The Elephant in the Room: The ESG Contradiction

We all agree that finances play a key role in getting to zero. But we cannot ignore the elephant in the room: the inherent conflict between the “E”, “S” and “G” in environmental, social and governance (ESG) investing.

As much as we’d like it otherwise, the goals embedded in these initials don’t always line up with each other. That’s why a compromise must be made. Investors, asset managers and companies must agree on which of the three is most important.

So what is our position at SustainFinance? We believe that social, the “S”, should be the highest priority. Because? Because sustainability is a matter of humanity.

The “S” factor is broad. It varies by country, culture and context. Figuring out how they can be aligned within the bounds of net zero goals must be up to the people.

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In the end someone has to pay.

Convincing manufacturers with tight margins to spend money to reduce their greenhouse gas emissions is a huge challenge. It comes with consequences.

Let’s make this real: A healthy environment, living wages and strong worker rights cost money. Customers want these results, but at a reasonable price. The same goes for investors. They want their money to go to good companies that treat their workers well. And they want a good return on investment. But at the end of the day, none of this is free.

To reduce emissions, companies may have to sacrifice the profits they pay out as dividends to shareholders. At least in the beginning. And with falling dividends comes falling stock prices, both of which hurt returns for those saving for retirement or their children’s education.

This means we have to align multiple interests. Investors, asset managers and companies are ultimately people. Therefore, we need to shift our thinking away from a focus on environmental issues in isolation and towards a more holistic approach that looks at outcomes from a broad societal perspective.

In a post-pandemic world, this reset has far-reaching ramifications.

Fact Sheet for ESG and Responsible Institutional Investment Worldwide: A Critical Review

Investors want returns.

When it comes to future liabilities (retirement, education, etc.), the pressure is on investors to achieve the required returns.

Their usual focus is the accumulation or generation of income. This drives up the prices of sought-after assets. Those looking for income to fund their retirements will pursue companies that pay high dividends, especially in today’s low interest rate environment.

In Asia, many companies pay out a large portion of their profits as dividends. If they cut profits, and therefore dividend payments, to invest in greening their businesses, the market will punish them. Investors focused on income stocks will take their money elsewhere.

Part of the sustainability challenge is that the highest dividend companies are often in traditional, asset-heavy industries with a large carbon footprint. To support them in their net-zero transition, investors will have to accept lower dividend payments, otherwise these companies will not survive the move to low-carbon alternatives. While this green transition is desirable in the long term, in the short term it will generate uncontrollable economic dislocation.

File for the future of sustainability in investment management

The main challenge for the asset management industry is the saturated and highly competitive market in which it operates.

Fund managers are traditionally judged on performance. Now, however, their ability to incorporate ESG factors is another area of ​​competitive pressure. How do they maintain performance while meeting ESG expectations?

Yes, ESG strategies outperformed in 2020 and proved that sustainability can generate returns. But digging deeper, the data indicates that ESG companies with positive selection have lower employee metrics and tend to be asset-light industries. Automation doesn’t create jobs, and white-collar tech workers don’t need the same protections as those on an assembly line.

Investing in great ESG positive businesses also has a disruptive effect. It funnels money out of asset-heavy industries and into jobs that support local communities. And what about small and medium enterprises (SMEs) that score low on ESG and need to finance their net-zero transition? Does the market punish them or help them?

Businesses are at the bottom.

Companies have to walk a fine line. They need to keep their business profitable in the short term while investing in long term greenness. Sustainability is no longer a nice accessory, it’s a way to prepare your business for the future.

But delivering the “E” is expensive. If the cost cannot be passed on to the end customer, it will have to go out of business, either in staff salaries, bonuses or headcount. It may also make certain functions and jobs obsolete. The “E” comes at the expense of the “S”.

In Asia, the goal used to be to squeeze every last drop of profit out of the business. Now it is slowly shifting to longevity and legacy. Paying out all profits in dividends is short-sighted, while playing the long game can increase margins over time. To achieve this, companies need the right investors.

Journal of financial analysts Current number mosaic

What’s next?

Stakeholders must dispense with the quarterly mindset and build long-term relationships and expectations. They need to stay away from get-rich-quick investing.

Generating returns and staying true to the “S” takes time. Short-termism is the antithesis of sustainable growth. For companies to meet the net zero challenge, they need investors who understand what is at stake and what it will take to achieve it.

Now is the time to recognize the elephant in the room and start making that mindset shift. And that means adopting the S in ESG.

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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images / tiero

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Andrea Webster

Andrea Webster is a managing director at Chartwell Capital and a contributor to SustainFinance. With over 20 years of experience in the wealth and asset management industry, he has spent over a decade working with boutique asset managers on business expansion.

Paul Smith, CFA

Paul Smith, CFA, is the founder of SustainFinance and the former president and CEO of CFA Institute. He has over 25 years of relevant financial services leadership experience in many aspects of the investment management industry.

Kübra Koldemir

Kübra Koldemir is a sustainability business writer at SustainFinance as well as a sustainability researcher at Argüden Governance Academy. He has written numerous articles on sustainability that have been published in various global publications. Koldemir began his financial career in 2006 working as an investment analyst in New York City, first at a long-end fund and then at a hedge fund with $1 billion in assets under management (AUM) specializing in financial services companies. Focusing on international investments, he evaluated the strategy and results of numerous multinational corporations in various sectors. Koldemir holds a BA in International Relations from Mount Holyoke College and an Executive MBA from the University of Texas at Austin.

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