ESG – News ESG AND ETFS: TO BP OR NOT TO BP
Passive ESG funds are getting more and more popular, but questions remain over how sustainable they are. Patrick Ei- sele & Mona Dohle take a look.
One of the key themes of March’s PLSA conference in Edin- burgh was the growing onus on trustees to comply with respon- sible investment standards. Factoring in the material risks of cli- mate change is increasingly seen as a fiduciary duty, as the updated rules for the Statements of Investment Principles highlight. At the same time, a growing number of investors are seeking ex- posure to the asset class by investing passively. Indeed, more than half of European investors plan to implement their ESG strategy over the next five years using predominantly passive funds, a survey has discovered. Yet a detailed look at passive strategies for European equities shows that such an approach does not always create a sustaina- ble portfolio, highlighting the need for pension schemes and their asset managers to employ engagement specialists.
How green is your passive fund?
The universe of passively managed sustainable funds has in- creased exponentially. Morningstar lists 113 ESG-compliant ETFs in the UK for investors to pick from, almost 70% of which have been launched in the past two years. One advantage of this mushrooming market is that the average cost of newly launched funds has plummeted to 24 basis points from 64 in the past 13 years. Most of these new sustainable equi- ty passive funds pursue a best-in-class approach, where better performing firms have a higher weighting in the benchmark in- dex. But overall, they continue to have a relatively low tracking error to a purely market-cap based index fund. This raises the question of how sustainable those funds truly are, particularly when it comes to climate change. Virtually eve- ry European equity ETF (with the exception of ex-fossil fuel funds) lists Total, a French oil and gas firm that booked a $200bn (£152bn) profit last year, as one of their main holdings. In some cases, it is even one of their top five positions. This highlights the problem for passive investors who want to pursue not just financial but also sustainability targets. The commonly pursued best-in-class approach selects for each sec- tor the firms which perform better on a relatively basis. By maintaining a similar sector allocation to the standard index, the firms offering the funds aim to replicate the key properties of the index in question and ensure a relatively low tracking er- ror. Trustees do, after all, have a fiduciary responsibility to en- sure that the performance of these funds does not lag too far be- hind that of conventional indices. But to what extent does an
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investment in an oil refinery or a petrol station operator contrib- ute to reaching the two-degree target stipulated in the Paris Agreement? With a market cap of more than $100bn (£76bn) in August, To- tal is a heavyweight in the Stoxx 50 index. Similarly, oil giants Shell and BP take a prominent place in the FTSE100 and are therefore hard to avoid for passive investors who are cautious about significant deviations from the conventional index. More sustainable alternatives, such as Danish wind turbine maker Vestas, have a much smaller market capitalisation.
Controversy despite strong ESG scores The market cap dilemma allows the impression that many fund providers and end-investors prioritise a lower tracking error to traditional indices over sustainability. This is reinforced by many funds specifically referring to environmental targets and still in- vesting in fossil fuels. This is where engagement comes in with investors leveraging their voting power to make energy compa- nies change their practices, set emission-cutting targets or invest in cleaner forms of power. We cannot just stop pumping oil out of the ground, but we could use the huge profits such companies generate to fund the decarbonisation of the economy. While sustainability has rapidly moved up on investors’ agenda, growth in the investment universe is slow. Some firms have de- veloped indices with weighting towards energy consumption, for example, rather than market cap. But firms such as Total are too big to fully exclude it. Similarly, Royal Dutch Shell and BP are still the number one and number three firms in the FTSE100 in terms of market cap, making it harder to fully divest from them. Another reason why engage- ment is such an important part of sustainable strategies, wheth- er they are active or passive.
Oil giants are in low carbon indexes, but could they soon fall out these benchmarks? The crisis linked to the Covid pandemic has the benefit of hitting energy companies hard with the price of oil having fallen into negative territory at one point.
Focus on momentum One way of honouring the sustainability approach despite the inclusion of controversial sectors could be a relatively higher weighting of firms with ESG momentum, that can demonstrate progress in sustainability.
A good example of a best-in-class strategy is one that includes shares in firms that can demonstrate a positive trend towards improved ESG profiles. Those companies that have a robust ESG profile relative to their sector, as well as a positive trend in improving that profile.
It still raises the question whether a fund is justified in including companies such as Total as one of its biggest holdings if it has pledged to exclude firms from ESG sensitive sectors whose
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