Wealthy families already know they must look beyond ESG to their ‘legacy’

You’d be forgiven for missing the news last month that the new UK chancellor, Rachel Reeves, has brought forward the introduction of regulation for environmental, social and governance rating agencies. From next year, firms evaluating the ESG credentials of companies will be regulated by the Financial Conduct Authority.

And, while the continued development of ESG regulations is unlikely to have featured in earnest summer conversations on the French Riviera, it does indicate the UK government’s intent to push for transparency in an oft-confusing sector. But does it really matter to wealthy investors?

The problems with promoting investments under the ‘ESG’ tag are clear: the three characteristics that make up the acronym cannot be regarded as defining a single asset class — like, for instance, real estate — and notions of what constitutes good governance, social responsibility, and environmental protection will vary from person to person.

There is also disagreement over the best way to invest in line with your sustainable beliefs — whether to divest from companies that do not uphold them and thus starve them of funding, or to own these so-called ‘brown’ stocks and use your power as a shareholder to lobby the company to change its ways. In the absence of a uniform approach, wealth and asset managers have found themselves overwhelmed by the amount of data they need to collect, analyse and report, “especially given the legal and reputational risk of misreporting amid evolving regulations”, points out Emily Pilsworth, chief executive of ESG Stream, a data and reporting platform.

ESG ratings for companies and investment funds were intended as a way of addressing some of these problems. However, they are not without their own issues.

Investors cannot consider any of these ratings — which are just one of many tools available to gauge funds’ sustainability credentials — as in any way objective.

Rating agencies collate tens of thousands of different data points on every company in the economy, then decide which are the most important. “It’s much more an opinion about the range of different characteristics of a company,” explains James Alexander, chief executive of the UK Sustainable Investment and Finance Association, an industry body.

This often means that different rating agencies come up with different ratings. To most of the industry, this is not necessarily a problem. But to investors and money managers, it makes it necessary to dig into the methodologies of the ratings, and work out which of them best align with their own sustainability priorities. It is just not possible to look at the ratings on face value.

Being aware that ESG ratings are not the same as credit ratings is equally as important. While the latter is a measure of how likely a company or jurisdiction is to repay a loan, an ESG rating does not as easily translate into a guide to risk or future success, because it cannot predict liquidity events, the financial health of an organisation, or its ability to repay debt.

In addition, as ESG ratings do not have a long record, it is still unclear whether a company’s sustainability credentials impact its performance in the future.

There’s one other issue with these ratings: they only apply to public markets. This was not a problem in the early 2000s when private markets were still relatively small. But global private debt markets are now estimated to be worth about $2.1tn, according to the IMF. And ESG ratings are of no help here.

In spite of all these challenges, high net-worth individuals are finding an alternative route through the confusion.

“Our clients aren’t really talking about the ratings as much as the asset managers we work with,” explains Harlin Singh, global head of sustainable investing at Citi Private Bank. Among these investors, there has been a subtle shift towards the true impact of their investments as a whole, she observes. 

Singh adds that they are going further than just investing under an ESG banner, and looking to see how investments can work in complement to their philanthropy. “Clients want a legacy,” she says.

This trend does not seem to be going away. Although it is commonly thought that only younger generations are savvy around sustainable issues — and they have to push their parents to keep these issues front and centre of their portfolios — the reality appears to differ. While millennials and Gen X are more engaged in the particular methods that can be used for sustainable investing, their parents’ generation is equally engaged.

According to wealth managers, most wealthy clients look at all the companies they invest in through a sustainability lens, rather than allocating a specific part of their portfolio to these principles. And they do so not only for philanthropic reasons. “[This] allows them to identify opportunities that will deliver greater returns or be better risk managed,” says Singh.

For those catching up with the intricacies of sustainable investing, the increased transparency promoted by new regulations will help. But there is still work to be done.

Sally Hickey is a reporter at The Banker

This article is part of FT Wealth, a section providing in-depth coverage of philanthropy, entrepreneurs, family offices, as well as alternative and impact investment