Sustainable investing is hard
COP 15 kicks off. Vanguard defects. Lawyers litigate. Plus, SFDR trouble creates opportunity.
View from the top
🐾 Hot on the heels of COP 27, the UN Biodiversity Conference, COP 15, is underway. Negotiating parties are working to finalise an agreement on the post-2020 Global Biodiversity Framework, with targets to conserve 30% of the world’s surface by 2030. In his opening remarks, UN Secretary-General António Guterres appealed for an end to the “orgy of destruction” and for “tough regulatory frameworks and disclosure measures.” Those look imminent. The draft agreement mandates that businesses “report on their dependencies and impacts on biodiversity,” towards which standard-setters are making progress. On top of the TNFD, which publishes its recommendations in 2023, the GRI has opened a consultation on biodiversity standards. Contentious biocredits will attract outsized interest this week, warns the FT’s Patrick Temple-West, but Frédéric Hache of the Green Finance Observatory argues there’s a less greenwash-y way to mitigate biodiversity loss: taxes on commodity exports and marine traffic. Systemic, any ‘Paris moment’ for nature must attend to global value chains in the context of the energy transition. (On which note, one left-field spark of hope: Yesterday, nuclear fusion achieved energy breakeven.)
⛵ Forget knife catching: On Wall Street, tightrope walking is the trick to master in 2023. Having floated a bill to block SEC climate disclosure rules, Senate Republicans are “amping up efforts to rein in BlackRock, State Street and Vanguard on ESG issues,” reports Bloomberg. Their crusade is a preview of the fight to come when the GOP takes control of the House next month. In a blow to nominative determinism, Vanguard is its first major victim. Last week, the world’s second-largest asset manager pulled out of the Net-Zero Asset Managers Initiative (NZAM). Defending its commitment to help clients navigate the “far-reaching economic consequences” of climate change, Vanguard blamed “confusion about the views of individual investment firms,” particularly “regarding the applicability of net-zero approaches to broadly diversified index funds.” Blame anti-ESG politicking, says Kirsten Snow Spalding of investor network and NZAM founding partner Ceres, itself facing GOP scrutiny. Last month, Republican attorneys general petitioned the Federal Energy Regulatory Commission to ban Vanguard from buying shares in US utilities, claiming its NZAM association would “affect the cost and reliability of energy supplies.”
🎲 Following one defection, will fellow investment firms go down or double down? Morningstar’s Hortense Bioy warns of a domino effect, as US “ESG polarisation reaches untenable levels.” Al Gore caveats that Vanguard represents, in his view, an exception among firms demonstrating a “real, growing commitment” to fighting climate change. Not everyone agrees. BlackRock CEO Larry Fink faces calls to resign by activist investor Bluebell Capital Partners, which accuses BlackRock of ESG “hypocrisy” due to its changing position on coal and ongoing support of Glencore. Activists: Join the queue — or is it a melee? On the other side of Republican legal action, JPMorgan has warned of snowballing regulatory crackdowns on greenwashing claims. This comes after the Australian Securities and Investments Commission fined Vanguard for “misleading” product disclosures that overstated tobacco-related exclusions. (The funds excluded companies making, though not those selling, tobacco goods.) Between anti-ESG GOP and pro-ESG consumer-group lawsuits, reports the FT, “litigious fervour” is the new “multidimensional headache” for firms caught in the crosshairs of the new culture war. It’s a lawyer’s world; we’re just living in it.
Sustainable investing is hard
If you were a sustainable fund manager, and you had spent the last year caught between anti-ESG (as-imagined) backlash and anti-ESG (as-performed) regulation, you might think: why bother?
Sure, responsible investing is part of your DNA and your clients are at the heart of everything you do, but corporate biology is meagre insulation here. EU regulators have delivered opaque guidelines (“build sustainable funds, we just won’t tell you how”) and arbitrary action (“not knowing is part of the fun!”). US politicians have made perennially boring pensions the unexpected lightning rod in their culture war, though their action is, at least, predictable: AUM x ESG commitments = higher likelihood of a reaction.
Which is frustrating, because the assets under management (AUM) aren’t even yours. They belong to your clients. Most commitments to social and environmental principles are straightforward customer service. Free-market capitalism is under attack from an anti-free-market movement feigning free-market values to imply, wrongly, that an asset manager’s AUM sits on its balance sheet, leaving you with all of the suspicion of 2000s banking and none of the fun.
Of course, customer service is the reason you do continue to bother. Clients really want the green goods, and you really want clients — particularly those willing to pay a product premium. The irony is that AUM has a shrinking bearing on balance sheets: From 2015-2020, industry-wide revenue as share of assets fell 0.45% to 0.23%, operating profit, 26%. To survive, asset managers need to boost either flows or fees. To thrive, they need to do both — all while cutting costs. And litigation is expensive.
Vanguard’s decision to retire from the Net-Zero Asset Manager Initiative isn’t without context. Equally, it’s unlikely to hinder sustainable investment progress in the US. As it is for corporate pledges, the risk or reward associated with corporate defections is primarily a PR thing. Changes are unlikely to manifest at a product level. In the meantime, it gets politicians off Vanguard’s back.
Corporate decoration to product necessity
Sustainable investing has been a salve for an industry facing long-term challenges that far outweigh those capturing headlines in 2022. End investors want and will pay for — even tolerate more risk for — innovative funds that cater to their values.
Unsurprisingly, everyone boarded the bandwagon. Regulation took a while to catch up, leaving exuberant product teams with plenty of room to reinterpret ‘innovative’ and ‘sustainable’. Now it has caught up and yet the rules remain unclear, catalysing a backtrack among asset managers.
In Europe, firms have downgraded Article 9 funds representing at least $100B since September, from a total pool of $470B. The green-standard category now accounts for 87% of reclassifications in the EU, and Jeffries anticipates “close to zero” fund launches in the new year. To date, Article 8 has absorbed the influx. Now, however, fund managers are “bracing for an ESG correction” in Article 8, after the European Securities and Markets Authority (ESMA) issued new proposals for funds labelled ‘ESG’ or ‘sustainable’. The latter will need to demonstrate that 80% of holdings are aligned to an ESG strategy and 40% of assets meet SFDR definitions of sustainable.
Article 8 funds account for $4T (and counting): far more than the drying pool of Article 9 capital. Yet, says Linklaters partner Martin Mager to Bloomberg, “asset managers can’t afford to downgrade from Article 8 if they want to keep ESG clients. “Managers realise they need it in order to do their marketing.””
The numbers bear him out. Global sustainable funds attracted $143B of net new money over the first nine months of 2022. The overall global fund universe, on the other hand, saw outflows of $335B.
Where do sustainable funds go from here?
Vapid marketing to premium products
As the window closes to deploy capital into Article 9 funds, those that remain are likely to become coveted products. But they won’t look like the vanilla ESG funds of yesteryear.
It’s over for the “rising tide strategy of the past decade of buying growth stocks,” warns the FT’s Alice Ross. “Next year, we should find out who is actually good at sustainable investing.” Characteristics shared by a winnowing number of Article 9 funds yields clues about what ‘good’ might look like: More VC-like, thematic objectives; Systematic and multi-asset strategies; Emerging market or international exposure, to meet reported asset owner demand.
For smaller players in particular, the backlash represents opportunity both ethical and financial. After years of success, the strategy favoured by larger index providers of being ‘all things to all people’ has hit a stumbling block. While they grapple with the scrutiny that comes with size, there’s a widening gap for specialist, innovative, and premium sustainable products that qualify for the increasingly exclusive — and elusive — Article 8/9 label.
Unrelenting demand is the reward for products innovative enough to meet it.