• The past two years have seen criticism of ESG become increasingly mainstream, from becoming a storyline in a TV drama (‘Industry’), to a talking-point in the US election.

• Rather than its death, we believe we are witnessing the evolution of ESG towards something more pragmatic, nuanced, and ultimately useful to investors.

• This article appraises recent developments and reaffirms two of our long-standing recommendations concerning how ESG can be most beneficially integrated into the investment market.

Mahatma Gandhi

At the start of 2023, we wrote two pieces in this report evaluating some of the key themes in ESG and responsible investing (here and here). In those reports we also outlined how Hosking Partners’ approach fits into the wider market, particularly highlighting where we differ from consensus views.

Two years later, it seems an appropriate moment to revisit this theme. Since then, the consensus has shifted quite noticeably, driven partly by a growing body of academic research focused on the aims and outputs of ESG investing. The first and most obvious observation is that the view that the old ESG investing paradigm is not working – what we have previously called ‘ESG 1.0’ – is moving from the margin to the mainstream. A growing range of academics, commentators, and professionals now voice this perspective. As the Cambridge Institute for Sustainability Leadership (CISL) wrote in a major new report in September 2024, “the hype bubble around ESG has burst in the face of economic headwinds, confusion about what it was seeking to achieve, and legitimate concerns about greenwashing.”

In our initial articles, we offered five suggestions for a more constructive approach to sustainable investing. In this report, we revisit two of these recommendations, both of which remain at the heart of the evolving debate around ESG. In so doing, we hope to provide an update on the state of ESG heading into 2025.

Recommendation 1:

A diversified public equities product can occupy a key position in a sustainable allocator’s portfolio, but its primary objective should be to generate outperformance rather than impact, as the latter is more effectively accomplished through primary markets.

This gets at a key issue which we think is still under-addressed by the industry - when it comes to driving real-world change, all asset classes are not alike. Some have an easier time generating impact than others. Primary investments, whether through equity or debt, are a zero-sum game. Either the capital exists, or it does not. Either a company has the money to invest in R&D aimed at – for example – decarbonising its operations, or it does not. The provision of that capital by prospective lenders or equity partners can be tied to covenants associated with – if appropriate – outcomes which are not explicitly financial. “We will give you $100 to open your second lemonade stand on the provision that it is zero-carbon lemonade.” This approach is straightforward and effective. Most importantly, it is demonstrably material for the lemonade company and will affect management’s behaviour. The investor can then go to the market and say, “the money you give us is being used to help build out the zero-carbon lemonade industry”. On the other hand, buying or selling $100 of the lemonade stand’s secondary equity has no such effect. Not only is this less effective than providing (or not providing) primary capital, it is also less effective than not buying $100 dollars of the company’s lemonade, or even worse, selectively buying a competitor’s instead.

This is clearly understood by impact funds, where just 14% of impact managers’ assets are invested in public equities, according to the Global Impact Investing Network. (1) This is a clear contrast to global capital markets at large, where almost 50% of assets are in listed equities. (2) On the other hand, while just 5% of global assets are in private equity and private credit combined, these asset classes account for $1 out of every $2 dedicated to impact (see Figure 1, below). This large discrepancy reflects the fact that impact investors themselves know that real-world change is hardest to lever via buying or selling securities on secondary markets, and easiest by the provision or withholding of primary, private capital. Despite this, different asset classes continue to be treated as mostly similar by the ESG investment industry, and more importantly – and disappointingly – by regulators.

In our report two years ago, we highlighted the UK Financial Conduct Authority’s then upcoming Sustainable Disclosure Requirements (SDRs). These seemed designed to raise the bar on the lengths a manager would need to go to justify a ‘sustainable’ label, with particular attention paid to the highest class of label relating to impact. Two years later, with the SDRs now in place, our views are mixed. On the one hand, it does seem that the bar has been raised. As of the beginning of October this year, just ten firms had received a label, with only a handful in the ‘impact’ category. This is promising because, as we have argued previously, while sustainable strategies are an important part of the product mix from which investors can choose, they must be closely regulated to ensure their claims are rigorously evidenced. Without such standards, they gain a competitive advantage over products which make no such claims, without achieving the real-world change towards which those claims are directed. Rightly, these funds should be relatively rare in a market dominated by single-mandate firms that are primarily designed, incentivised, and legally obliged to seek a financial return and nothing more.

Disappointingly, in the latter stages of its policy consultation, the FCA rolled back on its original position that listed equities products should not be eligible for an impact label at all. This was due to pressure from a small subset of interested funds. The rationale for the initial position – which we agreed with and advocated for – was that marginal impact is almost impossible to prove for a listed equity fund. The concept of marginality (also called additionality) is important in impact investing because it requires funds to be able to draw a line between every additional dollar of capital ‘in’ leading to an additional unit of impact ‘out’. Without that clear chain of causality, investors cannot be sure that their allocation is ‘doing’ anything in the real world, which is the fundamental claim of impact investing. Instead of additionality, the dissenters argued, managers should only have to prove ‘intentionality’ to justify receiving an impact label. The basic argument – which was used by the first listed equities product to successfully receive an impact label – was that investors themselves need not generate additional impact via their investment, they merely need to invest solely in companies which are themselves delivering a demonstrable impact.

To us at Hosking Partners, this seems somewhat back-to-front. All companies have an impact of some kind. Normally, these impacts are diffuse, wide-ranging, hard to measure, and may even be contradictory. A mining company may provide critical materials into an energy transition-related value chain and provide invaluable employment to local communities, but it may also – directly or indirectly – contribute to localised environmental issues such as water cleanliness or have an impact on local biodiversity. Even in this simplified example, what is the net impact? Assuming the company is working hard to reduce negative externalities, should an investment product be able to call itself an ‘impact fund’ if it owns the stock, even if it admits that its presence or absence on the shareholder register is irrelevant to the scope or nature of that progress?

Academic studies have failed to show decisively that changing a firm’s cost of equity has a reliable effect on its sustainability-related behaviour. In some studies, it has been shown to have a counter-productive effect. (3) So, even if positive effects are sometimes observed in specific cases, there is no academic consensus to justify the notion that merely owning the secondary equity of companies that deliver ‘positive’ impact should justify a manager premium, be it in the form of a marketing label or additional fee.

Rather, we believe that assessing the interaction between such externalities, the strategy and capital allocation of management teams, and the generation of long-term shareholder value, is the central value that ‘ESG integration’ adds to the investment process. Understanding the complex web of impacts a company has on its stakeholders, and where appropriate engaging to help direct that impact one way or another, is a core tenet of being an ‘active owner’ (see the engagement section of these reports for examples of such activity). However, we do not think being an active owner should afford us the right to claim any label, let alone an impact label.

As a firm with a single mandate – to act in the best financial interests of our clients – engaging in such a way is a basic principle of responsible long-term investing. And our incentives are most clearly aligned when all our efforts are in pursuit of that single goal, rather than spread across a range of financial and non-financial outputs. This is why we believe that impact funds should not only need to demonstrate marginal impact, but that they should also have clearly defined secondary mandates which explain their non-financial aims and the potential effect achieving them could have on returns. This is eminently achievable and there are many impact funds out there who do exactly this, to their credit. However, at present, their efforts are overshadowed – and undermined – by the continued regulatory tolerance of alternatives held to less stringent standards.

A possible solution?

As CISL highlights, “ESG as it stands — grounded in disclosures and voluntary market action — will not deliver the necessary change […] Governments must create conditions that make it economically compelling to phase out damaging activities. Otherwise, businesses that voluntarily transition will be undermined by those that don’t.” That friction is exacerbated by a sustainable investing paradigm which does not adequately distinguish between funds that drive marginal real-world impact and those that do not. Given the demand for sustainability writ-large is both healthy and here to stay, allowing a large ‘grey area’ to exist which consists of products that are neither truly unconstrained and therefore aligned with a single mandate, nor truly impactful and aligned with a secondary, is likely to continue to incentivise greenwashing and capital misallocation.

We conclude this section by offering a possible solution to address this problem. It is certainly not the only one out there, but it is something we have thought a lot about over the last two years and have discussed with a range of industry participants. It is straight-forward: To offer just two labels of investment products. Firstly, unconstrained products which have a single mandate to achieve the best financial return for clients. Secondly, impact products which have a clearly defined secondary mandate (or mandates) and can evidence the associated additionality. In such a world, governments could step in to incentivise the flow of capital between these categories of product, in accordance with their democratic mandate to redirect private investment towards political or societal ends. Meanwhile, asset allocators – acting in line with relevant government policy, internal considerations, and the wishes of their beneficiaries – would be free to balance strategic portfolios between impact and financial returns. Investors would have a much clearer idea of what they were buying, and incentives could be more clearly aligned. This should, in principle, lead to more efficient capital allocation.

We are not the only advocates for such a course of action. In a blogpost of June 2024, London Business School fellow Tom Gosling argues that there is a solid fiduciary justification to allocating a modest (c. 5%) portion of a strategic portfolio to impact. Furthermore, he argues that such a strategy has a more convincing fiduciary grounding than middle-of-the-road ESG 1.0 strategies, such as selective divestment or portfolio ‘alignment’ (the ‘intentionality’ approach described above). (4) Meanwhile, we have been intrigued and inspired by discussions with institutional clients who are themselves weighing these issues, and in some cases leaning towards similar conclusions.

Hosking Partners will continue to investigate this issue, as well as advocate for a clearer alignment of incentives and more transparent governing regime, as part of our ongoing engagements with industry peers and collaboration with ESG working groups and regulators.

Recommendation 2:

When assessing a public equity manager’s sustainable credentials, allocators should focus on the qualitative way in which the manager thinks about long-term, intangible value, rather than rely on quantitative ESG metrics which can offer an incomplete or even deceptive description of a portfolio’s approach.

In December 2022, at the time we made this recommendation, the quantification of ESG via ratings and similar simplistic measures remained a fashionable trend. This was particularly the case for the ‘grey area’ products discussed above which are orientated towards neither returns nor impact. The allure of quantification is that it allows complex approaches to be simplified in a manner that is graphically appealing and easily marketable. If a manager builds a portfolio out of stocks which all receive a high rating according to MSCI or some other ESG ratings provider, then not only could the manager use that to justify a regulatory distinction such as Article 8 under EU regulation, it can also paint a supposedly positive picture of its sustainability credentials in comparison to competitors or some benchmark. All of that can be used to justify management fee premiums or secure a market-entry competitive advantage. This was all despite mounting evidence that ESG ratings are poorly regulated, largely opaque, rarely cross-correlated between providers, disconnected from impact, and often represent little more than the subjective opinion of a single analyst or group of analysts. (5)

Instead, we suggested, allocators should focus on qualitative analysis of the way that a manager thinks about complex problems, rather than rely upon metrics which attempt to describe the outcome of that thinking. This is a trend which we have seen gain significant traction in the last two years. Anecdotally, in our engagements with peers, asset allocators and other industry experts, we have seen a distinct shift away from over-reliance on metrics and towards the facilitation of more qualitative approaches. This has been catalysed by the rise of artificial intelligence-assisted natural language systems which reduce the resource-intensity of such analysis.

Moreover, a fascinating recent study has shown that the differences in approach between managers who self-identify as ‘sustainable’ and those who do not may be much smaller than assumed. Released in September 2024, the study surveyed over 500 active managers, split roughly 50/50 between traditional and sustainable labelling (Hosking Partners was one respondent in the former category). The study found that 66% of traditional managers incorporated ES (i.e. environmental and/or social) performance into selection decisions ‘often’ or ‘very often’. This was unsurprisingly lower than the 90% of sustainable managers (one wonders what the other 10% are doing), but nevertheless a clear majority. Similar proportions (64% and 92% respectively) have conducted engagement specifically to improve a holding’s ES performance. For both sustainable and traditional managers, the primary driver for such behaviour was related to returns. Perhaps surprisingly, just 30% of sustainable investors would tolerate sacrificing even 1bp of returns for better ES performance, only barely higher than the 24% of traditional investors who would do the same. Furthermore, just two-in-five sustainable managers (41%) were concerned by generating ES impact, versus one-in-five traditional investors. So, while there are some expected differences between the responses of these two self-identified categories of manager, the report highlighted that those are “smaller than commonly believed”. This is even though – presumably – these two groups look very different when their portfolios are viewed through the lens of simplistic metrics, which often describe sector or factor biases more than they show either demonstrable impact or even analytical approach.

Notably, the study concludes by commenting that “for asset owners, it is important to understand that whether portfolio managers act as ‘traditional’ or ‘sustainable’ depends more on their investment beliefs and ES constraints than how their fund is labelled.” In our view, not only does this conclusion firmly support the recommendation we made two years ago, it also underlines the requirement for greater regulatory clarity regarding labelling that we discussed in the previous section.

Conclusion

We have previously described Hosking Partners’ capital cycle approach as a bubble avoidance mechanism. Articles in this report have described how this mechanism has functioned in relation to certain themes that became popular with ESG-labelled investors in the early 2020s (see our reports on solar and wind).

This contrarian philosophy also stretches beyond the portfolio and informs our approach to wider industry trends, not least with regards to ESG. Over the past few years, it has helped us avoid bending our approach out of shape to meet the oversimplistic structures of ‘ESG 1.0’. Instead, it has helped us embrace complexity and better integrate the more value-additive elements implicit within ‘ESG 2.0’ analysis, of which there are several important categories, not least long-termism and active ownership. Moreover, it has helped us ensure that our strategy remains laser-focused on performance and has informed many of the conversations that we have had both with our clients – who have been a constant and constructive source of inspiration and challenge – and the management teams of the companies we hold.

We look forward to seeing how these trends evolve in the next two years and will continue to advocate for the sort of pragmatic and constructive approach to ESG that we believe lies in the best interests of both our clients and society at large.