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Guest Series: Why relying on ESG standards is not enough for sustainable investing

Environmental, Social, and Governance (ESG) has been an incredible success story for recent years and has developed from a niche to mainstream when it comes to investing.

However, with the broad adoption of sustainable investing and the variety of products and options, wealth owners face several critical questions:

  • Is the offering transparent enough?
  • Can you rely on product labels?
  • Are ratings sufficient to make genuinely sustainable investments?
  • How can values-based thematic investments be aligned with return expectations?
  • What's the real meaning of ESG?

Recently, the financial industry has come under pressure as more and more greenwashing cases have become public. Also, there are increasing concerns that ESG investments do not live up to the promises.

Thus, labels will not guarantee capitalism in line with enhanced environmental, corporate governance, and social purposes.

Today we speak to Christoph Klein, the founder of a multiple-award-winning ESG portfolio management firm based in Frankfurt, Germany, about his approach to identifying sustainable investments beyond ratings.

We also discuss the threats of greenwashing and how wealth owners can navigate the product landscape for positive investment impact aligned with their values.

Thanks, Christoph, for taking the time to chat with Centro LAW. What is your field of expertise, and how do you define ESG investments?

 

Thanks for having me. At my independent firm, we manage sustainable investment funds that promote real United Nations' Sustainable Development Goals (SDG) impact and put sustainability factors at the center of risk management.

Next to managing our two portfolios, I teach ESG seminars for an international risk, performance, and financial modeling company.

We define sustainable investments as investments that consider both ESG aspects and SDG impact as, in our view, only the combination of high ESG quality and positive impact is genuinely sustainable.

An isolated ESG analysis is not sufficient. Instead, an overall view combined with other factors such as the SDG impact or carbon footprint is necessary.

While we see the ESG and carbon footprint analyses as essential parts of risk management that allow us to sleep well at night, the SDG impact adds purpose beyond financial goals and gives us a reason to get up in the morning.

Therefore, we carefully select those companies that meet our ESG criteria and positively contribute to the Sustainable Development Goals with sustainable and forward-looking business models.

Also, it is crucial for our investment decision that firms have a low carbon footprint and are further reducing Greenhouse Gas (GHG) emissions.

Of course, we also have comprehensive exclusion criteria and do not invest in companies with business activities in controversial areas such as mining or weapons.

Furthermore, we actively engage and use our share voting rights and proxy voting in our funds to improve ESG quality and SDG impact.

Through a constructive dialog with the management of the companies, the risk of the investment will decrease, and the performance opportunities will increase.

We believe that high ESG qualities and positive SDG impact combined with detailed credit analysis and equity research are requirements for generating long-term competitive attractive risk-adjusted returns.

There is no gold standard for sustainable investment classifications. How can wealth owners leverage ESG ratings while minimizing the risk of deception?

 

We suggest the following tips: 

  • Use data from more than one research provider. 
  • Understand the methodology and what's behind the numbers. 
  • Do your own supporting research.

External ESG ratings from various providers are an excellent starting point for filtering but should be supported by internal research. This helps you understand the companies' sustainability performance and set a starting point for possible engagements.

Also, you should be aware of the limited correlation between ESG ratings from very different research approaches and look into the various methods if there is disagreement.

As explained earlier, another important aspect of sustainable investing is measuring and improving positive SDG impacts. We use licenses from two different data providers and other external research for our SDG impact measurement.

Based on this information, we select companies with positive SDG impacts that at the same time have no negative impacts.

The SDG impact of each position and the fund as a whole is measured as the proportion of revenue attributed to an SDG. This value should be above 30% for all our portfolios, while most sustainable benchmarks only achieve a value of around 5%.

Which industry standards of due diligence can investors expect? On whom can they rely upon in the selection process?

 

Regulation has significantly increased if you look at new developments like the European Sustainable Finance Disclosure Regulation (SFDR) or the EU Taxonomy.

The SFDR makes a fundamental distinction between Article 8 and Article 9 investment funds.

Article 8 products only commit to integrating ESG criteria into the investment process. Article 9 products are required by the SFDR to make a positive contribution to at least one sustainability goal and to demonstrate the impact achieved transparently.

In practice, many Article 9 funds aim to reduce climate risks. This follows from the outstanding global importance of climate change risks, the resulting prioritization by the EU Commission (EU Taxonomy), and increasingly better data and measurement methods.

For investors, this classification into articles 8 and 9 investments can be a reliable starting point for the fund selection process.

In our view, this classification system significantly improves transparency for investors and reduces the dependence on banks or external advisors.

Around 20% of all mutual funds are classified as "light green" sustainable investments under article 8 SFDR, while about 5% are classified as "dark green" under article 9.

Another reliable classification for sustainable investment funds which I like is the German FNG label. To decide which funds will receive the FNG label, every position in a fund will be carefully analyzed.

This rules out the possibility of Greenwashing. Depending on its sustainability performance, every fund that receives the label will receive zero to three stars.

We are proud that our funds have both received the highest classification of three stars.

For conventional investments, quantitative metrics predominate in the selection process, whereas sustainable investments require an additional qualitative assessment. How can both parameters be combined to spot ideal sustainable investment opportunities? What's your selection approach?

 

First, we apply our exclusion lists and create positive lists as our starting universe. This makes sure we will only invest in companies that meet our general sustainability standards by not engaging in any activities that we want to exclude from our portfolios.

Then, we apply ESG ratings and filter companies with positive impacts on Sustainable Development Goals in social and environmental dimensions such as "zero hunger" (SDG #2), "quality education" (SDG #4), and "climate protection" (SDG #13).

In addition, we carefully measure and make sure that the companies we invest in are Paris Climate Agreement aligned, meaning they cause global warming of fewer than 1.75 degrees by applying the so-called X-Degree Compatibility (XDC) Model by one of our research partners.

The XDC is an economic climate impact model that analyses the degree of global warming that an economic entity is compatible with under various scenarios, answering the question:

How much could global warming be expected if the entire world operated at the same emission intensity as the entity in question over a given timeframe?

Results are expressed in a tangible degree Celsius (°C) number: the XDC.

All companies that fulfill these criteria and pass our exclusion standards, having substantial SDG impact and being Paris aligned, constitute our investment universe.

These possible investment opportunities are then thoroughly analyzed from a financial perspective. We use in-house quantitative rating models applying the discriminant analysis method for our in-depth economic analysis.

Our approach is unique because we constructed a discriminant function that includes an ESG factor. This leads to having a higher explanatory power in discriminating between companies with good and poor credit qualities than similar models that don't include an ESG factor.

The dilemma of our non-financial filtering approach is that especially small issuers with excellent sustainable services and products, and thus evident very positive SDG impact, often do not have an ESG rating. The regular preparation of ESG data and ESG ratings is costly and time-consuming.

Therefore, we often invest in attractive bonds of smaller non-rated companies if we internally assess their business model to create significant positive environmental or social impacts and be financially solid.

To find these investment opportunities, we closely monitor new bond emissions daily.

The result of our unique selection approach is two portfolios that clearly outperform their ESG filtered benchmarks regarding ESG score and SDG impact.

You mentioned the combination of ESG and SDG to tackle the shortcomings of merely rating-based selection approaches. Can you highlight how wealth owners can implement it in practice?

 

In our view, both dimensions are necessary: disciplined ESG implementation as a tool of risk management and positive SDG impact to create true purpose above the financial goals.

Also, we are convinced that companies providing sustainable products and services should outperform their less sustainable competitors in the long run as they are generally more resilient towards ESG risks.

This becomes evident when you look at developments like the current price for CO2 emission allowances, which has been skyrocketing in 2021.

Companies that operate less carbon-intensive than their industry competitors - and therefore, on average, have a higher score in the environmental dimension - will face less additional costs and, consequently, likely outperform.

Coming back to our selection approach as a reference, we invest in companies with positive SDG impacts that, at the same time, don't contribute negatively to any of the Sustainable Development Goals.

This makes sure we achieve our goal of actually creating real-world SDG impact.

Greenwashing is the most significant threat of misalignment in sustainable investments. What is greenwashing, and how can you avoid it?

 

In general, greenwashing refers to misleading consumers and potential consumers into believing that a product is environmentally friendly.

Applied to the asset management industry, this means that some funds might claim to put sustainability and ESG factors at the core of their investment consideration, while in practice, it is just a minor aspect of their investment strategy.

To avoid investing in such funds, I suggest looking at the fund managers' sustainable investment process and exclusion criteria. Then I would check the fund's holdings and see whether you find companies you consider not sustainable.

If you don't have the time to Iook into this yourself, I suggest using high-quality sustainability labels such as the FNG label or the Austrian Umweltzeichen.

In my opinion, these labels provide additional value to investors as you can effectively avoid greenwashing if you rely on them.

In general, what advice do you have for wealth owners who want to catch on to the real meaning of ESG and develop a sustainable investment strategy in line with their values?

 

We think it's not enough to invest only according to any ESG label or rating, but also consider the impact of your investments on the real world. To that end, it is crucial to engage with companies actively.

As another piece of advice, I suggest looking at the Principles for Responsible Investment PRI website, which delivers excellent content regarding sustainable investing for free.

The six Principles for Responsible Investment offer a menu of possible actions for incorporating ESG issues into investment practice and were developed by investors for investors.

In addition, the CFA Institute just released ESG disclosure standards which can serve as valuable guidance.

To conclude, it is worth it to take a deeper look at the topic of sustainability as an asset owner and implement strategies beyond mere ESG ratings. 

About Christoph Klein

Christoph M. Klein, CFA, is the founder and managing partner of an award-winning portfolio management boutique for sustainable investments. The Principles of Responsible Investments network has elected the company in its 2020 Leaders' Group.

Previously, Christoph served as a portfolio strategist, managing director, and head of ESG credit of an international asset manager. He has served as a visiting scholar at New York University.

Christoph is a member of the DVFA Sustainable Investing Commission, the CFA ESG Technical Committee, and an instructor for ESG seminars. From 2011 until 2018, he was a UN PRI Fixed Income Working Group member. He speaks and publishes on responsible investment. Christoph received his diploma in business administration from the University of Trier.

18-12-2021

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