Is it time to separate ‘E’ from ‘S’ and ‘G?

Back in the 1990s, when I was a reporter in Japan, one of the most prescient commentators about financial trends I knew was Chris Wood, the veteran reporter-turned-stock-market-analyst, who predicted the collapse of the Japanese bubble, and now writes perceptively about global markets for Jefferies.

So I was struck by his recent observations about ESG and Ukraine in his latest Greed and Fear report. He argued that Russia’s invasion is sparking the demise of “green” policies. “[I]f the trigger for a reappraisal of ESG has been the Ukraine-triggered energy surge and a related rethink as regards the value of so-called stranded assets, the reality is that an energy crisis was already brewing,” he writes. However, he added that “going forward, there will hopefully be more focus on the ‘S’ and the ‘G’ and less on a highly politicised interpretation of the ‘E’. In which case ESG will [look like] good old corporate governance, which is what all good bottom-up focused equity investors have always paid attention to anyway”.

Many observers will disagree. Philip Verleger, an oil analyst, for example, thinks that a long-term focus on “E” is rising, amid a rush for renewable energy. “Economic crises incentivise nations, their citizens and domestic companies,” he noted, predicting an investment boom that echoes the second world war’s industrial scramble. (While the US only produced 3,611 military aircraft in the second half of 1940, when it entered the war it increased production sevenfold by 1944.)

Who is correct? Moral Money will be tracking this closely in the coming weeks; the Ukraine invasion has created a potential pivot point for ESG. But in the meantime we have stories about a central bank analysis of whether it makes sense to disaggregate the “E” from the other components of ESG, and the challenges of linking executive pay to ESG metrics at Starbucks (and elsewhere). We also spotlight that thorny issue of corporate lobbying. Read on. Gillian Tett

A more granular approach to ESG

In recent years, Elon Musk has presented a problem for many ESG investors. On the one hand, the company seems to be “green”, since electric cars can reduce fossil fuel consumption; on the other hand, the company’s founder, Elon Musk, has an idiosyncratic approach to corporate governance (at best), hostility to unions, and the company has purchased commodities from mines with poor environmental standards.

So how should investors respond? Or handle the myriad of other “trade-off” dilemmas that haunt ESG judgments? The doughty Bank for International Settlements has just waded into the issue with a fascinating new paper that asks whether investors would do better to use overall ESG metrics and ratings when constructing portfolios — or choose a more granular, customised approach that only attempts to respect one or two ESG sub-themes.

The details of the paper are too dense to properly capture here. But the BIS economists essentially conclude that many investors would do better to adopt a more limited approach that just chases one element of ESG, rather than relying on overall ESG ratings to be virtuous in a wider sense.

“Devising investment strategies based on an amalgamation of three fundamentally different topics underpinning ESG investing has been a practical hurdle, especially given the potential for weak scores in one pillar to be offset by strong scores in another pillar,” they wrote. What makes it worse, they argued, was “the methodological choice of Refinitiv to assign a negative score when firms fail to disclose ‘yes’ or ‘no’ information [on ESG topics, since], these categories suffer from a high proportion of scores equal to 0, which makes it difficult to differentiate among firms”.

Introducing a more customised approach, instead of relying on overall ratings, has its own perils, they admitted: it may leave a portfolio riddled with idiosyncratic bias, and thus be inappropriate for any passive strategies (and, of course, difficult to implement at any scale.) But the BIS argued that “a focus on specific categories” — be that carbon reduction or the elimination of child slavery — could give more intellectual clarity to ESG, provide better accountability for asset managers and enable asset owners to develop their own proprietary systems for tracking sustainability. In plain English, credibility would rise.

Index providers will howl. So will many ratings groups, given that they are developing lucrative businesses based around whole-of-ESG scores. But investors should take note of the BIS report, given that the institution does not have any commercial pony in this fight; and doubly so given that the Russian war in Ukraine is going to create all manner of tricky trade-offs in the future. (Gillian Tett)

A bonus for fewer straws? Academics hammer ESG-linked pay

Starbucks shareholders will vote on Wednesday on one of the most ambitious US company bonus plans to include ESG criteria. Chief executive Kevin Johnson’s 2021 bonus was tied in part to slashing plastic straws and methane emissions.

Investors are already applauding Starbucks’s new bonus criteria. “The company stands out as a leader” on ESG-linked pay, said investment management company Neuberger Berman.

But the rise of these ESG-linked bonus metrics can be dangerous to shareholders, employees and the environment, according to research published this month by Lucian Bebchuk and Roberto Tallarita at Harvard Law School.

Too often, these new ESG-linked bonuses are vague, opaque and “can be exploited by self-interested CEOs to inflate their pay-offs, with little or no accountability for actual performance,” they said.

The duo analysed ESG pay metrics at the S&P 100 companies. They found that “in almost all cases” it was nearly impossible to say whether the incentives changed anything or “merely lined CEO’s pockets with performance-insensitive pay”.

Among other things, companies do not consistently report a starting point for measuring ESG performance, they said. “Reaching these targets might have been so easy that linking a fraction of compensation to such a goal had little or no incentive value,” they said.

Boardroom enthusiasm for ESG-linked pay comes as shareholders are increasingly concerned about huge bonuses for executives. Shareholders in 2021 voted against a record number of executive pay plans. This year, shareholders will want to see ESG pay criteria that is more than a fig leaf covering up enormous bonuses. (Patrick Temple-West)

Investors launch new effort to demand climate lobbying disclosures

When companies want to water down looming environmental regulations in Brussels or Washington, they don’t like to get their hands dirty. Fearful of reputational blowback, companies prefer to deploy their trade associations to be the attack dogs.

Now investors are taking action to shed light on murky lobbying. Today, the Church of England, Swedish pension fund AP7, BNP Paribas and other investors have unveiled a global set of climate lobbying standards. Specifically, the investors ask companies to disclose how much they are paying trade associations as well as organisations like think-tanks that might also be influencing regulators.

The investors also called for companies to have board-level oversight of climate change lobbying activities.

“Corporate lobbying can significantly influence public climate policy,” said Clare Richards, head of engagement at the Church of England Pensions Board. The goal of the initiative is “to encourage a move away from ‘negative lobbying’ [and] towards actively engaging in ‘responsible lobbying’” on climate issues.

In recent years, shareholders have become more concerned about corporate lobbying. In 2020, BNP Paribas Asset Management won majority support on a shareholder petition it led at Chevron to require lobbying disclosure. The company issued its first climate lobbying report in January 2021.

These new climate lobbying standards will spare investors from fighting with companies one by one for disclosures. Now that many big US companies are disclosing detailed trade association payments, it should not be too difficult for small- and medium-sized companies to publish this information as well. (Patrick Temple-West)

Smart read

• The greenwashing saga around DWS, the asset management arm of Deutsche Bank, has sparked endless soul-searching in the ESG world in the past year. So sustainability advocates may be interested to note that “the bank broke the terms of an agreement with the Department of Justice by failing to flag a whistleblower complaint about greenwashing allegations at its asset manager DWS in a timely manner”, according to a FT story. Read the details of this cautionary tale here.