Has ‘ESG’ reached its expiry date? The term needs a rethink

As with any investment, your capital is at risk.

Siobhan Cleary is Baillie Gifford’s new head of ESG. The post gives her responsibility for coordinating the firm’s environmental, social and governance efforts.

The appointment comes at a time when ESG’s role in finance and the broader business world faces scrutiny. Critics of different stripes claim that it oversimplifies a complex range of issues, that related metrics are often contradictory, that ESG pledges sometimes amount to little more than empty ‘greenwashing’ PR exercises, and, moreover, that it distracts from the task of achieving superior returns.

Baillie Gifford has long believed that environmental, social and governance matters can affect companies’ long-term financial performance and that having a better understanding of ESG issues helps us achieve strong long-term returns for our clients. But as Siobhan discusses with the head of our Clients Department, Nick Thomas, the term itself has become problematic.

Nick Thomas (NT): Siobhan, you’re from South Africa and were head of strategy and a director at the Johannesburg Stock Exchange before coming to Edinburgh. What brought you to Baillie Gifford?

Siobhan Cleary (SC): It was the post-Covid period. I’d done a master’s degree in climate change, was working with the United Nations and was doing some corporate consulting.

One day, on a train, a headhunter contacted my husband. She had found his profile on LinkedIn and seen that he’d written reports on sustainability. She was trying to put him forward for a job, but after about five minutes of chatting, he stopped her and said, “I’m not who you’re looking for, but I’m sitting across the person that is,” and handed me the phone. Next thing, I was interviewing with Baillie Gifford.

I have to confess that at the time, I didn’t know the company that well. My work had been in and around the finance sector, but not specifically in asset management. Baillie Gifford is one of those firms that’s incredibly respected within the industry but not necessarily that well-known outside.

When I later told people more familiar with the firm that I was joining, the amount of admiration they showed reinforced that I’d made the right decision to come here. And, when I met some of the partners and the people in the team working on environmental, social and governance matters, it again confirmed for me that they were thoughtful people who took this seriously and really wanted to do this thing that we call ESG well.

NT: You recently became our head of ESG, could you tell us a little bit about what that involves?

SC: We’ve got quite a big team, about 40 members of staff. Some are embedded in investment teams, helping to do company analysis. A central group advises investment teams on shareholder votes. There’s a dedicated Climate Team, underlining the topic’s importance to most if not all of our holdings and many of our clients. And we have a Data Team that helps with data analytics and all client reporting.

My job is to ensure that they all function well and that we continue to evolve in line with our clients’ expectations and support our investment teams.

NT: It’s a large and varied team you’re now responsible for. Focusing on the investment process, can you contextualise how we integrate ESG considerations into our investment decisions?

SC: Essentially, individual investment teams incorporate ESG factors as they believe it makes sense given their particular investment philosophy and style and the specific company that they’re looking at.

Most teams will have embedded ESG analysts working alongside the investors. In addition to making sure we understand environmental, social and governance issues before and after we buy a company, they’ll also do deep dives into areas that they think are particularly tricky or if they just want to understand the topic better. This work can identify areas where we need to speak with or otherwise influence a company to encourage improvement or to support it through a difficult time.

Our Climate Team has provided analytical frameworks that it has developed to help the investment teams understand the potential impacts of climate change on their holdings and their portfolios.

But really, it’s up to every investment team to work through what it believes the relevant ESG issues are, given the particular companies and other assets it is looking at.

NT: The term ESG was first popularised in 2004 by a UN Global Compact report: Who cares wins. How well do you think the concept has held up over the intervening two decades?

SC: As we all know, the term has become quite politicised – challenging. It’s become a little bit of everything and nothing. Over the years, it’s become one of those terms that everyone sort of reads into it what they want it to be. And that’s created some problems.

In the investment world, it was initially framed as this idea that companies, in order to thrive, had to consider their material environmental or social considerations and factor those into how they conducted their operations. It’s a little bit weird that G was in there ever, because, in a certain sense, governance underpins effective management of companies generally, including oversight of environmental and social issues.

But over the years, it’s become something that those who don’t like the idea of investors looking at environmental and social issues sort of want to push to one side and say: “Well, it’s got nothing to do with financial returns.”

And it’s also become something of an article of faith that people hang on to and say, yes, every issue is financially material in some way. So we’re probably at a point now where we’ve got a reckoning around the concept and a need to start to be a little bit more precise about what it is we mean.

NT: We’ll dig into that a little bit more. So if you think that the term ESG has been quite loaded with conflicting interpretations, is there something we should use instead that would be a more constructive framework?

SC: I’ve been going back and forth on that because, obviously, my title is head of ESG. And maybe we’ll have to change our view on that. But just to start. We don’t or shouldn’t ever be talking to a company about its ‘ESG performance’. We should talk to it about how it’s managing employee relations, how it’s thinking about health and safety and its operations, how it’s thinking about supply chains. All of those fall under the header of ESG, but you can talk about the specifics without resorting to jargon and probably should be in any event. So come back to me on the term in six months’ time.

NT: The investment community is experiencing a lot of polarisation around sustainability. The fundamental debate seems to be whether investors should at all consider a company’s impacts on society or on the environment in matters that do not immediately relate to financial gain, and maybe it is a time horizon question. We’re finding this difficult: Baillie Gifford is a very client-focused organisation, but we have sets of clients that want quite conflicting things. How are we going to navigate this challenge?

SC: A few things in there. Your point around time horizons is exactly right. If you think about environmental and social factors in the company’s performance, there are certain things that will be immediately relevant. So if water is an input into a company’s manufacturing, then availability – access to water – and the tensions or otherwise that access creates with communities is going to be a directly relevant consideration. So that’s a clear area where this is a relevant factor.

But over longer time horizons, the kind of time horizons we invest in, the impact that a company has on an environment and the impact it has on society might become material even if it’s not immediately material. We have to factor in those impacts. We may not make different investment decisions once we’ve thought about it, but we have to at least think about it. So that’s the time horizon question.

When you get into this idea that clients want different things from us, I would suggest that the bulk of clients actually want the same thing, which is to deliver them investment returns in accordance with the mandate that they’ve given us. We’re very clear on that, and we understand that. What we do have, however, is some clients who themselves are thinking maybe over even longer time horizons than we are and are really thinking about the contribution they can make to addressing some big challenges like climate change. And they want their managers to help them in regard to that.

Then you have some clients on the other side who perhaps have a much narrower framing and a much narrower understanding of fiduciary obligation. And they’re saying all we want you to focus on is investment returns. What’s really important is just being clear with clients about what their expectations are and then making sure that you’re managing in accordance with that. But also being clear about what your own investment philosophy is, and how we think about these things, which I think we have tried to do very much, certainly as long as I’ve been here.

NT: One phrase I’ve heard us use internally, which helps to make sense of this topic, is social licence to operate, which you’ll be familiar with. What we’re saying is our investment time horizon is five to 10 years – we need to think about the negative effects that the company could have on its environment or its stakeholders, and then how that will come back to it and affect its financial performance. So it’s saying how you treat people you’re involved with affects your own business performance. Does that help?

SC: That’s exactly right. It’s this idea that companies don’t exist in a vacuum. They exist in a society, in a community. They employ people from the community or around the world. They use environmental resources. They impact environmental resources. All of those things taken together will influence the long-term success of the company. So the company’s social licence to operate is dependent on how it thinks about those relationships that it has.

You mentioned at the start that I’m from South Africa originally, and one of the things when we moved to post-apartheid democracy in ’94 was a very clear understanding about exactly this idea. We called it a social compact at the time, but the idea was that the collective wellbeing of the country was dependent on government, civil society, trade unions and companies working together and recognising the role they had to play for that collective future.

You find the same idea, and it will play out in different ways: companies that ignore the impacts that they have on the environment, on society, they’re probably not going to be great investments, certainly not over our time horizons and probably not the time horizons of many of the clients we invest on behalf of.

NT: Staying with complex, difficult topics: last year, we exited two climate-related bodies – the Net Zero Asset Managers (NZAM) initiative and Climate Action 100. To me, our membership seemed to be partly about signalling a stance on the climate and partly about working with other investors. So, what difference has our exit made?

SC: It’s important to be clear the exit hasn’t changed what we do internally. We continue to analyse where companies are positioned relative to the climate and energy transitions and what the implications are of those transitions occurring in an orderly or disorderly fashion. That analysis continues, and we are engaging with companies to better understand how they’re thinking about climate, how they’re adapting to climate change. And where appropriate, we will encourage companies to be more ambitious in what they’re doing.

Obviously, when we withdrew from those organisations, the opportunities we had to share expertise with other parts of the industry fell away in that setting. But again, we are finding other ways to exchange knowledge and hopefully contribute to improving industry understanding of these issues. We’ve done some fantastic work around climate scenarios, which we’ve shared with many of our clients and also made available to other asset managers, regulators, academics and other interested parties via our website. We’ll continue to develop that.

We’re also about to start work on the potential financial losses arising from extreme weather, rising sea levels and drought, causing physical damage to property, infrastructure and ecosystems – and what investment opportunities there might be in making those elements more robust.

We’ve also done some work on executive remuneration and spoken to others in the industry who are also thinking about this topic. So those are the avenues where we can hopefully continue to contribute.

NT: Those sound like ideas that are a bit different and maybe additive to what the broader industry is doing. But how does that help us to deliver better returns for clients?

SC: Ultimately, all of this is about understanding how prepared companies are for big, long-term trends; about identifying where new investment opportunities and challenges might come from; positioning our portfolios to deliver strong returns. It’s about doing the right thing for our clients.

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