Just three weeks into the new year, and it already feels like 2022 will be the year when ESG investing will have to grow up. While markets in general have had a rocky start, this appears to be even more so for “ESG-friendly assets”. At the same time, prominent investors have made comments about the genre which are either negative or more nuanced than in the past. All of this once again raises relevant questions of how best to incorporate ESG in a value-added manner into investments. 

One rocky start to the year

If the old investor adage of ‘as goes January so goes the year’ holds true, then there will be plenty for investors to worry about this year. ESG equities have had a poor start to the year, with a widely followed global benchmark down 5.2% YTD as of 20 January.

To an extent this reflects the fact that markets in general have had a rocky start, with the global benchmark down 4% (everything was falling even further at the time of writing, on 21st). It is worth noting that this is the weakest start for ESG stocks in over a decade (i.e., since ESG started moving out of the investment fringes), and ESG equities are also underperforming overall equities by the largest margin in 10 years. And the more focused S&P Global Clean energy benchmark is down double digits YTD, something that hasn’t happened in a dozen years in January, a traditionally bullish month.

Two interesting fund letters

The year also began with two notable missives from famous investors, with ESG implications. First the latest annual “Letter to CEOs” from Larry Fink, the head of Blackrock – one of the world’s largest asset managers. Interestingly, the tone and content of the letter saw a subtle shift from the past. While previous letters have had exhortations to CEOs on the need to combat climate change, this time the letter talked about ESG in the context of “stakeholder” capitalism, as something that is aligned with capitalism.

The letter was at least partially a response to those who have been criticizing the ESG agenda as going too far, with Blackrock itself facing censure, particularly from fossil fuel dependent states in the US. Given the pushback from some quarters, it appears there specifically was a need to state that stakeholder capitalism is not “woke”, and that blanket divestment from fossil fuels is not on the Blackrock agenda. (See Larry Fink’s Annual 2022 Letter to CEOs | BlackRock , and for previous letters Larry Fink CEO Letter | BlackRock , and Larry Fink’s Letter to CEOs | BlackRock)

Meanwhile from the UK, writing more acerbically, the celebrated investor Terry Smith excoriated the management of Unilever in his annual letter. Smith, whose fund is one of the largest shareholders of Unilever, chastised its management for having “lost the plot” with a focus on talking about and highlighting its sustainability cred while neglecting operating and financial performance. Unilever’s problem appears to be that it couldn’t hide years of pedestrian growth by talking up sustainability; and nor did that improve the company’s valuations, which is ultimately what investors most care about. (See Terry Smith’s annual shareholder letter here – Fundsmith analysis | Fundsmith). Something similar happened last year with the French multinational Danone, where shareholders, tiring of years of poor performance, demanded (and got) the ouster of the then Chairman/CEO. In both cases, growth had been the main issue, compounded by a lack of innovation in operations, as result of which margins were pressured. All the action on sustainability was thus rendered irrelevant – Danone in fact had formally adopted a dual economic and social agenda, becoming an Enterprise à Mission, or purpose-driven company, becoming the first listed company to adopt this framework and showing its commitment to social performance.

Three takeaways for investors, and companies

1. Blanket exclusion won’t work. Divesting from fossil fuels exacerbates the costs of going green, and while usually well meaning, risk becoming just a form of virtue signalling.

Blackrock should be commended for explicitly ruling out a blanket exit from the fossil fuel sector. So long as the world needs fossil fuels, they will need to be provided by someone. Far better to work on funding and finding alternatives before outlawing fossil fuels. In the meantime, investors can play a crucial role by engaging with managements, pushing them towards using fossil fuel profits to fund decarbonisation alternatives. Total divestment only reduces any role investors may hope to play on influencing management decisions on decarbonisation and future investments.

This is particularly relevant at a time when inflation is roaring ahead everywhere, in part due to price rises in energy driven by rising demand as the world economy reopens. Removing supply without first reducing demand adequately is a recipe for inflation and raises the interim costs of switching to a green economy.  That is neither good policy, nor good investing. Energy sector stocks globally and in emerging markets handily outperformed with returns in 2021 of 41% and 21% respectively; excluding them thus didn’t help investor performance either.

2. Evaluate a company relative to its sector and market, not based on opaque ESG ranks/scores.

Consider this – both Unilever and Danone have been leaders in sustainability on many considerations. While Danone is aiming for B-company status, Unilever has one of the most ambitious climate action targets, aiming to become carbon neutral across its value chain by 2039, 11 years ahead of the Paris Climate Agreement goal. It has already halved its Scope 1 and 2 emissions since 2017.

But more relevant to us here is that most large European consumer staples companies also score very well on most typical ESG metrics, with the overall sector having significantly better ESG credentials than the market as a whole. Therefore, beyond a point, advances on the ESG front may incrementally matter less to investors. This makes understanding sector dynamics crucial even while applying ESG principles. ESG improvements may mean more investment upside in some sectors than in others.

3. You can’t “integrate ESG” without evaluating companies’ operational and financial strategies together with ESG practices.

When analysing companies, it’s worth remembering that making a big splash on the ESG front won’t work unless backed up by actions at the ground level in terms of operating strategy and business models. When evaluating investments for ESG, and when engaging with managements, investors need to analyse whether sustainability and ESG are headline goals or is the company then actually using these principles to improve operations and strategy.

This is of course a challenging ask, requiring a deep understanding of both business outlook and strategy, as well as relevant ESG materiality. Has the company thought through its supply chain based on ESG materiality, and how has that been reorganised? Have any of the sustainability factors driven fundamental change in the business model? Has it changed pricing, or delivery? In other words, how closely has ESG/sustainability been integrated into overall strategy. Evaluating the two together is likely a much better guide to future valuations than a simplistic ESG numeric or alphabetical score.