ESG 2.0: A Conversation with Sustainable Market Strategies

As investors increasingly focus on environmental, social and governance (ESG), Nasdaq’s Ahad Minhas organized and moderated an internal fireside chat to discuss trending topics in ESG investing with ESG strategists at Sustainable Market Strategies. The conversation explored a wide range of topics, including ESG philosophy, investor behavior, and corporate innovation. The full transcript is available below:

Ahad: Critics suggest that ESG investing in its current form may not help the environment or create positive social change. What are your thoughts on the current state of ESG investing, and does it help the environment and society?

Francois: Our first thought is that the implementation of ESG has significantly evolved over the past two decades. ESG started with exclusionary criteria being the dominant strategy put into practice, moved on to various forms of scoring, and finally, engagement techniques from asset managers. More recently, we are seeing ESG megatrends that tend to take a more transformative approach to ESG investing. These trends generally entail capital moving towards ESG leaders and innovators, which may ignite real economic change. Ultimately, ESG investing is moving away from investing based on backward-looking reporting and, in some cases, is trending towards asset managers moving capital away from harmful companies and increasingly seeking alpha in areas that can positively impact society. 

Ahad: To what extent do you think ESG will impact shareholder return over the coming years? How different will ESG’s definition and implementation be in the future?

Lenka: The ESG industry has matured a lot in recent years. We are now in a world where companies may not get additional returns for producing a CSR report but will undoubtedly be punished for not having one. In terms of the definition of ESG, I think the broad three pillars will remain the same. As topics around climate change, biodiversity, and inequality only continue to gain prominence, they will grow in importance to investors. In terms of implementation, the significant change will be that ESG increasingly makes its way to the front office, and portfolio managers will further look at ESG as an opportunity set rather than a risk mitigation tool. 

Ahad: How do you think the rise of impact investing will affect portfolio composition, and what will be some of the challenges portfolio managers could experience when seeking impact alpha? How will this play into growth and value biases present in ESG investing? 

Lenka: As ESG matures, we will move away from a world where exclusionary screening, which has created some of the stylistic and sectoral biases we see today, is conflated with true ESG investing. Portfolio managers will have to be pragmatic about sectors and sub-sectors essential to the real economy of the future and will begin to pay more relevance to the winners and losers. At Sustainable Market Strategies, we are trying to build a portfolio that participates in all aspects of the economy of the future and, in our case, we find you end up with a natural overweight to industrials, engineering companies, and generally companies in the cyclical space that has solutions to physical problems.

Francois: We are facing a transitioning world and will have to take real risks to realize a positive impact; we cannot continue to do what we were doing two years ago and expect that we will have a transitioning economy without any cost. This concept also applies to the asset management world, especially with regard to the orientation of ESG investors. Our view is that you will not receive any notable ESG outcome by being a traditional passive investor. Instead, you need to short companies that are going down the wrong path while rewarding those positively innovating. This will raise a few tough questions at the world’s largest passive asset management firms about how they approach and market their impact. 

Ahad: What are your thoughts on engagement and divestment in carbon-intensive industries?

Francois: You can engage as much as you want with some carbon-intensive companies, but if they aren’t already making a concerted effort to change and know you are not going to divest, there is no stick to the engagement approach and this is where engagement often fails. We believe that if a company isn’t willing to transform for the economy of the future, you should be shorting it and that market forces are strong enough to induce change in some countries and industries. We focus heavily on this in our research. 

Lenka: Specific to the energy sector, some companies are making a solid effort to change their sustainable DNA and may benefit from forms of engagement. However, you have many companies that haven’t changed their mission to align with the economy of the future and make it hard to believe that a couple of forced measures will change the underlying mechanisms and mission of the company. These dynamics make energy an exciting long/short space to research and invest in. 

Ahad: Many net-zero plans are predicated on nascent technologies that are not ready for scale or commercial use. How are investors pricing this into their models and decision-making?

Lenka: A large portion of the emissions we need to cut by 2050 rely on prototype technologies that don’t yet exist. As far as investors go, I think it comes down to behavioral economics and how much of an optimist or a pessimist they are. A massive amount of capital needs to be allocated to this space, which will lead to very exciting opportunities for those with an optimistic outlook on our ability to scale and innovate in climate tech and cleantech. 

Ahad: Can you share some notable examples of innovative ESG initiatives you have seen at corporates?

Francois: There are a few companies trying to engrain sustainability in management incentives by, for instance, tying pay packages to sustainability performance or carbon emissions reduction, which may lead to ESG being transformative at the corporate level. Another innovative practice we have seen is corporates creating built-in incentives, such as additional dividends, for investors who hold the stock for long periods. Having committed investors willing to take short-term pain for positive long-term outcomes may ensure more sustainable development for the future. These near-term mechanisms are of interest to ESG minded investors looking for companies to start walking the talk with short-term changes, especially with regards to net zero. 

Ahad: What are your thoughts on how the buy-side is currently consuming ESG data, and what do you think the future holds for ESG data?

Francois: There are a plethora of ESG data providers in the ecosystem, which are mostly backward-looking. This data is undoubtedly helpful for some investors looking to begin examining how their portfolio is positioned from an ESG lens. However, more sophisticated asset managers are starting to rely less on ESG data providers and are focusing more on building out teams to perform internal research and proprietary ESG analysis and ratings. Additionally, the ecosystem’s current data can be biased due to the lack of third-party verification, which will change over the coming years as certain ESG ecosystem participants attempt to create further standardization and regulation. In the short run, we expect more ESG research and data to migrate to some level of macro research and strategy within asset management firms, which is a much more complex and messier proposal than having ESG data or scores associated with company names. 

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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