SUSTAINABLE FINANCE AN ILLUSION? Doesn't it Depend on the Risk inherent in Risk-Adjusted Returns?

Ex-BlackRock Research Head calls approach to Sustainable Finance ‘an illusion’: she’s right … but do some secretly want it that way? & what constitutes ‘Risk’ in any case? [Extracted from last Edition of The STOCKtake]

Former Head of Fundamental Research at BlackRock Carole Crozat is only one of a number of Sustainable Finance experts and professionals who have started to ring alarm bells about the sustainability of, well, the sustainability agenda.

Reported in the IPE back in November last year was her view that returns, ethics and impact are not aligning in the way that so many had hoped: ‘The biggest sin of sustainable finance’, she says, ‘is maintaining the illusion that those three objectives could always go together.’

Crozat says this misalignment became especially clear around the Paris Agreement, when ‘collectively, investors understood that it was an illusion – that over the short term, governments will always prioritise jobs and the economy over any long-term target … And that’s when this belief that these three objectives sit nicely alongside each other completely unravels.’ She also points out that ‘externalities’ are still not being factored in.

There are so many issues to unpack here. The one thing that seems undeniable is that, yes, Governments are always going to put the short-term economic interest first. Not least, Governments have short timespans and are vote-focused, so it would take an unusually ethical/brave/self-effacing Government to truly think beyond their own term. (Might there, though, come a tipping point if enough voters ever care more about the long-term than the short-term, and kick short-termists out of office? Too, it is not really Government who ‘rule the world’ anyway, is it, to paraphrase Beyonce? If business collectively flipped to the other side simply because consumers and investors forced them to, and markets followed suit, Governments would follow like sustainable lemmings. But perhaps I am both more optimistic and more cynical than Crozat about where power ultimately lies.)

Nonetheless I fully concur with her implication that the blurring of the lines between impact, ethics and the bottom line is doing nothing for the cause of Sustainable Finance.

When it comes to promoting Sustainable Finance, ‘woolly’, ‘fluffy’ and ‘feel-good’ is ironically the last thing we need. We need to be flinty-nosed, that is, to prove that Risk-Adjusted Returns do or can sit simultaneously alongside ethics and impact. But we can’t prove that if there is no evidence that it is true.

Actually, far from being ‘feel-good’, woolly thinking and rhetoric around SF is actually helpful only to those with a vested interest in obfuscation: it is precisely how dubious companies want it: some may in fact quite literally be banking on it.

As I’ve said countless times, far too much company verbiage, copy and ‘content’ is produced thought-free (sometimes fact-free!) and precisely in order to spin an obscuring yarn. I’ve read (and, in the past, written) enough Social Impact statements to know that much of it is hogwash and greenwash: only one of many reasons I keep pushing on the point of authenticity in, e.g., ESG and SRI statements. The hazier the thinking, the more there is room for fudging, which may seem beneficial to those who don’t really want to do things properly or accurately. It is far easier – and cheaper - to sound green than be green and many know it.

However, if these objectives truly don’t align, we need to face facts. Evidence has always been very mixed on this point. Back in 2016 a review of previous studies, undertaken by Busch, Bauer and Orlitzky, could produce nothing more compelling than that ‘at the very least, there is no clear indication of a negative relationship, or trade-off, between corporate social-environmental performance and corporate financial performance’.

Other voices – including from those fully pro-Sustainable Finance – have argued that there may be an issue with distinguishing between cause-and-effect or simultaneous effects: for example it has been argued that reports that show improved financial performance for sustainable investments could just as easily be because the same Management Teams that are

managing financial growth well are also managing sustainability well, i.e. it may reflect the excellence of a particular Management Team, rather than a direct relationship between sustainability and financial performance.

But it’s actually a bigger issue because this alignment depends on at least 3 factors:

a)      What do investors in SF think they are doing?

b)      On whose behalf are they investing?

c)    What do Risk-Adjusted Returns actually mean?

For a start, SF or Impact Investors may themselves be ‘okay’ with a slightly lower Return (and in fact more clarification of investors goals / motives is now being demanded within the Principles for Responsible Investment). This is little different to a consumer being ‘okay’ with paying more for sustainable produce in a supermarket.

Yet it of course only applies, however, to investors investing on behalf of themselves. It would be far harder to justify for an Institutional Investor who in effect has endless pensioners, say, as its end-clients and with no possible way to make sweeping ethical decisions on their behalf. (I am assuming here a perfectly ethical Investor whose only concern is for its end-benefactors; in reality, personal ambition may also come into play.) The point is, serving those pensioners well could be considered just as ethical.

But there is a third question raised to which I’d like to dedicate the rest of this Think Piece, and which is as regards the nature of Risk-Adjusted Returns themselves: can they be mathematically separated from the issue of a given impact project or company’s sustainability performance in general?

How accurate are Risk-Adjusted Returns anyway? As a way to measure the performance of one Fund Manager from another, taking into account the level of risk of the type of investment they largely undertake makes sense. For example, if one Fund Manager specialises in lower risk investments, and another is hardcore for aggressive Betas, measuring their performance without taking into account the level of risk of the instruments or investments would be futile because the less risky investments will tend to produce a lower but steadier return over a period of years, where the ‘riskier’ Fund Manager – and let’s say they get lucky for a while – would inevitably appear to be a superior performer, which may be far from the case. And the need to account for Risk is of course the basis for various methods of calculation – the Sharpe Ratio, for example, being frequently deployed. So far, so mathematical: look, it spits out proper actual numbers! It therefore seems set in stone.

But remember: when it comes to given investments, the inherent ‘riskiness’ is far from truly mathematical. All stocks (and instruments) are ultimately tied to the performance of companies: even derivatives, albeit being ever further removed from underlying assets, are still ultimately tied to the performance of businesses. (Perhaps only crypto can be said to have no true underlying asset, although if the crypto company goes bust – or runs away! – similar result!) And so an investment (or series of investments) that is low-risk today may become high-risk tomorrow.

Risks to companies caused by poor sustainability performance are – or can be - genuine financial factors. At the most obvious level, for example, there is the risk of stranded assets every time a new cultural shift – or sudden unforeseeable event - turns an acceptable stock into a ‘sin stock’. In the 1970s, did the Risk-Adjusted Returns of, say, a portfolio with a high proportion of, e.g.. cigarette companies reflect at that time the future financial risks when smoking became socially unacceptable?

Pre-Pandemic, did holders of lumpy assets with less than stellar Energy Efficiency credentials predict the massive speeding up of Work from Home, combined with ever-growing public demand for sustainability? Non-prime office is now bordering on a stranded asset, so socially stigmatised that no key players want to lease it.

Increasingly, events happen all the time that decimate infrastructure projects and businesses unexpectedly and almost overnight - the Pandemic, the Energy Crisis (whose effects on the German ‘economic miracle’ I have discussed in The STOCKtake).

Can we be sure that a sudden event (globally, or for a specific country or company) directly related to a failure to take sustainability seriously, might not have near-instant and direct effects on Returns? What about an extreme weather event and its knock-on effects on a business, either directly or because that business had failed to factor in its own ‘externalities’ and suddenly becomes subject to class actions? Or a brand becomes so tainted that it loses significant portions of its consumer base? What about an entire industry turning almost overnight into a ‘sin stock’ through a failure to look closely at creeping cultural shifts?

Take the beef industry. Until fairly recently I scarcely recall any discussion of sustainability around cattle farming. Yet this is now the subject of highly publicised campaigns run by popular media figures, not to mention the sudden and unexpected ‘trend’ for veganism. For now, the beef industry seems to be at no major risk simply because the anti-beef message is still quite niche - but in my opinion they would be ‘mad cows’ indeed not to be seeing great possible Financial Risk in the near future. What happens if a supremely popular influencer suddenly becomes vegan overnight, loudly denouncing cattle farming, and millions of ‘followers’, well, follow? (This is the type of future event that most Middle Management simply don’t follow.)

Are we as sure as we think that society won’t move faster / farther than most companies want it to? For now, a majority of companies lie around the SF 1.0 mark (Sustainable Finance 1.0, which is largely exclusive – i.e., avoiding obvious ‘sin stocks’ and ‘sins’), where increasingly, it seems to me, the public at large, and particularly the younger generations, are almost pushing for SF 3.0 (let alone SF 2.0). Of course younger generations don’t necessarily equate what they are demanding with the effects on their Pension (if they even have one yet). Nonetheless business tends to court the young consumer even at their peril.

Finally, when we are into that territory, the demand to ‘internalise the externals’ is at play, as Crozier has pointed out. That is, pressure for companies to include in their financial accounting the negative consequences of their behaviour that to date have been considered beyond company boundaries.

As but one very obvious example, if companies in the UK pay so little that a majority of their workers must claim welfare supplements such as Working Tax Credits to subsist, those companies do not at present account for the income lost to Government. And of course Government don’t push on this because they know / believe that forcing higher wages either reduces the rate of start-ups and/or companies either go – or hire – abroad. It’s a difficult balance. But my point is not a political one, rather simply that this is all possible because at present in SF 1.0 and even SF 2.0 such ripple effects are not included in Financial Accounting.

SF 3.0 pushes for these externals to be (somehow) literally accounted for and would profoundly affect bottom lines. I personally doubt we will ever see this happen. But then I also never thought that Greggs would make a killing introducing a vegan sausage roll. What the younger generations will consider acceptable is something often not accounted for at all – and the pace of change at present seems far faster in society at large than it does in business.

Perhaps I exaggerate? Time will tell. But the clear distinction between Risk Adjusted Returns and the very real Financial Risks associated with failures of sustainability can be rather startlingly blurred by unforeseen disasters and by sudden or swift cultural shifts in attitude. Certainly Crozer’s points are a springboard for broader debate.