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Ideology’s threat to ESG

A company prints on the cover of its annual report, “Making sustainable living commonplace”. Another, on its report, has the slogan, “Enabling a zero-carbon, lower-energy future”. We barely notice these sound bites as we turn to what we consider the meat of the report. They are ubiquitous and the sentiments they carry so familiar as to be invisible. So why do companies bother with them? Why not print something that should really get investors excited, such as, “Another year of inflation-busting growth”?

For one explanation we can turn to a famous essay from the late 1970s by Vaclav Havel, a Czech writer, where he discussed why a fictitious greengrocer somewhere in Russia’s soviet empire put in his shop window a placard saying, “Workers of the world unite!” As with the slogans in those companies’ shop windows – incidentally, from Unilever (ULVR) and Drax (DRX) – no one actually notices the greengrocer’s sign. It’s part of the scenery.

All of these signs are innocuous. They express sentiments with which no one would disagree. What’s wrong with the workers of the world uniting? Who could object to a lower-energy future or sustainable living becoming commonplace? But, according to Havel’s essay, The Power of the Powerless, they are also signs of something else. All are expressions of conformity. As such, they offer breathing space. By mouthing these platitudes, companies in today’s western world, much like greengrocers in 1970s eastern Europe, effectively say that they behave in the manner expected of them. As such, they can be left alone by the powerful – or by the social-media mob – to run their businesses in peace and quiet.

The trouble is, as Havel warned, it does not end there. By making these signs of acquiescence, greengrocers and company bosses alike tacitly endorse what lies behind the slogans – and that is an ideology.

Ideology is comforting, said Havel, who would later be the first president of the Czech republic. Uniting behind a big sentiment, such as happy workers acting as one or a sustainable planet full of smiley people, can feel great. “It offers the illusion of identity, of dignity and of morality,” he wrote. But he added darkly that it “is the veil behind which human beings can hide their own fallen existence” and that applies both to the little cogs in the wheel (you and me) and the people who run the engine – all can unite in an illusory harmony in the name of an ideology.

It gets worse. Because the ideology must be infallible, said Havel, the system it underwrites ends up “being captive to its own lies. It must falsify everything. It falsifies the past. It falsifies the present. It falsifies the future. It falsifies the statistics.”

Arguably, falsification of statistics was the worst. The Ukrainian corn silos were full on paper but half empty in practice. The high-grade steel coming out of central Russian steel mills oxidised in the first breath of atmosphere. Eventually, the gap between the numbers on paper and the reality of production was the hole into which the soviet system disappeared; if the corn isn’t there, no amount of ideology will make it appear. That said, Havel’s essay, played its part.

So let’s make explicit the link between Russia’s most recent empire and the ascent of ‘ESG’ investing, where, roughly speaking, ‘E’ stands for ‘tackling climate change’, ‘S’ for ‘being diverse yet inclusive’ and ‘G’ for ‘legitimising the directors’ rent extraction’. Both the soviet structure and ESG investing are powered by ideology. In Russia’s case, that was uncontentious and fatal. ESG investing has become inseparable from the ideology of ‘wokeness’.

Helped – appropriate for these Covid-infected times – by a dollop of social contagion, ESG investing has spread like an epidemic these past 12 months or so. And why not, since the spirit of the age makes investors – perhaps especially those new to investing – susceptible? This spirit demands companies must be virtuous, but that their virtue must fit a specified template. They must emit less CO2 for every unit of revenue they generate, use less water, recycle more waste, employ a higher proportion of women and so on.

So strongly are these virtues asserted that the link between corporate practice, company performance and share price performance should be easily proven. Yet the proof is lacking. Which is not to say that it’s not there or can’t be found, but it hasn’t been yet.

However, that’s not for a want of trying. According to a paper from analysts at investment data provider MSCI, “meta studies have summarised the results of over 1,000 research reports and found that the correlation between ESG characteristics and financial performance was inconclusive”. That’s a lot of papers to find no connection and the analysts added that “even researchers finding a positive correlation between ESG and financial performance often fail to explain the economic mechanism that led to better performance”. In other words, such studies were guilty of data mining.

Yet the MSCI analysts also reckon they have found such a link and they spot it on both sides of the valuation equation – the top line (the numerator), which is the profit or cash flow capitalised into value, and the bottom line (the denominator), where an interest rate is used to do the capitalising. Using MSCI data for over 1,600 stocks from 2007 to 2017, they found that companies in the top fifth for ESG factors also produced the best levels of profitability, so their numerator was nice and fat. They also found that share prices for those in the top fifth ESG companies had the least volatility and lowest beta, indicating that their cost of capital (the denominator) would be the lowest.

At the end of the day, however, the analysts could only bring themselves to say “the research suggests that changes in a company’s ESG characteristics may be a useful financial indicator”. Hardly a ringing endorsement.

While the search for the magical correlations continues, there is no questioning the obsessive way companies signal their ESG credentials. A simple way to assess this is to dig out the data shown in Table 1 for Unilever. It’s easily done. All that’s needed are PDFs of annual reports and a reader that can count the times key words are mentioned in a document. The time-lapse contrast between Unilever’s reports for 1982, 2000 and 2019 confirm what we instinctively know – and how. If the world could be made sustainable and responsible simply by repeating the right words over and over, Unilever would have cracked it.

 

Table 1: Unilever – increasingly correct
Number of times words mentioned in annual report
 198220002019
inclusion/inclusive2538
environment(al)02164
social/society35164
diversity1328
climate2096
sustainable(ility)012139
gender0023
responsible(ility)142155
Source: Unilever annual reports  

 

However, what the table does not tell us is how Unilever compares with other companies in proclaiming its virtue. Therein lies a major problem since assessing ESG credentials is essentially a comparative exercise. While companies devote lots of resources to digging up and presenting ESG-related data, it’s not necessarily comparable with other companies’ data, either because what is being counted is slightly different or it is collated using different rules.

Take, almost at random, the sustainability reports of two FTSE 100 mining groups: Anglo American (AAL) – shop-window slogan, “Re-imagining mining to improve people’s lives” – and Antofagasta (ANTO) – “Developing mining for a better future”. Both have a major impact on the land where they operate so it would be useful to compare their environmental scorecard. Yet much of the data is idiosyncratic; for example, the declining incidence of Aids and tuberculosis at Anglo American and the rising number of female supervisors at Antofagasta.

Sure, in some areas data are comparable. On the sensitive issue of water use, both groups seem to collate data according to the same standards recommended by the Global Reporting Initiative. But the results are patchy, as is the case with almost all inter-company ESG comparisons.

Help is on its way; perhaps too much. Enter the CDP, CDSB, GRI, IIRC and SASB. These five ESG-orientated standards setters, whose acronyms aren’t worth spelling out, have produced the ponderously titled Statement of Intent to Work Together towards Comprehensive Corporate Reporting. Meanwhile, the IFRS Foundation, parent body of the board that produces the accounting standards by which companies quantify their financial performance, has set up a task force on sustainability reporting. Weighty though its contribution should be, the foundation trails far behind the Task Force on Climate-related Financial Disclosures, part of the aforementioned CDSB, which has produced enough research on its topic to occupy a life-time’s study.

The list goes on. Whether it matters much in the medium term is debatable since the proliferation of ESG funds and ESG indices indicates that the investing public is completely sold, even if people aren't sure what they’re buying.

In practical terms what they seem to get is performance very similar to that offered by companies and funds that don’t have the ESG moniker of approval. Why should it be different? In a world where any company can put on the mantle of virtue (except those whose activities consign them to a special circle of hell) then almost all will do so. As a result, ESG performance will be inseparable from the other sort.

In an unscientific way, Table 2 demonstrates this. It takes six pairs of indices – a parent index and an ESG offshoot – and compares performance over the five years 2016-20. For five pairs of indices, the performance of the parent and its offshoot are only minimally different – and not necessarily in favour of the ESG version. The exception is the MSCI UK indices, where the difference between the two is so wide as to suggest they are not actually comparable.

 

Table 2: Spot the difference
Index (% change on year)20162017201820192020
MSCI World6.816.3-9.124.911.7
MSCI World ESG6.016.0-9.026.012.4
MCSI UK0.74.0-11.918.2-10.7
MSCI UK ESG14.27.2-12.610.8-16.1
MSCI USA9.219.5-6.329.119.2
MSCI USA ESG 9.318.1-5.029.116.7
MSCI Japan-2.617.6-16.816.06.6
MSCI Japan ESG-3.617.4-16.518.08.4
FTSE All-World  8.624.6-9.127.216.6
FTSE All-World Green Revenues8.724.7-8.927.317.6
FTSE All-Share (ex Inv Trusts)16.812.9-9.819.0-11.4
FTSE All-Share Women on Boards13.1-7.517.8-12.1
Source: MCSI; FTSE Russell. MSCI indices – price returns; FTSE indices – total returns

 

The continuing absence of overtly superior performance does not really matter while ESG investing is powered by its weird mix of social contagion and ideology. The contagion will exhaust itself soon enough, leaving level-headed investors to demand three things from ESG reporting – materiality (ie, information relevant to financial performance), consistency and reliability; currently, the first two are still some way away and reliability means little if data lacks materiality.

The hope must be that ideology won’t stand in the way of these being achieved. If it does, ESG investing will eventually implode. But the process will be painful, especially for those investors who did believe the slogans in the shop window.