Why ‘Negative Screens’ are Bad ESG

This action will see BHP reduce its fossil fuel exposure to ~9% of revenue. It’s not unsurprising that the sale takes BHP’s hydrocarbon assets to the point which most ESG funds consider as an allowable threshold for revenues from ‘bad’ assets. Our issue is that this is merely the shifting of assets to another owner, which is not the intention of establishing ESG criteria and it isn’t a win for the environment.

The reason ESG is an important force in the investing world is that it is driven by investors’ belief that their money can be used to do good, to help improve the world. The investment industry’s response to this moral imperative for ‘doing good’ has become just another risk to be managed to maintain funds.

By casting climate change in terms of risk, it transforms this existential moment to a mere ‘input’ where, if you eliminate the risk, you (by proxy) eliminate the issue. We contend that this is dangerous and leads to the kind of fruitless, in terms of GHG emissions, corporate action where assets are shifted, not extinguished.

This is, we believe, bad ESG.

Good ESG, instead, has as its defining purpose: ‘change’.

Change, however, is hard. It takes time, effort and application. To begin with, a good investment manager will need to understand the business in its entirety – from what it does, to how it does it, to why it is done, to working out how long it can be sustained. By means of this analysis, the investment manager can form an insight about how ‘good’ the organisation is and where it can improve. Once this exercise has been completed, investors, as part-owners, are able to begin a dialogue with management. A dialogue, which is always a two-way street, can hopefully lead to change.

Bad ESG chooses to short-cut this process through applying so-called ‘negative screens’ as if, by not investing in bad actors (by means of non-engagement) those organisations will change their ways (for the betterment of our world).

Negative screens are the current prevailing methodology deployed in the world of ESG investing: as a solution it is simple, easily observed and, as evidenced by the above example, ineffective.

The problem is that negative screens are not moving the world forward, they are, in fact, doing nothing – the solution on climate change is not as simple as pivoting (overnight?) to renewable energy and shuttering coal mines and petroleum installations: the lights would go out. Negative screens that exclude polluters are, ipso facto, bad ESG.

Now, we are not suggesting that good ESG companies are bad investments (clearly, they’re not, though it does depend on what you pay for them), it’s more the case that to solve the world’s environmental issue, it’s just as important that we encourage all companies to be better.

What does good ESG look like?

At Platinum, we emphasise a balanced approach, looking at what both detracts and contributes, and combine this with engagement rather than divestment.

Two months before BHP divested their petroleum assets, there was another event involving BHP which caused much ESG consternation: Glencore, one of the world’s largest mining companies, bought its junior partners’ interests in one of the world’s largest open-pit coal mines. BHP was one of those partners.

This, in our view, is a positive ESG action. But how could buying (more) mining assets, thermal coal ones at that, make sense from an environmental pollution perspective? How could this be an ESG-positive decision?

“Disposing of fossil fuel assets and making them someone else’s issue is not the solution and it won’t reduce absolute emissions,” said Glencore’s former CEO, Ivan Glasenberg.

As Glencore has often argued, coal divestment is “pointless” – they view coal mines as a source of cash to be re-invested into the production of the raw materials, such as copper, cobalt and nickel, which will be needed for the world to shift (dramatically) to cleaner forms of energy, such as wind turbines. How can we ensure this? By targeted and thoughtful engagement ensuring that Glencore is held to account; Platinum, through being an (active) owner of Glencore, is doing exactly that.

Furthermore, Glencore pointed out that with full control it now holds the keys on how to reduce the life of the mine, whereas with having to manage other partners, Glencore ran the risk of the mine-life actually being extended.

The next part of this transaction is that, as investors, we can ensure that Glencore makes good on its promises. How can investors ensure Glencore ‘stays honest’? It’s called engagement, of being part of their journey, no matter how reputationally uncomfortable that might be in the short term. While it is both glamourous (to a point!) and exciting to be part of building the new renewable energy economy, the success of this rests on combining this with helping the bulk of the economy adapt and transition – to make the current ‘bad’ players into tomorrow’s ‘good’ operators.

So, not only is the outcome potentially ESG-good it was also a courageous thing to do, for it flies in the face of the “shut all coal mines” orthodoxy.

The seductive thing about negative screens is that they’re easy to explain (“I won’t invest in this because it’s bad… ”) and they’re emotionally satisfying, as it plays to our negativity bias and therefore, signals (very simplistically), virtue – of doing the ‘right’ thing.

The problem is that negative screens reduce something very complex and long term (for instance, our environmental concerns and how we better our situation), to something so simple it’s, at best, a lacklustre response and, at worst, destructive.

And yet, when looking at ESG funds, the exclusionary (negative screen) style has dominated:

Fig 1: ESG fund flows continue to be strong across strategies
Quarterly flows (US$ bn; LHS) and trailing twelve-month growth (RHS) by ESG Strategy

Q2 2021* only through May 2021 – Source: Morningstar, Goldman Sachs Global Investment Research.

We ended up here largely because the investment industry has, in the recent past, focused only on short-term returns (and then done so in the most simplistic of ways through measurement against some nominal index). Consequently, the industry has lost touch with its purpose – to generate wealth  – and now, through its focus on excess return (alpha) it is incapable of deepening its offering in the form of generating wealth worth having.

Is there proof? The chart below says it all:

Fig. 2: Reasons why firms adopt sustainable investing practices. What do you believe are the primary reasons firms adopt sustainable investing practices? (n = 300)

Source: Morgan Stanley Institute for Sustainable Investing and Bloomberg.

Though it might be a little unfair, but this chart would suggest that the investment industry’s response is not about recognising what our customers intend to achieve and more about “what is the lowest hurdle we can get away with?”.

We would go further — the current offering of the majority of ESG funds/ETFs actually are complicit in actively promoting cynical ESG behaviour, and potentially, are guilty of ‘greenwashing’. At the beginning of this piece we pointed out the convenience of BHP’s 10% fossil fuel revenue threshold – by this mechanism ESG funds/ETFs ensure they still get to partake in the upside if there is a lift in commodity prices (and stay near their index comparator). The 10% materiality threshold therefore actually encourages companies to sell their GHG-intense assets down to a nominal threshold – paradoxically, this approach encourages poor behaviour.

We believe that a thoughtful long-term investor has an ability to be part of creating a better world through engaging, enabling (an investment supports an organisation in developing new ideas, processes and products) and contributing in the future, which is yet to emerge. Good ESG is patient and encourages new technologies whilst recognising that nobody can be left behind, and thus, will therefore also be part of transforming legacy ‘smokestack’ industries.

Solving the complexities of the climate isn’t about taking sides or being non-inclusive, it’s about harnessing all the technology, know-how and skill we can muster.

That’s ESG: done responsibly.