Buyer beware: ESG-screening has its faults
Author: Jon Sigurdsen, Portofolio Manager
In 2004, the then Gucci chief executive Domenico De Sole and his wife Eleanore paid $8.3m for the Mark Rothko painting “Untitled 1956" and hung it in their home. In 2011, frustrated, they took it down. The painting was a fake sold through Knoedler & Co, a Manhattan gallery, which shut suddenly that year.
The moral of the story? Buyer beware. That same warning applies to investors with environmental, social and governance mandates as ESG strategies flood the market. Often, the portfolio manager of an ESG fund will select a biodiesel stock over an oil company. You may assume that the former is more sustainable — but that is not necessarily the case. Some biodiesel companies that use food crops to produce diesel have a carbon footprint larger than oil companies.
Palm biodiesel, for instance, is derived mainly from forests in Malaysia and Indonesia. According to a report by the Royal Academy of Engineering, palm biodiesel from peat and forest lands produces between three and 40 times more greenhouse gas emissions than diesel production, while deforestation in order to grow palms for palm oil and biodiesel can directly threaten local biodiversity. Palm biodiesel is not the only villain among biodiesel feedstock. Biodiesel from soyabean, corn, rapeseed and sunflower, among many other foods, can be as unsustainable or worse. It should be impossible for unsustainable biodiesel companies to penetrate ESG screening but they are in many ESG funds. Investors would be better off investing in oil and gas companies, which have historically performed well. In fact, some oil and gas groups have diversified with their own investments in renewables. Why, then, do some ESG investors choose biodiesel over oil and gas? The problem stems from the industry’s emphasis on negative ESG screening, which weeds out “dirty” companies in favour of “clean” ones.
In this case, there is no doubt that biodiesel is a renewable and an important step towards reducing carbon emissions, particularly for aviation and shipping. That means every biodiesel company will always score higher than any oil and gas company in an ESG fund, regardless of whether the company is sustainable or not. Negative ESG screening can also change industry or regional exposure in a portfolio. In the example of palm biodiesel, the investor could unknowingly put funds into the destruction of Asian rainforests and may also incur an unintentional overexposure to Asian markets, depending on how many other Asian companies are in their portfolio.A positive approach to ESG screening would be to consider the steps biodiesel companies take to be sustainable.
A portfolio manager using this method would consider whether a company’s business model helps reduce greenhouse gas emissions. This positive theme, combined with a bottom-up model and a Darwinian attitude to stock selection, can help identify companies that capitalise on sustainable investments. In the case of biodiesel, a “positive” portfolio manager must consider the feedstock and the group’s business model as part of ESG screening. We also believe it is important to invest in companies that contribute to solving climate challenges.The energy sector is accountable for two-thirds of man-made greenhouse gas emissions globally. As the race for energy efficiency intensifies, with countries committed to lowering their carbon footprint and companies pledging to become sustainable, the opportunity for ESG investors is boundless. ESG screening methodologies must evolve to meet this challenge. As the problem with biodiesel demonstrates, some unsustainable renewables can pass negative ESG screening. In fact, the potential for renewables investing is most likely underestimated because the industry is focused on negative ESG screening. Positive ESG screening can capture that upside.
Jon Sigurdsen is a portofolio manager in our funds DNB Renewable Energy and DNB Eco Absolute Return retail (ECO). This blog post has also been published by Financial Times