There is currently an intense focus on rewiring the global capital markets to be more sustainable and eco-friendly. Unsurprisingly, this year’s SIBOS conference theme is “Progressive Finance for a Changing World”, with a heavy weighting towards ESG topics and how the industry can move from theory to action on combating climate change, ESG data standardization and increased levels of financial inclusion.

My own panel session, entitled “Green, clean and ESG: Rewiring capital markets for a new generation of responsible investors”, happens on the main conference stage on Wednesday, October 12.

The concept of rewiring is interesting. It could be as mundane as rewiring the plug of a household appliance or a bigger (and far more costly) job like rewiring an entire house. Alternatively, it could be a more dangerous job like we often see in films where an intrepid hero must defuse a world ending explosive by tinkering with colored wires as the countdown clock draws closer to zero.

So, let’s unpack the session title a little to determine what rewiring is needed now to address the climate emergency.

Rewiring Capital Markets

I feel the task of rewiring the complex interconnected, yet often independent global capital markets, is hugely ambitious. Policymakers are in essence asking the markets to rewire themselves away from the current hardwired profit-centric mindset into one that considers a range of non-financial measures of success as it assesses its business activities.

It is this rewiring of the collective industry mindset that is possibly the most challenging component when it comes to financial markets. They have traditionally held the belief that companies have one purpose and that is to use their resources to increase its profits while fairly engaged in open and free market competition. However, climate crisis and deepening social inequity continues to exercise global governments and policymakers have now intervened to influence the movement of that capital towards environmental and social goals.

This interventionism, which has manifest itself in a raft of global ESG financial regulations, has prompted a vigorous debate on whether such policies are enough on their own to drive the change required. The level of ambition, complexity, and political polarization of the ESG policy shifts has helped to spawn a fully-fledged culture war across financial markets. Let’s briefly investigate this recent schism.

The surge in inflation generally and the specific energy crisis triggered by the war in Ukraine have moved renewable companies’ share prices far beyond subsidy levels. Such a move reflects the speed of growth and necessity for such technologies to meet existing energy needs but also the ambitious climate goals of global governments, as agreed under COP26 and similar multi-lateral political deals.

However, the pace of growth towards these goals has been slow. With 2050 coming into view and the shift towards climate commitments and safeguarding of national energy security, it is inevitable that the renewable sector is in for a period of rapid growth. Picking the winners and losers in this sea change is likely to impact portfolio returns.

ESG Culture War

A culture war is a societal struggle between distinct groups on certain "hot button" social issues in politics and public policy. ESG has been caught up in the culture war, casting people into one grouping or another based on whether they believe the concept of ESG is a moral imperative, whether they see it as a useful objective risk management parameter for better long-term investment returns, or whether they see the concept as misguided or worse.

When longer-term priorities (such as addressing climate change) come into conflict with immediate or short-term priorities (such as feeding and heating families), the latter tend to prevail. We have seen this play out most recently in Europe, where some countries are scrambling to find sources of energy to mitigate the loss of supply from Russia – without regard to environmental impacts, with some countries reversing long-standing plans to phase out nuclear power. Any localization of manufacturing and the addition of more sustainable business models will take some time and unquestionably be more expensive for consumers.

Is this really a price that government and their voters are ready and willing to pay?

Recent months have seen an intensification of the public backlash against the very concept of ESG investing. For example, a cohort in the United States claim ESG is counter to an asset manager’s fiduciary duty and that financial returns should be the sole focus of efforts.

In the European Union, the birthplace of ESG policymaking, many environmental agencies are campaigning currently for a legal challenge to include gas and nuclear within the EU Taxonomy, a policy initiative which aims to define economic activity as sustainable or not.

Great uncertainty still abounds regarding ESG definitions, how accretive to returns ESG considerations really are, and whether a broader range of investors globally are truly willing to pay more in costs or accept lower investment returns for the change they want to see in the world. Without uniformity of definitions, standardized data sets, more collation of regulatory fragmentation and investor polarization, we remain some way off from the goal of having an ESG-exclusive investment marketplace.

New Generation of Responsible Investors

The hypothesis that we are close to an ESG-exclusive market is too simplistic in my view.  While many investors want more ESG, it is also true to say that others do not, and they are standing up to suggest that the ESG narrative is not as simple as perhaps some people have described.

Supporters of negative ESG portfolio screening suggest that it is a method of increasing pressure on companies to change. However recent empirical research debunks this, suggesting that negative screening has little or no effect on the returns of so called “sin stocks” as there is always an investment bank or private market stakeholder willing to purchase or debt finance such entities to generate healthy returns.

Detractors of negative screening suggest that it reduces portfolio diversification, increasing risks and reducing returns - and that removing "sin stocks" leaves money on the table. The question of whether investors will pay for the application of their values through reduced investment returns remains uncertain. With surging inflation, a continuing cost of living crisis, and pressures on energy supplies, downward pressure on fund fees is unlikely to disappear any time soon.

No universal ESG definition yet exists, nor is there a consensus about what mix of negative screening, positive attribution analysis, intentionality, shareholder engagement or other stewardship activities makes for a best-of-breed sustainable or ESG portfolio. Many market commentators have found themselves in hot water by suggesting that ESG investing has “no effect whatsoever” on companies while there remain a host of buyers of last resort for most “sin stocks”.

What is probably true is that negative screening doesn’t have the impact that active stewardship and proactive proxy voting has in driving discernible change by large corporations.

However, there is no single thing that can save us from the climate emergency. Sustainability will remain a central policy debate for the next decade as policymakers grapple with finding the right tools and solutions.

ESG is everywhere and I hope to see you all at SIBOS where we can pick up these questions and themes of ESG.