Climate finance crunch. SFDR teething troubles.

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🌡️ 1.5°C is dead in the water. (Coral doesn’t have to be.) The annual Global Carbon Budget report, released Friday, puts the world on course to breach the Paris Agreement target in nine years. “Most in the field know this to be true,” reported The Economist last Saturday, when the carbon budget still permitted 10 years of emissions at today’s rates. “Very few say it in public, or on the record. But the truth needs to be faced, and its implications explored.” The New York Times observes climate rhetoric has started to soften—or rather, harden, “with existential abstractions thickening into something more like high-stakes realism.” ‘Realism’ means 2-3°C of warming this century, which shuts the door on continued normality. Equally, however, the dizzying pace of decarbonisation and innovation have ruled out total disaster. As the window of potential climate outcomes narrows, we get a clearer vision of a future “full of disruption, well past climate normal, and yet mercifully short of true apocalypse,” in which adaptation—word of the week at COP27—is the new target.

🌍 Climate adaptation is most urgent in the places least responsible. The previous 26 COPs were absent that conversation. At COP27, however, developing countries are making it impossible to ignore, pushing for compensation from and threatening litigation on wealthy nations responsible for asymmetrical “loss and damage.” If its predecessors were an exercise in itemising the climate bill, COP27 is time to pay up. Thursday, or ‘Finance Day’, addressed the question of how banks, investors, and insurers can better channel transition finance. In an effort to “answer the argument by private sector financiers that it’s too risky to invest in emerging markets,” UN experts published a list of projects worth $120B that investors could back. It might not be enough. Another report, published on Tuesday, claims developing nations need an extra $1T a year in external financing by 2030. But a shortfall in blended finance has been exacerbated by a dollar bull market sucking money away from emerging markets.

🏦 “Finance is used to feeling it’s in the driving seat,” Cambridge Associates’s Simon Hallett tells ESG Investor. “We must acknowledge that, in the transition to net zero, finance is an enabler, not the driver.” Now their ESG honeymoon stage is over, investors are adjusting to a new role. On the one hand, 2022 volatility underscored the limits of ESG action in a framework dictated by financial vicissitudes. On the other, governments are beginning to bend that framework towards decarbonisation—particularly in the US, where fiscal support for clean energy became all-but entrenched after this week’s midterm results. For its own part, ESG investing looks more sophisticated than it did a year ago. “Private sector capital has grappled with the challenge that although it can clean its portfolios, if it’s not financing the transition in a practical way, it’s not having impact,” says ESG Investor. Now, portfolios are trending towards transition plans over linear reductions or industry screens.

🔇 Companies might not be happy about it. In its State of Stewardship Report, communications firm Tulchan reports investor relations are “increasingly uncomfortable” over ESG. FTSE 100 bosses complain of “regulation and interference,” of which there is plenty at COP27. CDP announced plans to incorporate ISSB standards into its reporting system, while the UN unveiled a High-Level Expert Group on Net-Zero Commitments (UNHLEG) to hold businesses to account on net-zero commitments. With a nod to GFANZ, UN Secretary General António Guterres announced UNHLEG would address “bogus net-zero pledges” with “loopholes wide enough to drive a diesel truck through.” Take heart, readers of the Edelman Trust and Climate Change report, which claims “that Business, normally the most trusted institution in the world,” [really, asks Alison Taylor?] are now the least trusted spokespeople on climate. Edelman would know: The PR firm has an entire SubWiki dedicated to its ‘Controversies / Fossil fuel companies and climate change deniers’.

Story of the week: Nobody wants to do harm

Here’s a scenario. You decide you want to park your funds in a mutual fund or ETF—perhaps an unregulated crypto exchange wasn’t for you—and so you approach a fund adviser or provider. They ask you about your risk tolerance, as well as your sustainability preferences, as is now required under MiFID II regulation.

You don’t know what an Article 6, 8, or 9 fund is. Your adviser—required, too, to elucidate sustainable products while “avoiding technical language”—explains there’s a spectrum: On one end is unsustainable, or brown, on the other is super sustainable, or bright green, and somewhere in between is light green, which, like, pick a side.

“What does sustainable mean?” you ask. “Nobody really knows,” responds your adviser. “Broadly, however, somewhere between 0.1% and 100% of its holding companies should either: contribute to an environmental or social objective; not significantly harm other environmental or social objectives; and be well governed.”

Maybe you cheered on Elon Musk during that Twitter feud with S&P, and so you say “not interested, thanks, I like badly governed brown harm.” More likely, however, is that you self select ‘do-no-harm’ sustainable over the implicitly ‘do-harm’ non-sustainable.

Asset managers are nervous.

The “billions chasing contested ESG funds leave insiders “mystified,”” bemoans one headline. Puzzling and puzzling 'till their puzzlers are sore, blindsided “industry insiders confess they don’t understand why investors aren’t being cautious” anymore.

Even as Article 8 outflows hit €29B in Q3 (YTD outflows: €120B (Morningstar); €173B (Refinitiv)), Morningstar data show Article 9 inflows reached €13B (YTD inflows: €29B (Morningstar); €33bn (Refinitiv)). Spooked by the greenwash associated with broad-brush ESG funds, investors are fleeing Article 8 for the greener pastures promised by dedicated impact or thematic sustainable funds. Speaking to the FT, CEO Patrick Wood Uribe says the trend signals “huge potential for much better products.”

But does Article 9 plug the gap?

Their popularity is unsurprising, but dark-green funds aren’t secure in their status. Those “industry insider” jitters are justified. Absent clarity from ESMA, asset managers are “struggling to guess” what qualifies as “sustainable,” prompting preemptive action. In the time since Q3 data were published, the SFDR Green Reaper has been hard at work: Last week, BlackRock, UBS and Invesco announced plans to downgrade Article 9 funds housing tens of billions of dollars.

Article 9 has two problems.

The first and widely accepted version is that the category may not be as sustainable as it appears. Some questions, such as whether weapons qualify as “sustainable,” shouldn’t be up for debate and yet are for at least 165 Article 9 funds, as Patrick tells Ignites Europe. Morningstar warns that fewer than 5% of Article 9 funds “target sustainable-investment exposure between 90% and 100%.” Our own analysis yields some suspect activity under their bonnet, including hundreds of millions in exposure to Coca Cola, which—as we discussed last week—does quite a bit of harm, actually. Hundreds of millions may not sound like much, but it isn’t insignificant in the context of a relatively compact 400B in Article 9 assets.

And that’s the second issue.

In terms of impact, it’s harder to find pure—and established, and liquid—‘green’ companies than it is to find ‘complicated’ companies. Blame an economy in the early stages of change. Blame a messy one. Supportive fiscal policy, rapidly advancing innovation, and blended finance solutions all help. In the interim, however, there’s a lot of interest in a rather small universe.

It’s hard being good.

By our own analysis (data as at October 2022), the 18 largest Article 9 funds by AUM represent €86.9B, or around 20% of the total pot—a share that grows as the number of funds shrinks. By median average, their top-ten holdings represent a chunky 32% of total portfolio size. These are concentrated funds! And they sit in the eye of a perfect storm. If money keeps pouring in, and funds keep dropping out, then flows will accelerate towards the remaining highest-impact thematic funds, many of which have a necessary bias to smaller cap companies.

It’s a scenario that could expose Article 9—and the companies to which they funnel capital—to regulatory as well as volatility risk of the type that destabilised the iShares Global Clean Energy ETF last year (and of which we warned Bloomberg at the time). One of the biggest Article 9 funds, its top-ten holdings represent almost 50% of its total exposure today. Its impact may be best-in-class, but are there enough undervalued best-in-class opportunities to meet demand?

The SDG impact of the iShares Global Clean Energy ETF (Util data)

Critics have been quick to blast Article 9 funds for their perceived inadequacy, but could the problem be the labels rather than the products? Is it realistic to shoehorn investment vehicles into highly marketable categories that don’t, comfortably, exist? Might it make more sense, at least for now, to access the full—often messy, rarely unimpeachable—value chain of sustainable themes, understand and communicate the tradeoffs, and engage with companies to improve their impact over time?