Morals, markets and menus

Sustainability means different things to different people. Stances on major environmental, social and governance (ESG) topics usually come down to our personal belief system. I think about this belief system in two dimensions.

First, sustainable investment beliefs: what you believe about the future and your associated view of risk and return. This could be how moving to low carbon economy will lead to huge disruption that is not priced in.

Second, sustainability preferences: what you may want to avoid/achieve/align with as an individual or institutional investor. For example, a sovereign wealth fund may want to promote sustainable development in its region, or a pension fund representing the education sector which is predominantly female may want to make sure diversity, equity and inclusion standards are high in how it allocates capital. Alternatively, an individual/organisation may simply want to ensure that the capital it allocates does not breach global human rights norms.

Avoiding reputational damage from sustainability issues is also a valid sustainability preference and does not require any belief about the materiality of ESG issues on returns for preferences to be included in a portfolio.

Part of the reason it is so hard to pin down a definition of sustainability is because it is constantly evolving. An intricate dance between science, media, regulation as well as global and societal norms helps shape our opinions of how the world should look; what is important to us and what is not.

There are parallels with the rest of investing in the sense that there is no one-size-fits-all portfolio for any investor. Value vs. growth is a long-held debate; as is the active/passive divide. Some investors can stomach illiquidity but it is not within the risk envelope for others. It is about matching risk appetite and investment objectives.

When it comes to sustainability, we also need to match sustainability preferences to the individual or the organization. So far as I can see, we are not particularly mature as an industry about articulating those preferences. We often conflate sustainable investment beliefs (e.g., are human rights a financially material issue or is climate risk priced into markets) and sustainability preferences (preferred outcomes from allocating capital such as not breaching minimum human rights standards or not damaging the environment or even achieving positive environmental outcomes through capital allocation).

Investors need to spend more time working out what their sustainability preferences are as individuals and organizations. This should then help navigate the plethora of ESG confusion and find the best suited portfolio to meet all objectives.

But we also need to remember that this work is never ‘done’. Sustainability, like the law, is a fluid concept. In the movie about the late Supreme Court justice Ruth Bader Ginsberg, ‘On the Basis of Sex’, there is a great line expressing this:

Judges are bound by precedence, but they cannot ignore cultural change. A court ought not be affected by the weather of the day, but will be by the climate of the era… The law is never finished. It is a work in progress...and ever will be.

We must therefore acknowledge that sustainability is continuously evolving and that investors should also continue to evolve their portfolios to ensure their sustainability preferences reflect the preferences of their beneficiaries.

The law is never finished. It is a work in progress. Ruth Bader Ginsberg

We can therefore confidently assert that there will never be a one-size-fits-all solution to sustainability. However, if carefully managed, the variability of client preferences also provides us with a great opportunity to innovate and offer a range of solutions to our clients.

We can, and already do, address varying investor ESG preferences through portfolios that target a range of particular outcomes meaningful to them. And these can and should span active and indexing, as well as public and private markets. The growth of impact and sustainable thematic strategies, as well as sustainable indexing and ETF solutions is testament to this.

In addition to providing traditional ESG portfolios that screen out firms involved in controversial practices, investors are now able to allocate to active or passive investment strategies targeting sustainability-linked themes like climate change, biodiversity, the blue (marine) economy, the circular economy, waste management, nutrition and gender equality. The targetable themes can be even more granular: for example, investors can choose from a number of ETFs that take exposure to lithium – a crucial component of the batteries playing a vital role in the transition to net zero.

Meanwhile, there has been a proliferation of investment products designed to promote progress towards the United Nations’ Sustainable Development Goals.

There is also a growing movement to put the votes at annual general meetings into the hands of actual shareholders. Regulations and technology are currently colliding here to give investors a greater say over their portfolios’ stewardship impact. The European Union has been leading the charge: the EU Taxonomy attempts to clarify what the playing field should look like for ESG investments.

Since August 2022, financial firms operating within EU states have had to comply with the new requirements of MiFID II. Distributors now also have to obtain information about clients’ sustainability preferences to determine their suitability for a particular product.

In the UK, meanwhile, the Stewardship Code – which has been signed by 235 organisations¹ – requires investment managers to offer fuller and more personalized reporting, including on ESG. “Investor stewardship is important for maintaining focus on the creation of long-term sustainable value for a wide range of economic and societal needs” explained CEO Sir Jonathan Thompson in the Stewardship Code’s latest report.²

68% Predicted growth of ESG as a category in Fintech by 2025

Collaboration between standards and corporate reporting agencies, proxy advisors like Glass Lewis and ISS, and research consultants have led to examples of ‘pass-through’ voting powers being transferred to investors “Pass-through voting” is a technique that gives investors a say proportionate to the size of their holding.

The intermediated nature of our industry means that much of the onus for securing such end investor insight is on others within the value chain. However, we have an annual review process of our voting policy, which guides all our votes and includes consultation with clients, to ensure alignment.²
 

As pressure mounts for institutions to reflect investors’ wishes, the number of ESG fintech firms clamoring to help them is growing. In fact, ESG is the fastest-growing category within fintech. It is expected to grow by 68% over the three years to the end of 2025 to become a USD 53.5 billion industry.³

¹Review of Stewardship Reporting 2022, Financial reporting Council, Nov 2022.
²Review of Stewardship Reporting 2022, Financial reporting Council, Nov 2022.
³Enabling tomorrow: The emergent ESG Fintech ecosystem, KPMG, 2020.