Practices must be more forward-looking to achieve change

The ways in which investors, companies and governments think about the role of environmental, social and governance (ESG) frameworks and how they are applied can still differ widely. Of concerns for emerging markets such as SA is that the way in which fund managers assess companies for ESG investing could lead to the exclusion of companies in those jurisdictions that most need it.

The identified problems of ESG emerge largely from the passive nature in which ESG is operationalised, said Intellidex chairman Dr Stuart Theobald.

Companies from across developed and emerging markets are ranked according to the same metrics and based on existing data that reflex historical performance, he said.

“This approach means that a company that has a fossil fuel profile, but that is on the cusp of major breakthroughs to transform itself will find itself excluded because of the historic data.

“ESG is not forward-looking. It doesn’t assess what change is going to be made in the world by a company or issuer.”

Theobald was speaking at the recent launch of the Sanlam ESG Barometer, a report compiled in partnership with Intellidex and Business Day, which assesses how SA companies are changing their businesses to deliver improved ESG outcomes.

One of the ways in which the “buy side” was integrating ESG frameworks into their decisionmaking was through an assessment guided by concern and reputational risk management. Research showed, he said, that fund managers use ESG as a mechanism to screen out certain exposures. That could be alcohol and tobacco, or it could be fossil fuels, for example.

This was concerning for SA which was “an emerging market that looks very much like a developed market that is exploiting fossil fuels”.

There are also outcomesbased perspective - ESG as a tool to drive change in societywhich tends to be what governments and the broader public think about ESG.

“This approach says that by using ESG as an intervention on the way the capital markets and financial system works, we can get better social outcomes, we can deal with climate change, as well as various social benefits that affect the way people live.”

There were huge debates and political contestation in Europe and elsewhere about how ESG should be enforced through regulation in those markets.

“When you think about how ESG screening models function, the type of approach that we often see fund managers use is to assess issuers on an ESG scoring and then either wait [to make a decision on including them] or they decide to exclude certain companies from their funding universe.”

This can lead to some surprising outcomes, he said.

“For example, you might find that a company that is intending to increase costs in its effort to reduce carbon emissions output gets identified with ESG risk, even though this could, in the long term, in fact reduce an ESG fund’s exposure to that particular issue. In this way, we have found, ESG isn’t always about driving the flow capital towards relatively successful companies who are improving ESG outputs. In fact, in some ways, it can do the opposite.”

While the debate rages in the EU over regulations regarding sustainable investments, there is very little to no mention, said Theobald, of the consequences of such regulations for development in the emerging markets.

One of the purposes of the research project done to compile the Sanlam ESG Barometer was to bring that perspective into the ESG global debate.

“This is really important for SA where the Just Energy Transition is key to economic development in the country,” he said.

Its overwhelming reliance on fossil fuels was one of the metrics that negatively bias SA in the minds of investors, creating the risk that international capital will downweight SA exposure in their portfolios.

“We clearly stand out as an outlier on carbon emissions. SA is very much a coal-based economy. We produce 9-tonnes of CO² per capita whereas the G20 average is 7.5-tonnes.”

On social issues SA ranks poorly on several metrics because of high levels of inequality and unemployment. SA also ranks poorly on measures such as sanitation and education outcomes. This is balanced, to an extent, by positives such as SA being a constitutional democracy and press freedom.

There were also many indicators weighing negatively on SA’s broad governance environment such as its poor ranking in the Corruption Perceptions Index (in 2022 SA got a score of 43 on a scale from 0, “highly corrupt”, to 100, “very clean”) and the recent greylisting by the Financial Action Task Force an indicator fund managers can use to show that the rule of law and governance in SA is relatively weak, Theobald said.

Even though indicators such as greylisting and SA’s continued reliance on fossil fuels could be classified as “sovereign level factors”, in practice, he said, investors could argue that even if there were companies “doing great things”, they can still be affected by operating “where corruption is rife”.

All of these factors create a risk that international capital is going to downweight exposure to SA at a time when the country desperately needs global investors willing to support its costly just transition efforts.

The numbers quoted for investment needed to achieve the just energy transition are “massive”, said Theobald.

The country’s Just Energy Transition Investment Plan (JETIP), launched ahead of the UN’s COP27 climate summit in Egypt in February, sets out the funding needs for the next five years to, primarily, transition from coalfired to renewable energy. The transition, as set out in the R1.5-trillion plan, will be integral to SA meeting is global emissions reduction commitments.

It is estimated that of the R1.5trillion

needed, no sources of funding have yet been identified for about R700bn of this total.

This is just the funding needs over the short- and medium term. The Presidential Climate Commission estimates about R8.5-trillion will be needed by 2050 to transition SA in a just way which means that people will not be negatively affected by the transition.

“The just transition is critical for SA and it will require enormous flows of offshore investment if it is to be achieved. So, making the argument that ESG needs to be more sensitive to development is critical right now. That’s why it’s important that this project (the Sanlam ESG Barometer] is coming together,” said Theobald.

The concept of additionality, he said, is really important in the debate about how to guard against emerging market players being at a disadvantage when it comes to the flow of capital to sustainable investing.

Additionality, according to Theobald, refers to a specific investment that ensures an outcome that would not have occurred without it.

“Through additionality, instead of merely screening companies out on the basis of their environmental features, a fund manager is actively looking to include companies who are doing things that will enhance environmental and social outcomes in the world.”

He said that with where SA was now, at the cusp of the just energy transition, the country was running national projects to achieve additionality on an environmental and social level.

“This is why SA needs additionality to be a criterion that global investors recognise and understand. They need to see SA as opportunity to achieve additionality on environmental and social outcomes.”

SA really does present that opportunity, he said.

Many SA companies are already engaged in how their environmental and social metrics can be improved. “We cannot starve them of capital because of their metrics as they are now. We need to be directing capital towards those who have genuine plans to change, and where capital can assist in achieving that change.”

THE WAY IN WHICH FUND MANAGERS ASSESS COMPANIES FOR ESG INVESTING COULD LEAD TO THE EXCLUSION OF COMPANIES IN THOSE JURISDICTIONS THAT MOST NEED IT