climate change / leolintang

There is perhaps no more topical, engaging and hotly debated subject among investment professionals in recent years than ESG investing.

The intense, ongoing discussion is not surprising. The spectacular rise of investor interest in and product offerings catering to the enthusiasm for ESG investments is unparalleled. As National Bank Financial Management stated in its Canadian ETF flows report for 2021: “ESG is moving money and shaking the foundation of the asset management industry.”

ESG has special significance for ETFs because of the dramatic rise in product offerings in a remarkably short period. The number of ESG ETFs doubled to 100 in 2021 from 50 in 2020, National Bank Financial stated, while inflows accelerated in both years, benefiting ESG-themed equity, fixed-income and asset-allocation ETFs.

Investor Economics’ ETF and index funds report for 2021 reported that $7.7 billion was invested in Canadian ESG ETF assets by the end of last year, up from $2.75 billion the year before. The worldwide growth picture is equally impressive: the ESG ETF industry had 954 products, 2,730 listings, US$379 billion in AUM, and 188 providers in 32 countries, ETFGI announced in February.

Accompanying this extraordinary upward trend, and the corresponding need to validate ESG differentiation claims, has come an entire ESG intelligence ecosystem. It includes an array of ESG principles and standards, assessment and scoring criteria, financial management methodologies, analytical tools and information resources to support investment measurement, selection/rejection and comparison.

Your firm probably subscribes to at least one ESG reporting platform from a host of reputable international firms. You can also use free online screeners from NEO ETF Market, TMX Money and CETFA to search for ESG-oriented ETFs.

There no lack of information for investment professionals to make ESG selection decisions — in fact, there is probably too much. More than a few frank observers have called out inconsistencies in ESG ratings and assessment criteria. These criticisms have not diminished the appeal of ESG products for investors, but they do undermine confidence among investment professionals about the legitimacy of ESG labels and in making recommendations.

The sector recognizes it needs to improve

Ultimately, investors who cannot trust an ESG claim will either decline to invest in or pull investments from funds that don’t deliver on their promises. Broad international agreement underscores the need for a consistently comparable global ESG standard. But that consensus has not yet produced a durable, universally accepted formula.

For example, a recent article from ETF Stream said that Europe’s Sustainable Finance Disclosure Regulation holds sway with European investors “more than any other tool” (28% rely on it). However, U.S. investors primarily select ESG ETFs based on “brand recognition of the ETF issuer.”

As Investment Executive reported last November, the International Organization of Securities Commissions (IOSCO) called for “greater oversight of ESG ratings and data providers.” IOSCO also issued “recommendations for regulators to follow in establishing requirements for ESG ratings and data, and the firms that provide these products.”

In the same month, the CFA Institute issued its final Global ESG Disclosure Standards for Investment Products, “the first global voluntary standards for disclosing how an investment product considers ESG issues in its objectives, investment strategy, and stewardship activities.” The CFA declared it will follow up with additional resources to provide explanation, interpretive guidance and procedures to enable independent assurance by the beginning of May.

Adding further momentum to the search for a convincing solution, in January the Canadian Securities Administrators (CSA) published guidance on ESG-related investment fund disclosure. The CSA guidance is based on existing regulatory requirements and broadly affects disclosure, marketing and sales practices to help “investors make informed decisions about ESG products, as well as preventing potential greenwashing.” The CSA also declared it will continue to monitor ESG-related disclosure of funds.

The CSA guidance brings Canadian ESG regulations into alignment with other international investment regulatory and governance bodies, namely the U.S. SEC as well as the European Union, which is widely regarded as the leader in sustainable investing.

Will unbundling ESG work?

Some stakeholders have asked whether E, S and G should be lumped together in a single rating when each factor captures its own unique concern. (The Financial Times Moral Money microsite features a thoughtful examination of this and other ESG-related issues).

Others argue that governance is just table stakes: all investment-worthy companies require good governance. The social dimension is extremely complex, especially in an international context, and is influenced by the other two metrics. Meanwhile, some say the environmental aspect has been the true draw for investors. However, judgments and rankings vary widely about what constitutes “good” environmental behaviour.

Focusing on only one aspect of ESG “profoundly misunderstands the concepts of ESG and responsible investing,” Dustyn Lanz, senior advisor with ESG Global Advisors, told CETFA. ESG integration “is about taking a broader lens to company valuation to get a more complete picture.”

Further, there is always more than one material ESG issue to consider: “It’s equally hard to perceive a sound case for creating separate sets of standards for each issue, because that would lead to more fragmentation at a time when the market actually needs convergence around a common framework.”

Moreover, “all-in-one” fund ratings do not consider a fund’s stewardship activities or its intentions and obfuscates nuances that are meaningful, Lanz cautioned. (Lanz’s August 2021 Inside Track column explores these issues in depth.)

We believe that any move to unbundle ESG is unlikely to gain traction. The motivation to clarify and solidify what ESG truly stands for – as a unified concept – isn’t going away. So where do we go from here?

Although some elements are still to be introduced, the CFA’s standards have already had an effect in Canada.

“The CFA’s disclosure standard for investment products is the only credible disclosure framework for ESG funds globally,” Lanz remarked. “There is still a gap in the market that needs to be addressed. This is easier said than done, since there are so many approaches to ESG, but I think it’s important for industry groups to explore this for the benefit of retail investors and advisors.”

Earlier this week, the Canadian Investment Funds Standards Committee released a second draft of its responsible investing fund identification framework, which largely aligns with the CFA Institute’s standards and will complement the CSA’s January guidance.

Work towards finalizing a workable and advisor-friendly ESG solution is progressing

From CETFA’s perspective, moving towards a comprehensive, binding set of ESG criteria in Canada remains a work in progress, but that work is progressing. Perhaps there can be never be a single, absolutely accepted codification of ESG globally, but that need not be a stumbling block for Canadian advisors to deliver advice prudently and confidently.

Eventually, the lack of a solitary worldwide “ESG rulebook” may not present as many complications to ESG investing as it seems today. Advisors may ultimately prefer to guide their clients’ ESG investment choices by applying their judgment to credible, vetted sources (plural) with an emphasis on using those with a sound, made-in-Canada perspective. Time will tell.