JEFF: Welcome to this episode of The Flip Side. My name is Jeff Meli, and I'm the head of research at Barclays. I'm joined today by Zoso Davies, a director in European credit strategy. Thanks for joining me, Zoso.

ZOSO: Thanks for having me back, Jeff.

JEFF: Today we're going to talk about ESG investing. Zoso is part of the team that developed our approach to fundamental ESG research at Barclays over the past year or so, and this is a topic he's pretty familiar with.

ZOSO: For those who are less familiar with ESG, ESG stands for Environmental Social Governance, and ESG investing is a way of investing that doesn't just take into account the final risk and returns; it also thinks about the impact that those companies that you're investing in have on the world around them.

It's a way for investors to align their money with their morals by supporting the companies that they think operate well, and withholding investments from companies that operate in a way that investors disagree with.

JEFF: Wow, Zoso. That sounds really beautiful. Almost idyllic. And certainly, if ESG investing was accomplishing all of that, it would be an important trend, but unfortunately, I think the reality of ESG investing falls pretty short of what you've just laid out.

I think ESG investing is the finance equivalent of virtue signalling. It's a way for asset managers to window dress investing styles that they were using already in a way that makes investors feel better about generating returns and helps raise assets under management. And it's a way for companies to window dress activities that they were already engaged in to make them seem more sustainable and thus more attractive to these same investors. But I don't believe ESG investing is really a force for change.

ZOSO: I think you're selling ESG is a little bit short. Look, we're certainly in the early days of ESG investing, and there are critiques that can be levelled, and I'm sure you're going go through a few of them. But there is evidence that ESG investing is already having an impact. It's advancing the agenda of regulators, it's affecting how companies operate. I realise we're slightly at risk of perpetuating that Europe/US divide, but I think there is a significant difference of views across the Atlantic.

JEFF: Well, just to be clear, I'm not saying I don't care about ESG, just that I'm sceptical it's going to achieve its lofty aims. But fine, we'll inject a little transatlantic tension here into the podcast. That's always nice. Let's get into it.

ZOSO: Okay. I'll set off. To me, the most obvious sign that ESG investing is important is simply the growth in AUM. ESG's been a concept in European investing for many years, but the growth in AUM constrained by ESG strategies really has started to accelerate over the last two to three years, and that's in both the US and in Europe.

For example, ESG-labelled corporate bond funds have seen inflows equivalent to more than 250% of their starting AUM since 2018, so they've nearly quadrupled in size, and that's in both the euro and the dollar market. These numbers are even more stark for equities. ESG-labelled equity funds have seen 180 billion of inflows in a period where the rest of the equity industry has seen well-catalogued outflows. And even within equities, more than twice as much money has gone into ESG strategies in the US as has gone into these strategies in Europe.

JEFF: Well, on the one hand, Zoso, the growth in AUM is undeniable, so those are just facts. But on the other hand, although funds with the ESG label have grown, I don't think that means that a specific investment style itself is gaining prominence. So I think we need to talk about how companies get rated on ESG.

ZOSO: Oh, dear. I think we're opening a familiar Pandora's box.

JEFF: Yeah, your work, Zoso, has actually highlighted the large amount of variation in ESG scores. So there's a number of providers out there. They rank companies on a large number of ESG factors. Usually, a company would get a score on the E for its environmental impact, an S for its social impact, and a G for its governance, and then those three scores get aggregated into one grand score. But there's basically no consistency beyond that. Assigning the scores is completely subjective, so much so that the same companies can actually get wildly different ESG metrics from different providers.

Then you add another wrinkle which is you're supposed to compare across companies, but much of the differences across companies is actually due to different levels of disclosure. So companies need to make a lot of ESG information available to these score providers, and those that make more available will tend to score better than those that make less. We see that when we compare scores across US and Europe where European companies tend to disclose much more of this information.

And all of that is just from the providers that sell signals out in the public. A lot of institutional investors who manage ESG funds use their own proprietary methods to score companies, and we have no idea what metrics they're using.

ZOSO: That's completely true. ESG scoring methodologies are still developing. New scores are coming out every day. New scores are being developed. This is very much the early days of ESG data generation. And we've had these conversations, you and I. We've had them with other research colleagues. We've had them with the data providers themselves. There are a couple of points I just want to challenge you on.

First of all, your point around disclosure. Well, disclosure is a changing behaviour, and that was one of the things we were looking for, and disclosure is the start point for any of those scoring methodologies. We can't score things we can't measure. So that is a necessary step. And I wouldn't say that there's zero consistency.

I think there are issues, but I think we need to be more specific because all of this data is around issues that investors feel are relevant to ESG. Well, the issue is, we have no agreement on which ones are the most relevant and how to weight them.

Some issues are fairly universally accepted. For example, diversity of board representation. That should be important for pretty much every company. Others are more specific like waste water policy. What we are seeing is a gradual progress towards common standards.

JEFF: Look, some providers rank companies on an absolute scale. That means they're comparing companies on the E, regardless of what industry they operate in. Others create scores that are done relative to a specific industry. Because of that, you could end up ranking the same portfolio as either high or low on ESG, depending on how you measure it.

So recent research from our quantitative portfolio strategy group looked at US domicile ESG equity funds. What we found was a massive variety in ESG scores across these funds, including many of them which ranked below the ESG score of the index. The one commonality in all of this was that ESG funds tended to have higher management fees. That seems to me like an indicator that there might be some window dressing going on.

ZOSO: True, but despite all of this noise and all of this variation, QPS also found out that there's a signal in there that's useful for investors. For example, governance scores give corporate bond investors by giving them an extra predictor of downgrade risk. That helps them build portfolios that are more robust and generate better returns over the long run. And the disparity between providers is also an indicator in its own right.

JEFF: And those results are very interesting. Knowing that the G score is an indicator for how well a company is run is definitely important insight to a portfolio manager and a real reason to pay attention to the score.

Similarly, I'm sure that there is a lot that analysts can do to better understand the risks and returns of the companies that they're covering using all of the disclosure around ESG metrics. Transparency is definitely better, and I think that if what ESG investing does is force companies to disclose a lot more about how they're operating, there is something there.

But this leads me to another point I want to make about how this isn't really ESG investing. That's regular investing. That means you're just trying to generate high returns. You're looking for signals about how well a company is likely to perform in the future. You just happen to be using ESG-related inputs, rather than traditional accounting or financial metrics.

ZOSO: Okay. There's a difference between ESG investing, where we're trying to encourage certain corporate behaviour, and what I call ESG factor investing where we're trying to make money by extracting signals from ESG-related information. That's one of the reasons that we have three pillars at Barclays, to try and tease apart these separate motivations and these different ways of using the information. That isn't the same as window dressing, and I think it's very important to look through the scores to understand what we're trying to achieve.

Take, for example, a fund that focuses entirely on energy companies moving from fossil fuel extraction to renewable generation. You're going to buy a lot of oil companies, energy companies. That fund is going to have a poor score, a much worse score than a fund that only invests in FAANG and other software company. But if the companies you invest in decarbonise, shift from oil production to renewable generation, that's going to massively reduce their greenhouse gas footprint, and that's going to have more real impact than investing in your highly rated software fund.

This actually brings us to a point that is under discussion flagged by some of our colleagues in a recent note on coal assets, which is: what are we supposed to do with polluting assets? Do we just get rid of them? The problem with just getting rid of them is that someone still owns them.

They're still productive assets. And when you completely divest them from your ESG portfolio, they get owned by investors who don't care about ESG who have active opted out of ESG, and that's literally the worst possible outcome from the perspective of an environmentalist. So consensus is shifting away towards actually owning these companies but supporting their transition to a greener business model.

What I'm getting at is the idea that there are a variety of goals and that the funds reflect these different goals, and that's a good thing, and that also means you don't get a clear signal from a single data point like what's its ESG score.

JEFF: Well, I think the most favourable interpretation of this from the standpoint of an investor looking at ESG would be that that investor needs to dig really deep into what a fund is actually doing to try to figure out whether that fund actually aligns with that investor's ESG goals, at least in the current world where we are absent structure on what ESG investing means.

ZOSO: Yeah. Look, investors should always do their due diligence on funds that they invest in. I do want to come back to your point on the long-term relevance of ESG, this concept of changing corporate behaviour. I think that's really what's going to define the success or the failure of ESG as a movement versus quote/unquote window dressing.

JEFF: No, I agree with you there. I think the ESG strategies being implemented by any individual investor really aren't the focus. It's really the effect on companies that's actually going to matter. I just have a hard time seeing how such divergent strategies being employed by investors can aggregate up to an effect that's anything more than a jumble.

ZOSO: I think the magic is when you start to get that consensus, and you start to get broad agreement. Take, for example, coal. Coal is right up there as one of the sectors that's almost universally accepted as being a bad ESG sector. And what we've seen is that coal exclusions have grown quite rapidly across different types of investors, across different parts of the financial services industry, and the response there has been from diversified miners to start shedding coal assets.

I mentioned that our colleagues have done a report on coal miners, and what you're seeing are broad commitments to, for example, exit South African coal mining activities, to cap their production of thermal and metallurgical coal, and you're also seeing, on the flip side, rapid shifts from utilities away from coal fire generation towards renewable energy and greener energy mixes.

And, of course, not every single ESG-driven change requires a complete business redefinition. Some of these are easier and low cost. The comments around board diversity, disclosing gender pay gaps, these things don't fundamentally alter the footprint of your business, but disclosure creates pressure for change, and many of these changes are real and positive.

JEFF: Zoso, I'm not so ready to chalk this up to ESG investing. A lot of what you've just described is companies getting ahead of changes and regulation. Governments change the rules, forces companies to adapt. Some of these adaptations are low cost, like increasing the diversity of boards. Others are costly, like exiting profitable coal mining businesses.

But regardless, companies that can anticipate or otherwise efficiently react to the changing rules are going to outperform. So we have a world where governments are getting more aggressive about how companies operate. I'm not sure that's really ESG investing. It's regular investing in a world where the rules are changing in a way that's related to ESG. 

So we know coal-fired power plants cause utility companies a lot of headaches as emission standards globally tighten. We know that the cost of alternative fuel is falling, and regulators are encouraging utility companies to transition into alternative fuel in all sorts of ways. Any investor in utilities or any utility company itself has to be aware of these issues, whether they're formally ESG focussed or not.

ZOSO: Regulations do affect company behaviour, but they don't appear from nowhere. Regulations come about because of protests, political pressure, petitions. They are a reflection of societal will. And, taking a big step back, what's ESG investing about? It's about bringing some of those societal norms into financial markets. It's about taking some of those ideas around what a good company is and trying to embed them into financial markets in a way that financial accounting hasn't been able to do so far.

So I think it's a feature, not a bug, that ESG investing does often end up pretty well aligned with regulation. Does that mean that ESG investing is redundant? I don't think so because I think you are able to amplify the signal from regulators, and not only that, you're allowed to move beyond the competencies of national regulators.

So let's take European autos. European auto market is arguably one of the most highly regulated in the world. The regulation levels are so stringent that some companies even felt the need to cheat on emissions tests in order to meet the standards. They thought the risk of cheating was a better business decision than the cost of developing new electric vehicles, new drive trains, and they got caught and fined. Fine, but that only affects European autos. In fact, we see it embedded in their ESG score. European automakers have high environmental scores because they have high-quality fleets today, but they have low governance scores because they've been caught cheating.

But if that becomes embedded into the financial markets, it's not just a one-time fine, and that internal calculus of the risk of being fined versus the costs of development changes heavily in favour of cost of development because now you're risking the entire cost of capital all the way from equity through your entire debt cap. And if those standards are applied at the investor level, they're not just applied to European autos; they're applied to global autos; they're applied to every auto company that that investor invests in.

So I think it can really amplify the impact of regulation, and it sort of creates this like one-two combo where the regulator steps in and that is built up and backed up by investor behaviour.

JEFF: Again, Zoso, that sounds great in principle. And I agree with you that the only way that investors are really going to quote/unquote change company behaviour is by changing the cost of capital. So I agree. If it becomes more expensive for companies with poor ESG scores to raise funds, or cheaper for those with good ESG scores to raise funds, then all of this is going to have an effect.

Just to be clear, what we're talking about here is two companies which generate the exact same risk-adjusted cash flows but differ solely on ESG grounds would have to have securities that are priced differently in the market. Then fine, the cost of adjusting your business model to improve your ESG score would drop, and a profit-maximising company would take into account the change in the cost of capital when assessing how to respond to these sorts of various pressures. I agree.

What I don't see is evidence of that. Maybe ESG is still too small, and there's just not enough money out there to actually force real changes in the cost of capital on ESG grounds. That's possible, but all of that AUM growth that you cited earlier means we ought to find it someplace, and yet we have really struggled to find any evidence that the cost of capital really adjusts in the way you've just laid out.

ZOSO: Okay. You've got me. The evidence to support the theory of cost capital adjusting is pretty thin. Take, for example, green bonds. A year ago, we found that green bonds trade exactly like any other bond. Why? Because in most cases a year ago, the investors didn't know they were green. We estimated that nine out of ten green bondholders were just bond investors. They were not specialist green bond investors.

The green label on the bond was pretty meaningless to them. They just bought bonds because they thought they were well valued and, therefore, the pricing of those securities reflected their preferences, not the preference of specialist green bond investors. But that's starting to change because of the AUM flowing into these strategies that you mentioned. Green bonds are now interesting not just to specialist green bond investors but really to any ESG investor. Having a green bond versus a brown bond is an easy way to signal that you are taking these factors into consideration in your investment decision.

Now, look, we can have a whole separate conversation about whether buying a green bond instead of a brown bond from the same company, particularly in secondary markets, actually achieves anything, but it shows that these bonds now, have a scarcity value, and that is starting to create a small premium that we were ready to measure a few months ago. And that premium could grow if the number of investors pursuing these strategies continues to grow.

JEFF: Let's just be clear what you're saying here. You have determined that there is a very small premium for something that is explicitly labelled as a green bond in Europe where every asset manager purportedly cares about ESG. It doesn't sound all that hopeful to me. Take that to the US where I remain sceptical that investors are really interested in accepting lower returns for better ESG investments.

ZOSO: But US asset managers are interested in winning European mandates, and these almost universally now need ESG overlays. This is what I'm talking about, about globalising regulations and norms, and also why the rapid adoption of ESG standards by major investment institutions, coupled with these large inflows into strategies, is such a watershed moment in my mind.

I completely agree with you that, up until now, ESG investing just simply hasn't had enough dollars behind it to impact financial markets. But we're seeing the money flow in. As you mentioned, the issue, at the moment, is that money is flowing in a fairly undirected way. And this is where I think greater regulation and standard will be the next step forward, because if we can funnel that money into a fewer number of better defined ESG strategies with better standards, better standardisation, then you're going to start seeing enough money pointing in one direction, then it really does have the potential to shift the cost of capital in the way that you would like to see.

And while that hasn't happened yet, again, we're seeing movement in that direction. For example, in the EU, we've seen the development of a green bond taxonomy, and there's so much further to go.

If I could have one concluding point here, it's that we're at the start of ESG investing. We haven't solved these problems. We're only starting to look at the practical issues about how to measure and implement these ideas.

JEFF: Well, that's certainly true, and that's why we're so focussed on this topic in research at Barclays, including our most recent report from our quantitative portfolio strategy group, entitled ESG Funds, Looking Beyond The Label. That report compares ESG and non-ESG equity funds and offers some policy solution to help the ESG market mature. A synopsis is available publicly on Barclays.com/ib. Of course, clients can log into Barclays Live to read the full report and all of our latest systematic, thematic and fundamental ESG research.