Lebohang Mofokeng, Equities Analyst, Argon Asset Management
ESG has become a mainstream business activity compared to yesteryears when these factors were marginalised against financial performance metrics. Over time, the relevance of ESG for policymakers and institutional investors has seen tremendous improvement. We are aware that change is necessary and we welcome developments in mainstreaming ESG so far.
However, in its current state, ESG incorporation has challenges that require a coordinated approach and collaboratively derived holistic solutions. These challenges and obstacles include multiple interest groups with heterogeneous interests, a lack of coordinated and holistic solutions that contextualise ESG risks and a lack of standardisation (for example, a high level of disagreeability between ratings provided by different service providers).
ESG challenges should be looked at relative to contributing factors per market
In recent times, institutional investors have been fielding queries on how they include ESG in their investment processes and how they approach investing in frowned-upon investee companies (based on unfavourable ESG credentials). We believe that the optimal level of ESG incorporation varies across jurisdictions (emerging markets relative to developed markets), over time and across firms. This speaks to ESG contextualisation, which we believe is vital for optimal ESG integration. An example of contextualisation is the importance of balancing the need to decarbonise while also preserving social value for fossil fuel miners in emerging markets. This challenge of balancing decarbonisation and social value may not be as intense for a developed country as compared with an emerging economy. To avoid the existence of differences between institutional context and company profiles between developed and developing markets, stakeholders should appreciate this variation and forge collaborative solutions on this basis.
We do not encourage disinvestment in the case of unfavourable ESG credentials
Exclusionary approaches by both institutional investors and investee companies are unfortunately inefficient in addressing ESG risks in our view. Arguably, excluding an investee company from a meaningful pool of funds based on ESG credentials can incentivise the behaviour of “passing the buck” on existing ESG challenges. In the name of unlocking value or appealing to the broader institutional investor community, investee companies may disinvest out of assets that have unfavourable ESG credentials – this is inefficient and irresponsible in our view. A good example is a public company offloading a fossil fuel asset to private hands – as much as this is viewed as a value-unlocking move through valuation multiple expansion, it concurrently moves these assets away from the public space where we believe governance visibility is better. Another example is the instance of first world companies that outsource emissions intensive business activities to third world countries, thereby reducing territorial emissions but not consumption emissions. Even when one looks at it from a broader shareholder primacy lens, some firms may feel the need and pressure to dilute their gross fossil fuels exposure by acquiring ESG-friendlier assets. We believe that this heightens capital allocation risk. Our view is that we need a balanced collaborative effort where the core aim is purely altruistic. Currently, the coherence interface between policymakers, shareholders and other stakeholders is not yet continuous.
Many managers continue to buy frowned upon fossil fuel companies where value on a risk-adjusted basis is identified. Many are of the view that the practical case of excluding such companies from the investment universe is not strong enough. Instead, the approach should take a pragmatic form. An example is engaging with a coal miner to wind down their reserves instead of disinvesting from the very same reserves. Such an approach is a lot more balanced in that it progressively addresses the need to reduce long run reliance on fossil fuels and the social value created by the very same fossil fuel reserves. In this context, the manager’s responsibility is to balance generating excess returns for clients and social value preservation.
Excessive engagement and interference counter productive
A form of engagement that does not limit management initiatives is important because it takes away misalignment between shareholder returns and long run ESG objectives. Excessive interference may create a misalignment as shareholders pursuing financial returns may influence management in making decisions that may undermine ESG objectives in the long term. Similarly, excessive engagement in ESG advocacy may create a misalignment that may influence management to undermine returns. For instance, a more balanced engagement for coal miners in the Mpumalanga area would yield a balanced practical solution for labour, firm value and environmental objectives (thereby looking beyond economic impacts by considering social impacts as well). In instances where the solution is a lot less complicated, ESG objectives should be prioritised. Importantly, it may be preferable to engage investee companies privately, especially when public platforms may be used to attract flows by institutional investors instead of purely addressing ESG concerns. These engagements need not be limited to ESG advocates and shareholders only – the role of policymakers in developing a coordinated approach is equally vital.
The approach toward ESG investment should be accommodative rather than radical
We welcome change and acknowledge that we urgently need to address ESG risks, but a radical approach can yield unintended consequences, particularly if we do not address the level of heterogeneity amongst different stakeholders. We want to engage and formulate holistic global solutions that take into context particular socio-economic dynamics and reduce using disinvestment as a tool to change investee company behaviour. Let the primary aim be purely altruistic and avoid exclusionary approaches that incentivise behaviours that are inefficient in addressing ESG challenges in a holistic manner. It is far better to move slower with globally accommodative solutions rather than to take a radical approach that will result in unintended consequences.