Episode Background

E03: ESG, China & Investability

An increasingly diverse regulatory landscape presents substantial reputational challenges for investment managers.

Amid the shifting ESG terrain at the heart of financial services, investment firms are recalibrating their approach to sustainability, grappling with the balance between upholding ESG principles and avoiding regulatory pitfalls. If you're managing ESG related funds, you could now be fired by some of the very largest pension funds in the U.S.

Asset managers need to navigate an increasingly vocal anti-ESG group of asset owners, as well as the renewable energy investments in China, and the tragic impact of global conflicts.

In this episode, Katten Partner Neil Robson, Lansons|Team Farner Asset Management Lead David Masters and Lansons|Team Farner Sustainability Lead Sam Sharpe delve into the evolving sustainable investment challenges faced by asset and wealth managers whilst regulations and attitudes move in differing directions.

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Episode Transcript

David Masters: Hello and welcome to the episode. This is our third episode in our new series for those working in financial services, particularly in and around asset and wealth management, where we seek to navigate a path through some of the more complex issues where regulation and reputation intersect.

This is also the second episode where we're going to be looking at the concept of ESG, something which is, I think, important to us all, but also quite an evolving and dynamic area within the investment management world.

I'm joined again by Neil Robson from Katten.

Neil Robson: Hello. Thank you, David.

David Masters: And my colleague Sam Sharpe from Lansons|Team Farner.

Sam Sharpe: Hi. Thanks, David.

David Masters: The 26.6 billion Wyoming State Treasurer's office has adopted a new anti-ESG language. The new statement mandates that fiduciary decisions be based solely on pecuniary factors that exclude the furtherance of environmental, social governance, political or ideological interests.

Further, the statement condemns such criteria as having crippled, corrupted, disadvantaged, subverted, damaged or otherwise harmed the children, citizens, industry and financial wellbeing of Wyoming and America, and authorises the Treasurer's office to take remedial steps should an investment partner behave in a non-pecuniary manner. So if you're an investment manager with substantial assets under management being managed on behalf of the Wyoming State Pension Fund or similar pension funds across the U.S., you're now faced with quite a considerable dilemma.

If you're managing ESG related funds, you could now be fired by some of the very largest pension funds in the U.S., which obviously has a massive impact on your revenue, and a massive impact on your business. Neil, what's the general state of play do you think in the U.S. at the moment?

Neil Robson: It's a bit of patchwork and it depends on what colour the state is.

So we've tended only to see Republican states making very negative ESG statements. I mean, the prime example, of course, is Florida with Ron DeSantis, who Trump famously referred to as ‘Ron de Sanctimonious’. Ron DeSantis, Florida state governor, has banned any Florida pension funds, state pension funds, from making any ESG related investments.

Again, it's that same sentiment as Wyoming that basically they must only ever invest on pecuniary factors. Basically, bottom line is the investment has to be chosen exclusively because it will make money for the pension fund and no other reason.

There can't be any suggestion that there's any environmental or social or governance factors taken into account, only that it's going to make money.

And of course, let's not forget that with climate change, Florida is the first state in the U.S. that's going to disappear under water. So, you know, it'll be too late by then anyway. But nonetheless, the fact is that we've got certain Republican states who have been banging the drum that ESG is bad for America, but for America's children and so on.

And what's been interesting is that senior Republicans last December, in fact, at Capital Hill, have accused big institutional asset managers of using their shareholder power to, quote, 'advance liberal goals', which is how they perceive ESG, that, you know, you're a Republican, therefore you exist to make money and nothing else. That's their perception.

Sam Sharpe: It’s all a bit 1980s.

Whereas it's interesting because then if you look at some things that are going on, for example, in California at the moment where they're actually going, I think he's Gavin Newsom as he just signed it recently in the last couple of days, where they've put much more extensive regulatory pressure on companies to disclose scope three, for a start, which is incredibly knotty and difficult.

They have to disclose scope three emissions. I think it's all companies over a certain size, both public and private, as well as then sort of their own version of TCFD. So it's just incredibly interesting how polarised you're seeing some of this, some of this discussion. And of course, with California being the size it is, actually, the reality is that most U.S. companies have some foothold in California.

And so therefore, even though state legislation becomes somewhat a de facto national way of looking at sort of climate and nature based disclosures.

David Masters: So, I mean, this is interesting, but it's also quite challenging, I would imagine if you're a business trying to navigate this this landscape where you've got very polarised views and you've got investors demanding ESG strategies on one hand and demanding that you as the manager are, you know, fulfilling your obligations as a responsible corporate citizen.

And on the other hand, you've got some of your largest allocators threatening to take money away from you if you do that. So, I mean, Sam, what would your advice be to some of these businesses in terms of how you might, you know, present yourself to the marketplace?

Sam Sharpe: If there's going to be two north stars that organisations think about around this, it's look at what the scientists saying. We now have pretty much complete agreement on what is happening. So that is not going to go away. The problems we have to deal with and face and fix largely through all financial systems are very clearly established and agreed.

The second thing I would say is that the lesson we've learned over the last 5 to 6 years, I would say particularly since 2018, when I think is when we saw that real explosion in ESG, if you like, coming into the main markets is current legislation on regulation has to be your lowest denominator. You always have to think of where the legislation and where the regulations are now as your lowest point and always look beyond them because at the moment, even with all the legislation coming in from the SCC in California, everything the EU is doing, it is still pretty Swiss cheese-y over the next five years.

I think those holes will significantly start to shrink and close up. So my advice would be this isn't going away and the regulations will get tighter. So always look a step ahead.

David Masters: So when we think about the U.S, perhaps we also think about the U.S. and its relationship with China. Now China presents the investment management world with another substantial dichotomy.

It's the second largest economy in the world. It's one of the fastest growing economies in the world. And there's also a lot of investment into renewable energy, whether that's through solar or wind or other forms of renewable energy. But on the other hand, they present quite a challenge, human rights abuses, the genocide against the uighur minority in the north of China.

We also think about the lasting damage caused by the Great Leap Forward and Mao's revolution. 

Neil, what are the sort of challenges you see from your perspective that China poses to global investors?

Neil Robson: I think you're right to refer to it as a dichotomy. I mean, the fact that China still produces a huge amount of its electricity from burning coal.

So the region of Inner Mongolia, which borders the country of Mongolia up in the far north, is a massive coal producing region. I was there some years ago and everywhere you go there's a black dust over literally everything. In fact, I was a backpacker at the time. I rode coal trucks hitchhiking around China. They burn coal to make electricity, yet of course they've got an enormous electric railway network, high speed rail, obviously a buzzword here in the UK at the moment, but nonetheless they've invested in a lot of electric power technologies.

They have a huge investment in renewable, as you say that I believe that the world's biggest producer of photovoltaic cells, when you get out of the major cities in China, most houses have photovoltaics on the roof. They generate their own electricity. 

But yet, as you say, on the S and the G [of ESG], they've got some pretty big problems. And then as an investor from the West, outside China, you think about, okay, who are you going to invest in?

So let's just look at, Nike trainers. 

Nike uses Uighur slave camps to make its trainers in China. That was a major problem that burst into the press last year that, frankly, you know, if you're an investor in Nike and you have an ESG or a social responsibility to your investment strategy, does that mean you've got to divest from Nike?

The same goes for the likes of Primark, who were using children some years ago to stitch tiny sequins onto children's clothing in their Bangladesh factories. So these are really difficult. And this really drills down into the corporate supply chain. Now, the new EU directive on due diligence in corporate supply chains, I think is going to help this in a big way.

But ultimately also the supply chain point is a fundamental one, because if you're a business that's operating in some way from the UK, you're subject to the Modern Slavery Act. And again, you have to look through supply chains to figure out who's doing what, where in your supply chain. You can't turn a blind eye to it, and you have to actively go through that diligence exercise to figure out who's doing what.

Where does this component come from? Have we done what we need to, to be able to say, we've done the requirements, we've checked, we're comfortable that there's not, you know, slaves in the Middle East or in China who are making this stuff and we're getting it cheap. Let's turn a blind eye because it's so cheap.

Sam Sharpe: So what I was going to pick up on there was how you how you prioritise or have that debate around the E, the S and the G, and whether you have to nail every single one or how you get the balance across all three within something.

Because I think something we hear quite a lot or will have for the past couple of years is you know, the G has to come first. If you don't get that right, then the E and the S are somewhat irrelevant, whereas actually on that principle no one would have ever put any money into Tesla and actually look at the impact, that's had from the E.

So I think it's, it's interesting how there are some, there are some aspects from a sin or a do-no-harm perspective when it comes to supply chain that you absolutely are hygiene factors across those letters. But then there are others where I feel it's you've got to dial it up and it's knowing where your priorities are or what's the most important and what you might sacrifice in order to do something really worthwhile.

Or perhaps that really influences an industry on one particular of those letters.

Neil Robson: Yeah, and of course that do-no-harm point is a really, really interesting one because that stems from the EU's SFDR, the Sustainable Finance Disclosure Regulation, which really drills down into the point are you looking at investments that do no significant harm, that don't damage principally the environment based on that particular piece of legislation, but you could take that principle more broadly because as we said in the last episode of the podcast series, ESG doesn't mean exactly the same thing to everybody.

And in fact, we have a patchwork or a mosaic of legislation around the world that big asset managers are going to have to try and figure out how to thread the needle and comply with all of them, but do no harm to people, to environment, to the people you work with, society. That's quite a good way to think about this.

And it drills all the way back, I guess, ultimately to corporate social responsibility, way back before ESG was even a thing. But it's a challenge. Again, as we said in the last episode of the podcast, it's an incredible challenge for managers to figure out how do you get through this? How do you hold yourself out to the world?

That sort of mission statement of this is how sustainable we're trying to be. Our ESG responsibilities are X-Y-Z. Setting forth what you truly believe in and then sticking to it so that you're not in any way accused of, you know, prospectus fraud or manipulating your investors with false statements.

Sam Sharpe: Yeah. And also how you make sure that that becomes what those principles are, are entrenched all the way through the organisation.

I think that's another way we've seen organisations not quite get it right is where there is a bit of a disconnect between what's happening and what's being said publicly at the top, between what every individual fund manager and person in comms, ultimately believes or how they've interpreted those principles. So there's a lot of work to do in terms of joining all these dots.

David Masters: Absolutely. Yeah. We can't ignore China because we're not going to mitigate climate change without the involvement of China. I mean, it's a practical impossibility, but it does I think it does highlight some of the geopolitical challenges which ESG has become a central point around. You know, when we think about these geopolitical issues, when we think about conflict in particular, what are the sort of key things that we need to be aware of?

Neil Robson: So I think it's a difficult one because I don't think a lot of people truly baked sort of global conflicts, war issues into their ESG sort of considerations. In the past, you know, we've lived through an almost unprecedented period of almost global peace in recent decades with small flare ups here and there. And of course, if you look back, as we said earlier, under sort of corporate social responsibility and the exclusionary elements of investment strategies, you might have excluded certain armament sort of businesses alongside tobacco, alcohol, pornography, etc.

But ultimately, it's a difficult one because, you know, we the West, the UK, the U.S. are providing arms to Ukraine to fight the Russians. In some ways you might say this is again a proxy war. You know, it's the West versus Russia, just as the scenario in Lebanon with their decades of civil war was the West versus, you know, the Islamic powers who were supporting the insurgents there

So I think it's really difficult. And to look at the context, of course, one of the problems we've had in the West is that with the Russian invasion of Ukraine, the West stopped buying Russian oil and gas. 

Obviously the sanctions in place that we couldn't do that. But that triggered, unfortunately, a massive increase from the G20 nations in terms of investment into fossil fuels.

So 2022 represented a peak of investment in oil and gas and coal. So it was 1.4 trillion, apparently, according to an article in The Guardian last year, which basically meant this was countries trying to find alternative sources of power because they could no longer rely on the Russians. That's a bit difficult when you're saying that we, the investor, want to try and be sustainable and green when we've got countries who are pouring money into CO2 emitting fuels in order to keep the lights on in those countries.

So conflict is a difficult one. And I think that ultimately, my view now sitting here, late 2023, is that I think a lot of companies have sort of got a social imperative to earn their license, the social license with the investors and the public that seems to be growing. And if you just look at what's happened in the past two years, you know, unprecedented global temperatures, September 2023, this year being the hottest September on record around the world, temperatures of 25 Celsius in October.

Climate change is, I think, undeniable these days, notwithstanding what certain Republicans in the U.S. might think. So extraordinary weather events, you know, half of Europe on fire this summer. I think they say the message is getting stronger and stronger and conflict is a difficult one because, you know, we stand with our allies in Ukraine against the Russian invasion.

But if you say we shouldn't be investing in armaments, does that mean we're abandoning our allies?

Sam Sharpe: It's a difficult question, I think, to pick up on one angle of that in terms of the impact of conflict, I think it does almost inject a dose of realism into what some of these investment decisions and strategies mean in terms of long-term security.

I think we have to also point out we have had this unprecedented period of peace, which we've all frankly taken a bit for granted. And now if you look at the impact of climate change that we're likely to see, so impact on harvests on energy security, which we've seen acutely very quickly, through which nobody really saw coming via Ukraine.

And if you look at migration patterns and the impact that it's already having on politics within Europe, and the reality is that is going to go up massively over the next decade. So I think it's injecting a dose of realism into some of these strategies and policies because at the end of the day, with that challenge, the sustainability challenge doesn't go away.

But life will always get in the way. So we have to build in that long term thinking. 

And I think we also have to get used to the fact that this is a to use an overused analogy, it is a long-term marathon over the next ten, 20, 30, 50 years, and there will be hiccups along the way.

But as long as that long term strategy remains in place, it can take the short-term hiccups where actually we do on a short-term basis. And I think we have seen this roll back slightly or we've seen it we have seen it balanced by increased. But, you know, we have seen that initial pump of capital back into fossil fuels.

We have seen that now balanced out by injections into renewable sources as part of that long-term strategy. But it's they have to work together.

David Masters: And it's not just that it was a, you know, huge, lengthy period of peace. But also we have to remember that during that period, interest rates and inflation were at, you know, historic lows.

And, you know, the Russia Ukraine war did not cause the spike in inflation. The spike in inflation was going to happen. The food shortages were going to happen. We were always going to have we were having a drought in the U.S. and it was always going to get worse because of the weather conditions. So the impact it had on grain supply, on fertilisers, etc., you know, have had this huge knock on impact on inflation, cost of living, which in itself has impacted investors ability to invest.

It also means that because most ESG assets are traditionally risk assets, originally it was it was all equity. Increasingly, these days, you know, you can be an ESG investor through sustainable bond funds, through sustainable real estate. And, you know, increasingly we're seeing impacts in private markets. But yeah, if you can earn 5% or so on government bonds, you are able to earn a reasonable return quite safely.

I think therefore that we are seeing, we have seen a little bit of a slowdown in the flow of assets into ESG funds, but they are still growing. And I think PWC have, you know, believe that the sort of total assets under management in ESG products will be somewhere just shy of 35 trillion by sort of 2026, which is only three years away.

You know, and if you think about it, the bought two or three years ago, there were about 18 trillion. So you can see that they will have doubled in about five years. The demand is still there, but there are increasing number of structural challenges for ESG investors. And I just think therefore what does the future hold. So Neil, from your perspective in terms of where do you think that the regulators are going?

You know, we've seen this direction of travel, you know, prove that you're doing what you say you're doing, etc., but what do you think are going to be the things that the regulators are thinking about or likely to be thinking about over the next few years?

Neil Robson: Well, I think that the direction of travel is clear and sort of the drip, drip, drip of new legislation around the world is almost exclusively focused on disclosure, disclosure, disclosure. making sure that how you approach your investment strategy, what you're investing in, everything has to be very, very clear.

Everything has to be disclosed in certain ways. Okay, they're going to differ from country to country. I think the likelihood of harmonisation between US, UK and EU rules is remote, to say the least. And you know, we've got UN standards, the PRI, for example. These are all very, very different. And as I've referenced in the past, this is a mosaic or a framework of all sorts of different things that you have to adhere to.

But what's coming next is, I think there'll be a lot more greenwashing enforcement action.

It's a lot more, I think, of what we've been seeing a little bit of that's going to become much bigger. So lots more enforcement, lots more focus on you said X, Y, Z on your website and you didn't do it. Well, that's false advertising. That's, you know, market manipulation in the sense of you're promoting a product, wheezing, using something that's inappropriate or wrong. So I think that's sort of where I see it going.

Sam Sharpe: Yeah. I would add to that that I think people have to be at peace with the fact that this is not going to get internationally aligned or simpler. It's only going to get more complicated. I think we have this pre in-built theory that things get better and more simple and we get our heads around them actually on this issue as we put some debates to bed, others are going to emerge like as we get comfortable with some regulation and technical concepts, we're just going to explore and realise the nuances within those that then make it take it in other directions.

You know, even things like NDCs, which will be at the forefront during this COP, we don't even internationally agree on what should be in and what should be out. We don't even agree as a country. I think, you know, it was a really simple concept five years ago when we needed to put some value on it. Now, as we've used it, that becomes more complex.

And I think we'll see that across the board, particularly with regulation.

Neil Robson: I think there's no point in waiting for the U.S. and the EU to be aligned. It's not going to happen and as we said earlier, this is a political football. Different countries have different approaches, the U.S. Republican versus the universe, even with the EU taxonomy regulation trying to figure out what is actually truly sustainable in terms of, say, an energy source - is nuclear safe and is it sustainable?

Sam Sharpe: Well, you've got thousands of years. The half life of uranium is 2000 years. You have a waste product that's going to be around for hundreds of generations. Should that truly be considered a sustainable energy source? What about, biomass or electricity production plants in Scandinavia that burn trees? Well, trees are renewable if you keep planting them, but then that's just putting CO2 back in the atmosphere that you took out the atmosphere over the last 20 years.

Neil Robson: So it's an absolute football, political football that is going to get kicked around with people having different agendas. It's going to be a challenge and staying on top of it is going to become a full time job for a very large group of people. And if you think about the evolution of business, you know, when I was a kid, human resources was not really a thing.

Health and safety was not really a thing. It was just be sensible and do the right thing. These whole sectors of, you know, large numbers of people working in industry, you know, health and safety, every business has to be focused on that. You have to have an HR Team… having an ESG focused team who understand exactly what the business is doing and saying it's going to become an absolute imperative.

David Masters: But I think what we're agreed on here is that, you know, whatever we call it, whether we call it sustainable investing, sustainability, ESG impact, it's around here. It's here for the it's here for the duration. There's definite ongoing demand for investors to want it. I suspect that it will evolve from an investment perspective and that what we have now where we've moved to this sort of ESG integration, the impact type investing, where you're investing for things like intentionality and additionality will become much more the norm directed towards public markets as much as they are currently towards private markets.

And that will be the way the mechanism by which a lot of investors, institutional and otherwise, will ultimately be able to see their values at work or their capital put to work in a way that is aligned to their values. So I think there is a long way to go between then and now.

And I think the politics of it, the regulatory divergence, will be challenging for a lot of businesses. 

And obviously there are other things going on within the asset management industry. But Sam, as our guest we're going to hand over and give you the final word. 

So what's your your last word on the way that the world of ESG is developing? How do you see the future?

Sam Sharpe: I think it's only going to get more embedded, more important and more incorporated into everything we do. And even though I think the politics of it is getting more polarised, I think we are seeing shifts in which it's being embedded in a more long-term way. Like if you look at what Biden's doing with the IRA, it's harder to roll back.

It's becoming much more entrenched in the way our economies work in the how in how we think about growth and how we think about jobs. And it's not going anywhere.

David Masters: Thank you. I think that is all we're going to have time for today. We will be back next time where we'll be exploring further areas where reputation and regulation intersect in the world of asset and wealth management.

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