Unearthing the true meaning and substance of ESG - Environmental, Social and Corporate Governance.
Courtesy of Colin Melvin - Founder & Managing Director of Arkadiko Partners.
What does ESG mean to you?
It’s interesting because I was involved in creating the acronym as part of the UN’s Principles for Responsible Investment (PRI) drafting process in 2004 and 2005. These were sessions centred on looking at specific principles within responsible investment, and because most of my career has been in stewardship, I contributed very strongly to those principles. After qualifying as an investment analyst, I’ve spent most of my career engaging with companies about ESG risks in their investment decisions. During that period, I have been involved in setting up groups here in the UK and internationally within responsible investment, and that led me to working for the UN.
At one point during the drafting process, the twelve or so of us were sat in one of the underground rooms in the UN’s headquarters in New York and were asking ourselves what we call this thing that might impact the long-term value of an investment or the stewardship of it, which, at the time, not many firms were considering. We cast around a bunch of terms around governance and finally settled on the acronym ‘ESG’.
However, we lost control of this pretty quickly because it [ESG] was rapidly attached to any particular concern that anyone might have. Most people now look at ESG and only see the first two letters. Even worse, some choose to focus on one or the other. They think about things that are genuinely concerning such as climate change or supply chain issues but not on the financial materiality of a broader set of concerns that might impact an investment decision.
So, what it [ESG] means to me is a challenging acronym that causes confusion within the investment industry. Whenever we see it, we should ask ourselves what exactly we mean by this. Do we mean impact or stewardship or investment decision-making? What are we actually talking about?
What is impact investing?
Traditionally, impact investing is similar to venture capital. Venture Capital is an early-stage provision of new money generally to a small start-up company where you expect your provision of capital will make a difference because other people might not be prepared to invest. The addition of your capital combined with the intention behind your investment of doing something good also applies to the company you’re investing in because you’re trying to do something additionally and intentionally good. So, as an investor, you will perhaps be prepared to take a lower return than you would have otherwise received elsewhere so that you can then make a difference in the world in some capacity. That’s traditional ‘impact investing’. However, the term has entered mainstream investing as applied to public markets investing in which case, you’re not actually putting in new money - you’re just buying shares from someone else. There’s no new provision of capital but rather just a transfer of ownership of the share.
That makes you think of what people actually mean now by impact investing. It could actually mean two things, at least in equity investment. One is that you might be interested in the impact of the company you’re investing in and you can report that back to your clients if you’re an investment manager. That doesn’t represent your impact because you’re just buying the shares from someone else. Your impact would be the stewardship - how does your behaviour as an investor change things. A lot of discussion around impact investing in the mainstream needs to look much more closely at stewardship, particularly for equity investment.
What is stewardship?
Stewardship within responsible investment refers to how you behave as an owner of, or investor in, an asset with a focus of seeking to guide it where appropriate. You’re entrusted to look after something on behalf of someone else. Take, for instance, you as an asset manager. You’re the steward of a client's capital in that there is some behaviour which you undertake to where you deploy the capital and engage senior management of companies of invested stock to get change that would be good for both you and your client in the long-term. That’s what stewardship means to me.
Currently, I run a consulting firm called Arkadiko Partners, and I consult with my clients including some very large pension funds and fund management companies on ESG integration, development of purpose and the quality of stewardship and reporting within an investment. In doing so, I don’t distinguish between my career and the understanding of my clients of responsible investment because I consider myself as part of a system and playing a small role in seeing that system change.
Why do you believe ESG now no longer represents its original purpose?
People seem to be engaging in selective blindness by ignoring the ‘G’. The problem here is that the ‘G’ is what is behind everything - the quality, direction and control of the firm. If you want to improve the quality of social and environmental risk management, then of course you need to improve governance. It’s quite a big mistake to forget about it, something which happened very quickly after the PRI were created.
There were a lot of people interested in the PRI that weren’t investors. They thought that the PRI and ESG could be a vehicle to achieve specific social objectives. I’m not saying that’s wrong, but you need to handle these things very carefully. If you want to change the system, which I think we are doing, then it’s really important to understand how to help fund managers change. By simply trying to force them into this acronym, individual little pet projects might not work very well.
The best work done in this area is when you’re looking to find common purpose with the investment manager or the pension fund company, and that acts as a common assured purpose of creating wealth and prosperity in the long-run. That means we start to see issues like climate change and supply chain problems as material to long-term value creation and, there, you start making sense. If investors see ESG as something different from the job of doing the investment and are encouraged to do so, then it’s going to be much more difficult to get them to change.
Why are people ignoring the G?
I think it [ESG] has come to represent something. I look at the material some of my clients present and it says ESG all over it. I sit with them and ask them what they mean by it. Without distinguishing, you come to realise very clearly that they mean all those different things - stewardship, impact investing etc. It feels as though they’ve been asked to do something different and have no idea how to do it. There are other types of investors who are already starting to incorporate many of the risks which you would classify as ESG risks but not realising they’re doing it. They look at the ESG market and, by definition, say “that’s not what I do”, and that creates this really interesting paradox.
What people really mean by ESG in that context is a desire to behave differently - stop investing only for the short-term but focus more on the long-term by investing in real assets and real markets and recognising the need to work together to reach a mutually assured purpose of long-term prosperity.
Do you see investment management companies returning to the original meaning of ESG?
My role is to help firms integrate ESG risks properly into their investment practices, which some firms truly are. However, there is still a lot of greenwash around the topic. There’s currently a project in European Union which is trying to tackle this by having investment management firms create a circle of ESG products. Unfortunately, that has very little to do with responsible investment. It is more so a pretty wrapper around something which they already had. In effect, we must be very careful with how we deal with this.
Some people look at the PRI and ask whether it is service-ready. Some investors look at the tens of trillions of pounds invested within their definitions of ESG products and don’t see any change, at least not fast enough. What there is, however, is a real understanding of the need for change. They realise that after nearly 20 or 30 years of neo-classical, trickle-down economics that we can no longer assume that if we pursue profit for ourselves in the short-term, everything will just be fine. We know that it won’t. Capitalism, as it has functioned through the ‘80s, 90s and early 2000s, was broken. There’s much more demand for a longer-term trend towards getting back to greater fairness, equality and opportunity and recognising that we are dependent on each other in order to prosper.
Colin Melvin - Founder & Managing Director of Arkadiko Partners.