Balancing benchmark awareness with sustainability criteria

Understanding the increasing complexity of ownership in benchmarks

If 2020 was a year of reaction, ushering in some of the biggest changes to daily life in recent memory, 2021 brought a year of self-reflection and reassessment.

From an environmental perspective, extreme weather events, the Intergovernmental Panel on Climate Change (IPCC)’s sixth assessment report delivered in August and the COP26 conference in November highlighted the urgency of acting on climate change.

So far, 2022 has been categorised by a reinvigorated focus on sustainability, coupled with a return to ‘normal’ investing habits and rising demand for sustainability.

However, despite the positive momentum and increased demand over the past few years, ESG investors will still face a number of challenges in the year ahead.

Over the next year, we expect the back-and-forth between traditional and renewable energy to continue as a maturing economic recovery and rising interest rates may weigh on longer-duration tech companies in the renewables space.

From an investment perspective, as big tech firms continue to dominate the benchmarks, finding differentiated investments that positively contribute to the energy transition has become more complex and more challenging then ever.

This saturation creates a further challenge of ownership and benchmarking for ESG investors.

Lastly, with global investment allocations to sustainability strategies accelerating, regulatory bodies have stepped in to clarify the processes, objectives, and risks of credible sustainability funds, as well as to raise concerns of “greenwashing”, which will remain a risk for investors over the next year.

Balancing benchmark awareness with sustainability criteria

Equity markets allow for periods of rapid growth and dominance by a few companies, which is something we are experiencing today. The trend is not new however: General Electric, Exxon Mobil, Microsoft and Apple all have had their turns dominating the market in the past 25 years.

One of the key challenges today includes staying diversified in a narrowing market, especially where some widely-owned stocks present complex sustainability stories. The largest companies can have outsize effects, representing both a challenge and an opportunity.

Broad ownership of the largest tech companies, recently known as the FAANG stocks — Facebook (now Meta), Amazon, Apple, Netflix, Google (now Alphabet) — and which might also include Microsoft and Tesla, presents challenges for investors to both keep up with benchmarks and stay diversified.

There is inevitable concentration risk to manage here, but also complex ESG factors to sort out, including headline, operational and regulatory risks.

At the same time, some of these companies are best-in-class sustainability leaders and are powerful agents to set standards for climate change commitments and social goals.

This highlights the importance of active company engagement as investors seek to influence companies to improve their sustainability potential and learn from those setting positive examples.

ESG investors must appreciate the increasing complexity of ownership of large tech platforms, balancing benchmark awareness with fidelity to sustainability criteria. This must also be done on a case-by-case basis; as knowing what you own is key.

What really is an improver?

The complexity of ownership further highlights how greenwashing is still a challenge for both investors and regulators. This challenge will increase throughout 2022, as the value rotation in 2021 meant certain ESG investors seeking performance were looking harder at value companies often found in higher-emitting sectors of the market. Sometimes these companies can be considered “improvers.”

It is encouraging that there are cases of meaningful improvement among more challenging companies, but the risk is that managers really have to be dedicated to improving them and be transparent in their process.

Like flipping a house, it can require a lot of work, and not all managers are willing or able to put that work in. But not all houses intended to be flipped do so: some flop.

At the same time, increasing company disclosure, helped by continued investor advocacy and recent regulation, will be an opportunity for better discussions with management and helpful in understanding risk/reward cases for companies.

Again, knowing what you own is important, as is actively engaging with companies on a case-by-case basis, rather than simply seeking best-in-class sustainability stories.

As regulatory scrutiny increases on how ESG is marketed and implemented to avoid greenwashing, managers who are able to have discussions with companies on material ESG factors and who prioritise these as an essential part of ownership will stand out.

We continue to see an exponential increase in ESG data, from data providers and from those required by increasing regulations. As always, the risk is acting simply on data and not understanding company-specific issues from an investment perspective.

Extracting substance from noise in 2022 and beyond will challenge ESG investors to know the companies they invest in, both as a means to find securities that will help support long-term returns and as a way to have a tangible impact on urgent sustainability matters.

But while ESG investors will have plenty to accomplish in 2022, we are encouraged by the increasing number of tools at investors’ disposal and the ongoing shift in perspective of company managements towards making sustainability a core part of their businesses.