This article is sponsored by Quinbrook Infrastructure Partners
Why is it that ESG indices appear to be failing?
Anne Foster: I think that that is a myth. Yes, in 2022 we did see some level of underperformance. But it must be considered that there are a whole lot of constituents within the ESG mix. The majority of businesses included in ESG indices are currently technology companies, so are we seeing tech underperformance or ESG underperformance?
The next biggest constituent group is healthcare; a sector that recorded a fall-off following covid. These indices are primarily compiled on the basis of carbon footprint measures, and investors need to look carefully at what they want exposure to and whether the indices provide that. And, of course, indices will always go up and down. In 2023, for example, over one- and three-year horizons S&P’s ESG index has outperformed the S&P 500 and S&P growth index.
What does good ESG really look like?
Fiona Reynolds: I have spent a lot of time throughout my career working with large pension funds, and I believe that for such funds, good ESG involves the incorporation of the full spectrum of ESG factors across the entire portfolio, rather than a focus on individual themes. It is also about determining what is, and what is not, material. There are very few large pension funds that are doing this today because ESG is still maturing.
What about the ESG backlash that we are currently seeing in parts of the US?
FR: I find this deeply concerning. Over 20 states are currently considering banning those managing money on behalf of the state and its pensioners from taking ESG issues into account when making investment decisions. But if you are not assessing climate risk, for example, you are not thinking about risk in a holistic way – not to mention the opportunities you will be missing out on.
To what extent is ESG still primarily focused on environmental considerations?
FR: It depends on the investor, but for the vast majority, climate is the number one priority due to the sense of urgency around net zero. But it is important to remember that climate is not only an environmental issue; it must also be considered through a social lens. How do we support those who have been working in traditional fossil fuel industries in order to ensure the transition is just? How do we engage with coal mining communities, for example, so that no one is left behind?
Someone may understand and care about environmental challenges, but they also want to ensure they can pay their bills and support their family. Pushback on climate issues at the time of an election is a reflection of social issues that have not been adequately dealt with and that is why the two cannot be separated. I regret the extent to which we still seem to silo these issues into the E, the S and the G, rather than considering them from a holistic point of view.
AF: I was recently speaking with someone who was in the room when the term ‘ESG’ was coined. He mentioned that the E was put first because it was recognised that that would be the easiest aspect for people to get behind. It is also possibly the easiest to link to financial benefit. However, I agree with Fiona absolutely – climate is an overarching theme that incorporates all aspects of ESG. It includes everything from food security to jobs, migration and quality of life in our communities.
Is there less of a focus on the ‘S’ because it is harder to see the direct financial benefits?
AF: We have seen very strong short-term gains through a focus on the S and on human rights and modern slavery in the supply chain. Quinbrook took a hard line on these issues early on and within a short time of that being put in place, there have already been significant benefits because of the anti-forced labour laws that have since been introduced in the US. Those laws have brought certain solar projects to a complete stop, for example. Because we acted early, we were able to avoid those challenges to date. ESG is not just about long-term gains, it is also about capital protection and opportunity in the short-term.
How do you see scrutiny of supply chains evolving?
AF: A key step is to not only focus on internal portfolios, but to improve industries across the board, by also engaging directly with suppliers. There are also upcoming improvements in tracking and tracing, particularly where there are shortfalls due to the complexities of modern supply chains. Technology supported tracking and tracing extends across physical supply chains, components and raw materials, but also is important in carbon tracking and tracing, in energy generation, use, construction and procurement.
FR: The situation regarding modern slavery today is nothing short of horrendous. There are still more than 40 million people in some form of modern slavery, 71 percent being women and girls. Investors that care about diversity, equity and inclusion cannot only focus on board representation but must also focus on all those women and girls in third world countries that are being exploited. You cannot claim to care about the climate, whilst making money off the back of exploitation. For too long it has been a case of out of sight, out of mind.
As we see an increasing number of countries publishing regulation around modern slavery and human trafficking, however, these issues are becoming more deeply embedded in the ESG process. For a long time, human rights came at the back of the ESG queue but there is an increasing understanding today that we must balance profit, planet and people.
How challenging is that supply chain diligence in practice?
AF: It is important to interrogate as far as possible into the supply chain, including raw material sourcing, which can present significant challenges due to the complexities of modern supply chains. Blockchain technology is starting to make things easier in terms of traceability, but the complexities involved mean it is impossible to guarantee that you have no human rights issues in your supply chain at all.
This exposes a key aspect of ESG: the whole point of ESG is to interrogate – to assess and acknowledge problems where they exist, do everything within your control to resolve them and to seek out opportunity. Often in the process of seeking a solution, you can find large-scale investment or growth opportunities. Investors understand this and do not want to read just the glossy sustainability brochures. They want to hear about how you are genuinely pushing boundaries to resolve challenges and identify opportunities. Supply chains, tracking and tracing of materials and carbon are examples of areas where both challenges and opportunities abound.
Beyond the supply chain, where else are you seeing short-term wins from good ESG?
AF: We are also seeing almost immediate benefits when it comes to a range of decarbonisation, community and biodiversity opportunities. In understanding gaps in the energy transition that require investment, in emerging technologies that can support the energy transition, particularly hard-to-decarbonise sectors and implementation of technologies to support transparency of energy supply.
In stakeholder engagement, where communities can hold huge sway when it comes to local infrastructure. By acknowledging, assessing and embedding these risks and opportunities, we are seeing more short-term benefits than we had expected or than I believe the market is typically factoring in.
To what extent do you think ESG will retain its current trajectory in the face of a more challenging economic and geopolitical environment?
AF: I believe the interplay between ESG and geopolitical factors will prove to be one of the most fascinating evolutions going forward. The covid pandemic showed we have become so highly global that countries are vulnerable to not being able to access the products they need. It will be interesting to see the role ESG has to play in reinventing those supply chains and there will certainly be a lot of investment opportunities to be found there.
FR: In terms of the macro-economy, there is plenty of evidence to suggest that ESG provides strong downside protection during uncertain times. I believe this is largely because those that have thought carefully about their preparations for the future, will have thought about risk and opportunity in the most holistic way.
What kind of regional variations do you see during this maturation process?
Anne Foster: In some parts of the world, ESG is seen as a basic expectation. You are simply not doing business correctly if you are not adhering to best practice in all three areas. Other parts of the globe are earlier in their ESG journey and ESG may be seen as something additive rather than inherent to good business. In some extreme circumstances, ESG is not deemed to be compatible with financial returns, which just is not the case. ESG is about opportunity and value creation just as much as it is about risk mitigation and capital preservation.
I also think it is important to remember that these ESG factors exist whether an investor or corporation chooses to acknowledge them. In that sense, if you are not proactively looking at ESG from all angles, you are putting your capital at risk and will be missing out on opportunities. As a result, I believe ESG will become less niche and more embedded in the mainstream over time. Certain regions such as Scandinavia are already largely there, while others are working towards that goal.