We have been trying to figure out how to approach the topic of Environmental, Social and Governance (ESG) investing, but finding it a broad and moving target. Our first step was an industry look at electric vehicles (EVs); even that was a sprawling lift, and difficult to map for targets to short with confidence, given the wall of money being thrown at a hot industry. There seem to be innumerable sources of ESG data, ESG rating schemes and methodologies to sort through; then a teenager screams “greenwashing” as she stomps out of a UN panel. What’s a manager to do?
It turns out we’re not alone in our head scratching; the International Organization of Securities Commissions (IOSCO) just published their report “Recommendations on Sustainability-Related Practices, Policies, Procedures and Disclosure in Asset Management” which says as much. More on that to follow, but first, an existential rant of sorts.
If the wall of money chasing EVs impressed us, ESG writ large is astounding. Morningstar’s assessment of 2020 fund flows, entitled “Broken Record,” detailed how $51 billion in net flows to US sustainable funds was more than double the total in 2019 and ten times 2018 levels; global sustainable fund assets stood at $2.3 trillion—almost a third of all invested funds—in the second quarter of 2021. On The CFA Institute’s 8th Annual Global Portfolio Managers Panel, hosted in November 2021 by the CFA Society of San Francisco, speakers breathlessly described a “stampede” into ESG assets, driven by younger high-net-worth clients, at the same time managers said they spent an inordinate amount of time educating investors on definitions while searching for suitable metrics.
With thematic growth like that—coupled with the loose and unregulated definitions we describe further below—some high-profile short sellers consider ESG to be fertile fishing for exploiting information gaps and unjustified premiums, if not outright fraud. A Reuters analysis of 2019 Refinitiv data found that the five companies with the highest ESG scores in each of five European countries were shorted more than those at the bottom of the ESG score charts, and that those short positions against the winners were 50 percent larger collectively than those against the laggards. More colorfully, Carson Block of Muddy Waters famously called ESG the “paper straw of investing” after the virtuous straw that you hope doesn’t dissolve before you finish your big, plastic container-filled beverage. Even without a short seller’s scrutiny, mere claims of “greenwashing,” broadly defined as unjustified or exaggerated claims of ESG quality, can be reputation-wrecking and genuinely difficult to avoid.
“The greenwashing comes in if they are doing something different to what they say they do.” That’s a fair and manageable definition from an anonymous ESG specialist at a global asset manager, quoted by the Financial Times in an August 2021 article about the woes of German asset manager DWS; another was quoted as saying that “[what] has happened to DWS could happen to almost any investor.” More on the DWS travails further below, but the takeaway is paramount for those in the sustainable fund management business: even more than other strategies, transparency, clarity, and measurability are your best defense — against short sellers, celebrity-activist teenagers, and pitfalls in between.
But simply doing what you say you do may not help against the more aggressive, goal-post-moving activists; a recent Wall Street Journal investigation into claims of greenwashing in the bond market highlighted managers dumping green bonds due to an issuer’s unrelated positions and practices, even if the use of the bond proceeds complied with the publicly-stated and ESG-vetted investment purposes articulated at issuance. And Swedish furniture behemoth Ikea, one of the world’s biggest buyers of wood — which actively employs a three-layer protection program to police its supply chain and is regularly heralded as a sustainability success — was nonetheless documented as having illegally sourced wood in its supply chain twice in the last eighteen months.
In response to an ESG-induced staff rebellion, the head of consulting company McKinsey & Co. penned an important opinion piece in the Wall Street Journal last month, defending his firm for continuing to work with fossil fuel companies and other ESG villains while also vigorously pursuing a global economy with net-zero emissions by 2050. Bluntly put, he argued that—contrary to activist goals—hard to abate industries can’t simply be “cancelled;” employing over 30 million people in the US alone, and fulfilling more than 80 percent of primary energy demand with 90 percent of the global fleet non-electric, these pillars of the global economy are going to be financed by someone, and only by working with them can firms like McKinsey help them move toward reducing the roughly 80 percent of the global carbon footprint that they represent.
A simple and pragmatic message like that won’t sway the hard-core activists and green-at-all-costs governments around the world, but is irrefutable as China reopens coal plants, the US begs OPEC to increase output, and Europe buys all the Russian natural gas it can get in the face of energy shortages. And with many of the world’s biggest emitters being state-owned or private, as BlackRock’s Larry Fink warns, a one-size-fits-all pressure on public companies to go net-zero creates enormous market arbitrage opportunities for private equity to take cash-emitting dirty assets private.
Against this backdrop, perhaps activist investor Dan Loeb of Third Point presents a valid anti-greenwashing strategy in calling for the breakup of Royal Dutch Shell, which is no doubt on almost any ESG investing blacklist in spite of having a better ESG score than Tesla; the green side of the business would almost certainly take off without the “old energy” side, and both could “do what they say they do.” This pragmatism may be best witnessed in global bond markets, which are much larger and far less green than equities. A recent Financial Times article cited BBVA Global Markets Research estimates that sustainable bond inventory, as of late 2020, was less than a trillion dollars out of a total $128 trillion total market. To our mind, this makes some sense as the contractual nature of a debenture, and the ability to state obligatory uses for the proceeds, lends itself well to a strict green-vs-brown division of duties.
This seemingly clean solution to avoiding greenwashing accusations, while still attracting ESG capital, may work for companies where there’s a clear separation between the green and the unclean; however, other companies with a “sustainability” core value proposition have derivative problems and trickier issues. Current footwear darling Allbirds essentially has one eco-friendly consumer product to thank for its astronomical valuation, but since June has faced a class action suit alleging their claim of a low carbon footprint doesn’t take in all the environmental impacts from manufacturing their product, and particularly the full carbon cost of wool production. (NB: Despite having to remove much of the sustainability hype from its offering documents under SEC pressure, Allbirds’ stock jumped as much as 116 percent in its [upsized] IPO debut, valuing their wooly eucalyptus shoes at close to $4 billion—perhaps a cynical bet that the retail public pays more attention to Instagram influencers than the court docket.)
- We also can’t help but quote The Economist on a related subject—the quick, giant checks written to startups by outsiders such as Tiger Global and Softbank: “Whereas the arrival of Mr Son left denizens of Sand Hill Road in Palo Alto, where Silicon Valley VCs cluster, quaking in their Allbirds, they appear remarkably unfazed by Tiger’s presence.”
Global beverage favorite Coca Cola has for years fought to green its image with abatement steps like carbon sink offsets, but also faces a class action suit over its production of plastic waste, among other unsustainable elements of its business. And consumer behemoth Nestlé similarly touted sustainable procurement, but in 2019 was accused of having virtually no environmental standards in place for its West African chocolate supply chain. With a potentially volatile ESG investor class and near-total reliance on retail branding, such companies would do well to conduct enhanced diligence on their supply chains—not to mention key officers—and be prepared to fully disclose and defend any irreplaceable but less-than sustainable elements. Even Ikea’s woes, viewed from the outside through a supply chain risk management lens, may have been preventable, as their illegal timber infractions grew out of the forests of Russia and Ukraine — known hotspots for the kind of corruption that subverts sustainable permitting regimes.
The white hot ESG market has coincided with the spike in use of Special Purpose Acquisition Companies (SPACs) to compound the potential for grand green promises made on minimal concrete information. In some ways SPACs were built for new sustainable companies like moths to a flame: merger with a SPAC lets an ESG entrant move quickly to capitalize on favorable market conditions, including an appetite for high-growth technology-driven innovators or wooly-footed retail darlings. Critically, SPACs also allow for more expansive forward-looking statements; a leg up to many ESG-focused companies whose impact on climate change, social imbalances, or governance trends may be difficult to prospectively quantify and require a long-term perspective to realize. Because the deals move quickly—and sponsors conducting the diligence on the ultimate target of acquisition and operation may have differing interests from longer term investors — dedicated ESG investors should seek SPACs led by bona fide ESG specialists, that have external certifications guiding their acquisition process, or that designate acquisition targets with clear and demonstrable sustainability models.
ESG-directed SPAC Climate Real Impact Solutions in July brought electric vehicle charger EVGo—the only EV charging network provider powered by 100 percent renewable energy—to the public markets. For an ESG SPAC with prospective credibility, Renewable Resources Group and Capricorn Investment Group—the latter managing more than $8bn focused since 2004 on sustainable investments (not just on the ESG fundraising bandwagon)—have partnered on a SPAC with pending B corp status—a reputable sustainability accreditation earned for their commitment either to acquire a B corp, or to help an acquiree company attain B corp status as they address global challenges under the UN Sustainable Development Goals.
“Certified B Corporations achieve a minimum verified score on the B Impact Assessment—a rigorous assessment of a company’s impact on its workers, customers, community, and environment—and make their B Impact Report transparent on bcorporation.net. Certified B Corporations also amend their legal governing documents to require their board of directors to balance profit and purpose. The combination of third-party validation, public transparency, and legal accountability help Certified B Corps build trust and value. B Corp Certification is administered by the non-profit B Lab.”
So what are the most vivid ESG short sale stories? In many cases, while the sustainability fad is the crux of short targets’ claims and the driving force behind their ability to sell those claims to sophisticated investors, the stories come down to plain ole, boring, traditional fraud. The tale of electric truck company Nikola featured a startup CEO with contentious past of business partners/investors and romantic partners (i.e. sexual assault claims), former Nikola CEO Trevor Milton is now indicted on fraud for having made false claims—including a video purporting to show the company’s prototype under power when it was actually rolling downhill without a drivetrain—and misrepresenting the “billions and billions and billions” of dollars (his words) in committed truck preorders when there was, in fact, only one far smaller potentially binding order.
- Another target of short-seller Hindenburg Capital, Canadian plastics recycler Loop Industries, had a technology that was allegedly “technically and industrially impossible” to scale.
Less clear a fraud, but with price tag in the billions, is aforementioned ESG investment manager DWS, which Deutsche Bank spun off by publicly listing a fifth of DWS’ shares: consider the reputation damage to the company. Criticized for greenwashing by a previously terminated Head of Sustainability-turned whistleblower, DWS in August 2021 protested that they have always been clear about their ESG investing criteria (though on governance, how they left German fintech debacle Wirecard in an ESG fund after the company was the subject of fraud allegations is an eyebrow-raising question). Nonetheless, the company is the subject of German and US regulatory investigations, was heavily penalized, and the stock has yet to recover.
We calculate DWS’s ESG misadventure at $1.3bn (loss of capitalization, with conviction on 38 times prior day’s trading volume)—serving as one of the best examples of the market’s “fine” for a fund manager’s inadequate ESG due diligence. Ponder that CFA panelists breathlessly describing the “stampede” into your ESG funds. Asset managers coming to the company’s partial defense in press routinely point to the subjectivity of ESG investing writ large and the paucity of decent data upon which to make sound investments as an issue affecting all players in the space.
- ·The Financial Times quotes Catherine Howarth, chief executive of ShareAction, the responsible investment charity: “asset managers’ credibility on ESG investing ‘needs to be tested to the nth degree … I don’t think DWS is the worst out there by any means … If DWS has this problem, then a lot of other asset managers have this problem. I don’t think they were an outlier or a total pariah there — lots of others [asset managers] were doing something similar.’”
This makes the recent IOSCO efforts and recommendations even more important. The International Organization of Securities Commissions, recognized as the global standard setter for the securities sector, separated its work into three areas: sustainability-related disclosures for issuers; sustainability-related practices, policies, procedures, and disclosures for asset managers; and ESG ratings and data providers. IOSCO relied on surveys of members, as well as a repository of greenwashing case studies, for its recommendations (bear with us, we read it so you don’t have to). The 70-page IOSCO report uses the word “greenwashing”—which it defines as “the practice of misrepresenting sustainability-related practices or the sustainability-related features of investment products”—84 times; clearly a focus of securities regulator concern. Unsurprisingly, the bottom line includes a need for standardization of terminology as well as significant improvement in quality, reliability and accuracy of ESG data disclosures by corporate issuers and third-party data providers. IOSCO’s strong endorsement of the Michael Bloomberg chaired Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD) and its sustainability framework, plus the group’s encouragement that the International Financial Reporting Standards Foundation’s International Sustainable Standards Board adopt the TCFD Framework, gives a strong road map for the origin of this improvement and standardization.
According to a recent PwC survey of the C-suite, when asked how well boards understand company ESG risks, only 12 percent of executives responded, “very well,” and over half responded either “not very well” or “not at all.” With trillions of dollars flowing to ESG as a strategy, such ignorance can’t continue. Whether by more strenuously splitting green operations and assets from brown, as Third Point proposes with Shell, or by building in more rigorous ESG data and reporting standards through regulation, clarity regarding sustainability claims should rapidly improve in coming years. Until then, as sustainability activists target companies that claim social virtue while hiding vice, vivid short selling stories should continue to emerge, and issuers would do well to painstakingly define, systematize, and publicize their ESG diligence process.