26th Annual Financial Markets Conference Transcript: Policy Session #2: ESG and Money Management - May 10, 2022

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Policy Session #2: ESG and Money Management

Investment managers face increasing pressure from clients and governmental organizations to apply environmental, social, and corporate governance (ESG) standards. However, this raises practical issues for those who invest. Presenter Laura Starks, moderator S.P. Kothari, and discussants Lukasz Pomorski and Mikhaelle Schiappacasse address issues that arise for investors who want to implement ESG principles.


S.P. Kothari: Good morning, everyone. We are about to begin the next session, ESG and Money Management. Yesterday you listened to the more cerebral session on ESG, which was dissecting stock returns. Today we are going to delve into the somewhat more practical issues of ESG and money management. Investment managers face increasing pressure from clients and government organizations to apply environmental, social, and corporate governance standards. It is in that context that we are going to talk about ESG and money management.

I have the pleasure of introducing three amazing speakers. Laura Starks will be the presenter. She has a PhD and is the George Kozmetsky Centennial University Distinguished Chair professor at the University of Texas at Austin, where she teaches graduate and undergraduate courses on ESG investing, so she has experience in that. Her current research focuses on ESG issues, including climate finance and broad diversity, and she recently won the 2021 Moskowitz Prize for her research on ESG investing. She is also the president of the American Finance Association.

The next speaker will be, discussant actually, Mikhaelle Schiappacasse. She is a partner at Dechert LLP in the firm's London office. She advises on the establishment, management, marketing, and restructuring of alternative investment funds. She also advises European and non-European asset managers on the application of ESG-related European regulation and is a leading member of Dechert's global cross-practice ESG task force.

Finally, we have Lukasz Pomorski. He oversees ESG research at AQR Capital. A systematic asset manager, Lukasz also has a toehold in the academic world, publishing on ESG and teaching a course on ESG investing at Yale. He also serves on a number of industry ESG committees, for example, at the PRI [Principles for Responsible Investment], or IIGCC [Institutional Investors Group on Climate Change].

Thank you for being here. I'm going to turn it over to Laura, who will talk about considerations on ESG investment implementation. Then, we will open it to the two discussants, and I will insert a few questions here and there. Without further ado, Laura.

Laura Starks: Thank you so much, S.P. I really want to thank the organizers for inviting me to speak at this conference. To me, ESG investing is a very important topic. I just wish I'd been able to do so in person, especially because the sessions I've seen have been just really fascinating.

As I'm sure everyone knows, the growth and institutional investor interest in ESG has been great in the past 15 or so years. Also, if we look at the flows from primarily retail investors, you can see that they have been very high over the years. In fact, since many of these funds are domestic equity, if you look at other US domestic equity funds you find that they would have had net outflows over a lot of the period that we've had the net inflows on ESG funds.

The issue, and I think this is the primary issue with understanding ESG investing, is that, and it's similar to what was being discussed yesterday about digital currency, people have different definitions of what ESG means. Specifically, there exists a lack of agreement on what it means and what it entails. Context is very important when we talk about ESG investing.

If you think about the motivations for ESG investing, and the appropriate investment approach depends on this motivation, we have "ESG values" versus "ESG value." This is where I think a lot of the confusion comes, and this is really why I think there are suggestions that people don't understand what ESG is. If we consider the ESG values, it's based on people's preferences. This really goes back to the start of the SRI movement, the "socially responsible investment," or "sustainable and responsible investment" as it's now come to be called.

A main reason for this is avoidance of complicity, avoidance of complicity in products that people don't agree with, and avoidance of complicity in corporate behavior that people don't agree with. It also is people wanting to supply capital to the types of firms that they want to help. Also, with ESG values are the idea of making an impact. People want to make an impact with their investments. Again, supplying capital to what they want, impact investing, but also through engagement and stewardship, to get companies to change.

On the other hand, ESG value really has to do with risk management and return opportunities. When we think about return opportunities, we think about how you use ESG to select investments, for example, incorporating ESG into the investment process. Another part of this is also engagement and stewardship, looking at firms that have low ESG activities or quality, in other words high ESG risk. By engaging, many investors feel that they can change the risk profile of that firm or the ESG profile of that firm. With ESG value, ESG is used more as a lens to be able to invest better.

The investment approaches also tend to be different between ESG values and ESG value, but I think the main difference is that many people under ESG values use exclusion, also called divestment, [or] negative screening. Again, they don't want to hold firms that they don't want to be complicit in some of those firms' activities and products. On the other hand, ESG value, the major investment approach is ESG integration, which includes risk assessment using ESG.

A big question for an ESG investor is whether there should be positive or negative screening. With a positive portfolio tilt, you're going to weight the problematic ESG firms less, but you don't necessarily completely eliminate a sector or a type of business. With the exclusion divestment approach, you just don't hold the security at all to avoid complicity. The implications of these two approaches can be very different. For example, with a positive portfolio tilt you can still engage and vote on proxies to pressure for better ESG behavior. Whereas with the exclusion divestment, you can't engage or vote on the proxies because you don't hold the firm. I recently heard a story about some investors who were in an ESG fund and they got very excited about wanting to be able to vote on the Exxon proxy last year when there was a proxy contest. Then they found out, no, they couldn't vote because that fund didn't hold any Exxon stock. There is this difference. If you want to engage, you've got to hold some of the stock.

The positive portfolio tilt allows for diversifying across different sectors and businesses, whereas the exclusion divestment approach has higher tracking error and it's based on a mechanical decision rather than having higher tracking error because of taking some active investment bets. Again, there can be more cost to the exclusion divestment approach than the positive portfolio tilt approach.

Beyond exclusion, there are those who suggest that investors should consider shorting. This has particularly been suggested with regard to carbon intensive firms. You short the low ESG firms, and again, beyond divestment, then you have the possibility of increasing returns on that. You have the possibility that this would put more pressure on firm management through increasing their cost of capital, whereas in order for divestment to increase the cost of capital there'd have to be people who aren't willing to hold the shares. It has to be very elastic, in terms of the demand for the shares, and that generally just doesn't really happen. Another argument for shorting is that you can hedge against ESG risk, particularly climate risk, and it can affect a portfolio's net zero goals. One of my fellow panelists, Lukasz, has written quite a lot about this idea of shorting the low ESG firms.

There's also been in terms of "how do you report on the ESG of your portfolio?" This is difficult. The mutual funds that managers I've talked to, the pension fund managers, they really struggle with how to deal with the disclosure aspects of ESG. There have been an increasing number of sustainable finance policies and regulations across the 86 countries. This is particularly true in Europe, which is far ahead of us if we're going that way in terms of reporting on ESG. Mikhaelle knows a lot about this, and S.P. knows a lot about US regulations, so I think this will lead to very interesting conversations.

Beyond regulations, thinking about the investor needs or demands for more information on a portfolio's ESG, for ESG values the most important is the relevance. For ESG value, the most important is the ESG materiality. Where to report? Everywhere, because investors approach this from different ways, the prospectus, the fact sheet, the website, annual reports, marketing materials. I think it's all important for investors to understand, those investors that are interested in ESG. Then, what to report? I think besides talking about ESG in total, because I think it's very difficult to talk about ESG in total, the talk about E, S and G separately becomes important. Also, to report both backward-looking and forward-looking measures, because that's what's important to the investor, to understand where the portfolio managers have been, but also to understand where the portfolio managers are going.

If using exclusion, you could report on the sector, business types, firms that are excluded, the number of firms, which firms have been eliminated. If you're using a ranking system, again, there was discussion about the ranking yesterday by Anna [Pavlova], who's done some very nice work on this. If you're going to use third-party ratings as Anna and her coauthors recommend, if possible, use two. Interpret the ratings for the investors. They don't understand these ratings. If you have your own proprietary system, explain the system, explain the integration system, explain engagement. I often see that mutual funds or pension funds get criticized for holding low-ranked ESG firms, but it could be the case that they're holding these firms in order to engage and try to make changes at the firms. Without necessarily naming the firms, I think it's very helpful to actually explain your engagement process and success.

I know there was some discussion about performance yesterday, so I'll go through this quickly, but there are meta-analyses of ESG performance studies and these analyses show...all these studies have looked at both the performance of firms based on their ESG and the performance of portfolios based on ESG. The green here is positive, the red is negative, the blue is neutral, and the brown is mixed. As you can see, the green shows up higher in both studies because this is an earlier study, and then a later set of studies, and the red tends to be lower. The problem when you're looking at the portfolio studies is that they mix in SRI funds with funds that are using ESG integration, so you're mixing in funds with ESG values against funds with ESG value, and I'm not sure those combinations make any sense.

We need clarity on the definition. Given the mixed evidence, you get very diverse opinions. People have a tendency to interpret evidence according to their own beliefs. People that believe ESG is not a good investment style will point to the evidence that shows that there aren't higher returns, that there's a cost. Those that believe ESG is beneficial will point to the ones where ESG looks better. Just a few more points on the performance, because I think it's important. This graph shows, just for the last three years, the S&P 500 ESG Index, which is the green, and the S&P 500, which is the brown, where S&P has defined ESG. Something to take into account is, with the exception of the last quarter, ESG performance has had the influence of high performance of the tech sector and poor performance of the oil and gas industry. Thinking about the sectors becomes important. As pointed out yesterday by Lubos [Pastor] and by Anna and in their research, flows into ESG funds may explain the differences in returns. Down below, I've put in what the total AUM [assets under management] for ESG funds has been. Again, this is mixing the different kinds of funds.

Then there's a problem of reverse causality. Do firms with higher ESG profiles have greater firm performance because of their ESG activities, or do the firms with greater firm performance have the resources to conduct ESG activities, and thus have a higher ESG profile? I think this is, again, a difficult question. Another question: Should E, S, and G be combined, as I talked about? You may be combining these. This is less of a problem with the firm results, such as Lubos's and Anna's results, because they're looking at firms and so they don't have the influence of the themed SRI portfolio. Also, just to point out, as was pointed out yesterday by Anna, measuring ESG is difficult and the ratings are noisy, which can result in biased performance analysis.

In conclusion: what "ESG investing" means depends on the context. "ESG values" implies that nonfinancial factors are important, but "ESG value" implies that the E, S, and G activities can be financially material, particularly for long-term investors. You have risk management return opportunities, including engagement. Considerations on what investment approach to take, how to measure the ESG quality of a portfolio, how to report on the ESG quality of a portfolio, and the relationship between ESG qualities and performance, all of these depend on which context is important to the investors. Thank you.

Kothari: Now we have two discussants, one who is an actual practitioner of managing money, and Mikhaelle here, she is a lawyer and works on regulatory issues. I thought maybe we can begin with Lukasz, talk about the practical issues and your comments, and then followed by Mikhaelle, yours. Lukasz?

Lukasz Pomorski: Very good. Thank you, S.P., and thank you, Laura, for the great remarks. I will limit myself to three broad questions. I want to come back to the issue of trade-offs that Laura highlighted. I'll give you my take on them and basically will agree with Laura on pretty much everything, I think. Then I want to touch on stewardship impact. That's a very important, also very divisive, topic. I may or may not agree with everything that Laura says, and likewise, which is great. We're on a panel, why don't we have some conversation? Finally, I want to at least touch on ESG beyond traditional strategies, beyond standard, corporate, long-only equities, and maybe corporate bonds.

Let's start with trade-offs. I will use the framework that Laura presented to us, the ESG values and value, as a way to try to address the question, which is, in my view, the single most often heard questions in this space: Does ESG help you, or hurt you? The answer, of course, is both. It really depends on how you think about this. To drive this point, suppose that you have an investor or a portfolio manager who will just pre-commit never, ever, ever to look at any information that might have to do with ESG. That's a straw man, because that doesn't seem to be a very thoughtful investment process to follow. Maybe you can actually justify this process in some very specific circumstances. If you're running a high frequency trading shop, for example, or maybe you're following a stat arb [statistical arbitrage]-type strategy, then perhaps you don't need ESG.

I will posit that as long as your investment horizon is longer than some hours or days, the onus should be on the manager to actually do the homework and articulate a view whether ESG-type information may be helpful for the investment process, purely from the point of view of financial outcomes, so value, purely from the point of view of Sharpe ratios, information ratios. I will say that, in my view at least, there's actually a lot of instances where ESG can be outright helpful for questions, or even risk. Think about the sovereign bond portfolio, particularly emerging markets. I will posit that there's at least some dimensions of how well-governed the institutions are, that social pressures with the country might affect your view of the risk of a bond portfolio. Or return, as Laura said. There's actually plenty of academic studies that found at least some elements of ESG that seemed to be helpful for returns. Not everything, and personally I have a somewhat skeptical view of the usefulness of broadly available third-party providers who just put a single number on all of ESG. I think you need to dig a little bit deeper to find actionable insights.

So, ESG can help. At the same time, you can do more ESG than optimal. You can ask your portfolio or your portfolio manager to actually reflect your values or pursue additional goals that may be nonfinancial, that might have to do with impact, for example. I will posit to you that at that point, mathematically, ESG becomes a constraint, and a constraint usually has a cost. A constraint might not be binding, I think, for two reasons. One reason is that you chose the constraint to be so small as to never basically take any cost because of the constraint. In that case, you probably are greenwashing, or maybe you simply got lucky in the sense that your constraint was nonbinding because it was aligned with your investment theses. To Lubos' paper, for example, if you were smart enough to figure out that there is maybe a wave of money flowing into green strategies, and actually position pro-green, and actually articulate your investment view this way, then your portfolio will be green not because of the constraint but because of the investment view. I think it will be somewhat presumptuous to assume that it always will be the case, that there would be no point in time at which your investment view actually might be at odds with your ESG objectives. I think, again, the onus is really on the investor or the investment manager to try to articulate that trade-off, and ideally try to quantify this.

That's the first part on the trade-offs. Let me touch on stewardship. First of all, let me talk about impact and explain the term, which is often used with two different meanings. What I mean by "impact" is the impact of a portfolio manager, of an investor, on the portfolio company, or on the issuer of a security that you're holding. Some people use the term "impact" in the sense of the impact of your portfolio companies, for example, on society, on the environment. That is important, and we can talk about this, but I'll start with what I view as the more important question: can you change, let's say, corporate policies through your portfolio choices? I think the answer is yes, but it is a qualified yes. My personal view is that there's a lot of hype in the industry where you claim impact, and basically to Laura's point, you may not be able to actually show much evidence that you actually had impact.

Let me again propose to you that there's a bit of a framework and maybe go beyond Laura's slides to analyze the impact, at least in the context of corporate securities. I will posit that there are two channels that matter. One is obvious; it's voting. If you hold voting shares of a given company, you can vote, you can actually express your view this way. In illiquids, in private equity, for example, you outright control the company. I'm going to call it voting, but it's really direct control of the company. That's one. We might not agree on the second one, but I will posit that the only other thing that matters is the cost of capital. I make this strong claim because when you think about engagement you need to ask yourself a question: Why would a portfolio company ever talk to me as an investor? Suppose that you're holding a portfolio of corporate bonds. These are nonvoting instruments. You cannot vote, and yet companies are happy to, or maybe not so happy sometimes, to talk to providers of capital, to investors in corporate bonds. Why? What's the threat here? It's not that you're a monopoly provider of capital. It's not that if you walk away, the company won't be able to find financing. If you don't participate in the auction for the next corporate bond, somebody else will, as competitive markets. The only thing that, in my view, aligns the company and actually makes them want to talk to you as an investor is that the next person at the auction might charge a higher interest rate.

If you agree with me that these two things matter, and maybe there's some sort of, I would argue tertiary, other considerations, but to me these are the big ones. Unfortunately, you need to face a situation where we still actually often go in the opposite directions. To Laura's point about Exxon and being unhappy about not being able to vote Exxon, if you want to vote Exxon you need to hold the voting shares. You have to pretty much buy those securities, and as long as the demand curve for stocks is not perfectly elastic, which I don't believe it is, then you probably make, eventually, the cost of capital of Exxon a little bit lower. The cost of being able to vote is actually potentially on the margin, at least directionally, alleviating the cost of capital of the issuer. Similarly, if you wanted to influence the cost of capital, if you were to...forgive me for putting that word back out, but...punish a company that you don't agree with...how do you do this? By selling securities. Again, I'm leveraging the fact that I believe that that demand curve for stocks is not perfectly elastic, maybe even shorting. But if you do so, you cannot vote. In terms of impact, I think these questions are actually very poorly thought through, and very poorly articulated by both asset owners, pension plans and such, but also the managers. Perhaps the conversation is changing. To Laura's point, there's a lot of interesting conversations, and a lot of thought leadership from people like Laura who are putting good science behind good intentions, but I think there is still a ways to go.

My last comment, very briefly, is on other asset classes. What has happened in ESG, I think, is very, very understandable. We started thinking about the obvious things. We started thinking about 60/40-type portfolios that invest predominantly in corporate securities. Frankly, even those 60/40 portfolios that invest in sovereign bonds, sovereign bonds are kind of the thing on the internet today, we don't have good understanding, good consensus really, about what ESG means in the sovereign bonds space. Even with corporate securities, over the last maybe two years, people realized that there are more than just long-only portfolios that matter. A lot of asset owners who, in good faith, want to understand what they can do vis-à-vis ESG, need to address the question: if I have a 5 percent allocation to hedge funds, how do I think about the ESG profile of that allocation? If I have illiquids, for example, how do I think about ESG and illiquids? These questions are very fiercely debated with people who often take very extreme views on them. On the one hand, I'm very happy to be part of those conversations. On the other hand, I'm very much looking forward to a point in time when we have a little bit more consensus on those nontraditional asset classes. I'll pause here. Thank you.

Kothari: Thank you, Lukasz. Mikhaelle?

Mikhaelle Schiappacasse: Good afternoon, everybody. Or, sorry; it's still morning. Feels like afternoon. I'm going to try to approach this from a slightly different perspective. Obviously, I'm not an economist, and I'm not a practitioner when it comes to managing money. I am watching the regulatory developments that are happening, particularly in Europe, and notwithstanding my very American accent, I practice in the UK and have been there for one-and-a-half decades or so.

I think in order to actually talk about this in a meaningful way, I'm going to have to give a little bit of history or a little bit of background as to what's going on in Europe. For those of you in the audience who know it, apologies for going over old ground. But the European Union has essentially, maybe not sought, but in effect, become the first mover in terms of legislating around ESG, and particularly sustainable finance, trying to implement it as a policy matter into various aspects of legislation, both in terms of the operation of the financial markets and also the manufacturing sector and so on.

This has really been driven, obviously, by the Paris Agreement. Out of the Paris Agreement came the "European Green Deal" where the European Commission started to set out its proposals around how to move Europe to be basically a net carbon economy by 2050. The key aspect of that, they realized, was moving finance, private finance, into sustainable investing in order to move the economy into a more sustainable economy. They focus on really more recycling within the economy. They look at it in terms of the long-term sustainable investments and so on. They've approached this in a couple of ways.

One way is just to address the questions: What is ESG? What is sustainable? As we know, this is a difficult question to answer. In doing this, they have developed something that they call the taxonomy regulation. It establishes what is environmentally sustainable activity within the context of the European economic market. They're very specific about what areas they consider that to touch on. It's climate change mitigation, it's climate change adaptation, transition to a circular economy, protection of marine resources, reparation, or protection of biodiversity, and so on. They're very specific, and quite granular, about how you evaluate that, and that's been set out in this taxonomy regulation. They've created a language, shall we say. It hasn't moved into the social side yet, and as everybody can appreciate, social issues are more difficult. They may be, to some degree, more values driven as to what people think are social goods or ills, ad so they haven't developed that taxonomy yet, although there's some initial recommendations from their expert body as to what that might look like.

On the other side, they've looked at the financial industry and gone, "Okay, we need to encourage this redirection of assets. How are we going to do that? Well, we're going to do it by disclosure, by establishing a set of disclosure obligations that apply across the financial industry, relating to environmental and social metrics, both on a qualitative and quantitative basis." This Sustainable Finance Disclosure Regulation, as it's called, applies to banks, to insurance companies, pension plans, to investment fund managers, and managers of portfolios of assets that aren't fund managers. It's very wide reaching, and of course, as with any piece of regulation that is trying to target such a broad sector, it has its shortcomings, shall we say. Part of the shortcoming that's come out of this is maybe the timing or ordering of approach that has been taken in determining to move capital in this way, because where the regulators started was with the obligation on investors to disclose, so pension plans, insurance companies, investment managers, rather than focusing on where are they going to get the information. How are they actually going to disclose about environmental or social metrics relating to their investments if their issuers are not first providing that disclosure information or providing that data to them?

One of the issues that the entire financial industry is facing right now in Europe is they have a number of disclosure obligations but have a problem accessing data. As has been said by many people speaking, the data that is available is of varying qualities and maybe not as timely as would be desired. One of the issues that comes up within looking at regulating in this space, regulating ESG, is a matter of order. How do we order our approach to this? Interestingly enough, other regulators have been observing this and have taken a different approach. The UK, which is now outside of the EU post-Brexit, is looking at it from an issuer perspective as well as an asset manager perspective and trying to calibrate the timing. They're starting a little smaller. They're just looking at climate-related disclosures, and very specifically they're looking at basically greenhouse gas emissions and carbon footprint. The UK started there, and of course the SEC has now also just come out with a set of proposals. It also, no doubt having looked at the European experience, decided to start with issuers and issuer disclosure obligations because fundamentally that's where you need to start, where that information is available. That's one aspect I wanted to address, just the matter of if you're looking at regulating within a space, you have to think about the information flows, particularly if you're focusing on disclosure.

The second aspect of this that is interesting, or at least it is to me, I hope it is to the audience, is that the commission is trying to encourage movement into green assets, and by "green" I mean social and environmental, not just environmental. They're trying to encourage the movement by doing disclosure. What is the purpose of this disclosure, or what are you trying to achieve? Basically what you're saying is, "Big investment bank, you're going to disclose the negative impact your overall portfolio of investments has on different environmental and social criteria. What is the overall greenhouse gas emissions caused by your portfolio of underlying investments?" If every major financial institution needs to disclose that, and they need to disclose it in a 5-year lookback, this will be the first year of disclosure, starting next year, reporting on the current year, and so on. Of course, there's going to be pressure for those numbers to start dropping, right? So, it's pressuring particular behavior out of the financial industry, and it's doing it at two levels. At one level, the disclosure obligations sit with the firms themselves, the large banks, the pension plans, and insurance companies, sort of the ultimate investor shall we say, but it also sits in the investment products. There is a need, and this is not true across the board, some of it's voluntarily, some of it's mandatory, there's a requirement to also report like this so that investors who come into your products know what they're getting or know what their exposure is to bad things, not necessarily the positive aspects of ESG.

This is the policy tool that's been created to move money from one part of the sector to the other. The other interesting aspect that came out of this is it was always thought of as a set of disclosure obligations. It was just reporting. What you require firms to report on ultimately shaped the way they need to manage their money, or the way they need to think about the way they're investing. The end result is that you start with the primary legislation, which has a very broad-brush approach to this, but as your European regulators come in and start doing secondary legislation, they're driven to some degree by the values of the people who are legislating. The impact is that you start shaping the way ESG is conceived of as an investment activity for your underlying regulated entities.

What has happened is what was supposed to be a disclosure regime has actually become a product regime. People are now out there and, I'm going to use a little bit of jargon, they're saying, "We're an Article 8 Fund, meaning that we invest in investments, to some degree within our portfolio, that have environmental or social characteristics." Or they say, "We're an Article 9 Fund," which means that their underlying investments actually have environmental or social objectives. This goes to the impact of the portfolio company rather than your impact on the portfolio company. Here you have firms going, "I need to categorize myself," and what we're finding in the market, as a practical matter, is a rush to reidentify your fund or your product as Article 8, or light green, or Article 9, or dark green, to the point where you'll have the investment relations teams, the sales people, coming back to their portfolio management teams and saying, "I can't sell a fund that isn't saying that it's ESG." The difficulty around there is you could only talk about ESG if you meet the particular disclosure requirements under this regime. The only thing you can say if you're not that is that you do "ESG risk integration." In fact, you're required to say how you do ESG risk integration. That's another change that's being brought in by legislation. All asset managers who are selling a product in Europe or doing activities in Europe need to disclose the way they integrate ESG risks into their portfolio management activities.

We've moved from what was supposed to be a disclosure regime to what's become a product regime, and it has a knock-on impact because it's about selling, fundamentally. Then you get into the conversation about greenwashing. Are people actually changing their approach, their portfolio construction, or they just saying they're doing things that they've always been doing, adding a little bit of the nice words in about how good it is for the environment, and saying that this is a green product? What was supposed to help move assets has started to become a bit of a headache in terms of is there going to be a mis-selling crisis in the European market because everybody's saying they're doing green investing, but they're not? You have to think about it not just from the product. The people who are creating an investment fund, remember, those insurance companies and the pension plans have their own reporting obligations, so they don't want to be investing in those non-green assets. They need to go and invest in the green assets. The complexity that's also come out of this, "what is a green asset?" is being defined, and it's being defined fairly narrowly, in a way that means that you can really only hold yourself out as having something green if it's already sustainable, truly green, moving towards the dark green side of the spectrum if it's already sustainable and encouraging transition, so stewardship and engagement doesn't qualify. Of course, within the industry that is a big part of how firms hold themselves out as doing good ESG things. It creates a sort of unexpected set of results by trying to legislate in a way that we're supposed to basically move capital into more technologically and environmentally friendly outcomes.

The one last thing I wanted to say was there is, at least in the asset management sphere, the beginning of some concepts around how you evaluate levels of ESG investing. Laura touched on this to some degree in the way she was talking about value versus values, but if you look at it on a spectrum and you start with ESG integration, which really functions in a sort of risk management overlay to your portfolio, then you move into exclusionary investing so you just take out some of the bad stuff, then inclusionary, where you're going and investing in things that you think have better ESG qualities. Then you have impact, where you're investing in a portfolio of investments where you think it's going to go and fundamentally change the environmental or social nature of the area in which that company is operating. If you look at it on that spectrum, most people would say all of that is an ESG approach to portfolio management.

But the way the European regulations have approached it, ESG integration and ESG exclusion don't really count, in the sense of either you should already be doing that, and you can only talk about integration to the extent it's risk integration. You can't talk about...most people do, and they find a way to do it, but in theory you shouldn't be talking about...your exclusionary activities. You only become sort of an ESG product once you move into inclusionary and impact investing. It creates this situation where either managers have to say that they've changed the way they're approaching their portfolio, or they actually have to change the way they're managing their portfolio. It has had much more of an impact than you might expect in terms of behavior, and will probably do so more, because the legislation was supposed to be final and settled, [but] the commission's come out and suggested that actually the regulators go back and revisit a number of these things and come up with some new ideas, although the industry is still trying to catch up with what's come out so far. I think I'll finish there. I appreciate that I've gone slightly into a different area than has been talked about around ESG investing, but I just wanted to highlight some of the experiences that are coming out of trying to approach this as a regulated matter, rather than as a way in which the industry is choosing to move itself.

Kothari: Thank you, Mikhaelle. It makes it pretty clear how complicated regulation is. When folks in the industry complain about regulation, we have some sense for that. I know, Laura, you, as well as Lukasz, both of you had talked about ESG investing acting as a constraint and that, to some extent at least, if it is binding then you would sacrifice some performance. For the audience, I want to get a sense as to what magnitude are we talking about. Some people might say that, "Gee, you know, trillions of dollars of other assets are available, so this cannot possibly be binding. This is a theoretical construct." Whereas others might say that, "No, no, it can be quite substantial." It might be helpful if Laura, Lukasz, you might want to say a couple words on that.

Starks: Lukasz talked about this to some extent. I guess I mentioned it as well. Again, it depends on the context, though. If you're an ESG values investor, you may be leaving out whole sectors, so there could be a very big constraint. People who are using ESG for value purposes and aren't leaving out these sectors, it's not necessarily a difficult constraint.

Kothari: Lukasz?

Pomorski: Yes, let me try to unpack a couple of nuances there. First of all, why would it be a constraint that hurts? We can think about diversification, and Laura is spot on. For many investors, it's not just excluding tobacco and maybe alcohol, which doesn't really take up many stocks or much of the index weight, for example. There are investors who are very constrained because of their values. Think about a Catholic foundation, for example. They might remove 10 percent of the securities out there because of various links to business activities that they don't condone, that they don't want to be part of. From the point of view of diversification, I think, that actually can be painful already in the context of a passive index, which are adjustable, but maybe slightly wonkishly. There are certain states of nature where this lack of investment in those sectors was actually painful for the portfolio. That's one.

The second one, which I think is somewhat underappreciated and maybe misunderstood, is that narrowing of the investment breadth of the portfolio. This is much more relevant for an active manager. The way to think about this is that if you ask a manager to run a portfolio ex-tobacco, for example, then you're basically pre-committing never to take advantage of the insights of that manager in tobacco. As long as the manager has some skill, which may be debatable, but if they have skill then what you just did is you left a sliver of that skill on the table. It's not to say if it's an ESG-labeled vehicle that it will underperform, will do worse than the benchmark. Depending on the size of the same premia, for example, it might happen. I don't think it's actually necessarily a big risk for at least most ESG-type investors today. It might be there going forward.

The reduction in breadth can sometimes be very impactful, so where you are on that line, I think you need to kind of estimate. If you're interested, we had a couple of papers talking about the ESG-efficient frontier, effectively trying to quantify that. How much reduction, what is the sliver off our Sharpe ratio that you leave on the table, if you pursue ESG objectives? You can actually almost prove that initially, for a small step in the pro-ESG direction, it actually is not very painful, but you very quickly get to the territory where the constraint can be very harmful. It's difficult to say, without knowing more about the context, how harmful it is.

The last thing I'll say is that the fact that you put on a constraint doesn't magically mean that you will underperform a version of the process without the constraints. To put it bluntly, you can get lucky. So if you are an ex-tobacco, I'm using tobacco because a lot of investors in this space, for them tobacco is one of the obvious things to exclude. Well, if you exclude tobacco, and tobacco does really poorly, fantastic. You've just outperformed your benchmark because you removed an industry that did very poorly. That does not mean that the constraint wasn't there. It was there on an ex-ante basis. You just got lucky. I'll pause here.

Schiappacasse: If I can just comment on this, on a slightly different perspective. One of the disclosure obligations that come in with the regulation is to disclose the extent to which your exclusionary methodology, or in fact, your ESG strategy, actually reduces your investment universe. It's actually a reportable item. In fact, if you're trying to sell a product into France as being sustainable, it needs to at least have reduced your investable universe by 20 percent. Once again, regulations stepping in and assuming that because you're reducing your investable universe somehow it improves the ESG criteria of that portfolio.

Kothari: Good. I know all of you are talking about the flow, and how flow might influence prices and therefore performance. That was to some extent apparent also when Lubos...his paper yesterday that talked about the tech sector, and perhaps a lot of funds were flowing into that sector. If flow is influencing prices, do you think that automatically determines that the future performance would be lower? It's like the bond price. If it rises, then the yield is lower and therefore the expected return is lower. I realize what we're talking about is in which direction the causality goes, but the recent strong flow into green...do you think that has created the illusion of superior performance there, and has sown the seeds of lower performance down the road? Laura? Lukasz?

Starks: Lukasz, you can go first this time.

Pomorski: I think the answer is yes. A few years ago, I think it was much more prevalent than it is nowadays. You heard those heroic claims, that we can put on a constraint and it makes you better. I would say, if that's your investment view, if your investment view based on whatever analysis that you did, is that green stocks, green sectors are going to do well going forward, I have no problem with this. What I do have a problem with is that you impose a constraint, mathematically speaking, that is not for purely financial reasons, and just to claim that, "well, we just happened to get lucky, and the performance was really strong," and claim that this is a "you can have your cake and eat it" kind of situation. I think it's a little bit...well, I would argue with that stance.

Now, in terms of economic logic: should these flows affect prices? What is the impact on forward-looking returns? I find it really difficult to argue with that logic. It's like arguing with demand and supply. To me, it is obvious that eventually these flows will have an effect, and they will push prices of green securities higher than they should be given their fundamental value, cash flows, and so on. They will push prices of brown securities down, and then it has implications for yields in the bond market, for expected returns in the stock market. However, there are a couple of things that I wanted to point out here. I don't think we will resolve all of them but think about: It's not just the prices that move. Sometimes, it's also the end consumers who move, who vote with their feet. Sometimes, maybe this shift in demand is not just in the asset market, it's also in the consumption market, where, when you go to a store, you see all these products that say, "produced with low carbon" or "fossil fuel free," whatever else. Maybe there's some information that actually is there.

That's one comment. The second comment is that this could be a heroic statement, but maybe it's just repricing of risks. Think about green becoming more expensive, and maybe these are flows just articulating the fact that many investors nowadays consider climate as a risk, maybe even a systemic risk. Directionally you would see the same effect, but not because of price pressure per se. It's just pricing in the risk. By the way, the prediction going forward is still the same. If you're holding brown assets, they're a risk here, and that's a risk that you demand a compensation for. Then you expect to, on average, earn higher returns going forward on that, for example.

The last thing I'll say on this, this could be, again, somewhat maybe controversial. Certainly versus Lubos's work, less so versus Anna's work, is that I think I'm not yet convinced that the flows into ESG are so concentrated at the level of individual stocks that you actually meaningfully move valuations of these stocks. I think one of the reasons why, by the way we look at this at AQR, one of the things that we do when we assess third-party ESG data, we do precisely this. We try to see, does this data move flows, move prices. When you see a stop going from average to horrible on ESG, do you see outflows? When you see the reverse, do you see inflows? Do you see impact on valuations?

It's really difficult to tease out anything. I think to Anna's paper, and papers by her coauthors, one of the reasons is that people don't really focus on a single provider, and different providers will have different views on ESG. I don't think we're in that situation yet, at least in my view, based on the data I've seen, that we have such concentrated flows into individual equities, at least, where the impact on prices is just tremendous. I will give Lubos his due. Greenium, I think, is very clearly there, at least in some circumstances.

Kothari: Laura?

Starks: If this has been based on demand, then I think it depends on what the millennials are going to do, especially when they start getting money from their Baby Boomer parents. I think that's going to make a big difference.

Kothari: Okay. We have a number of questions here. Mikhaelle, do you want to add anything to that?

Schiappacasse: The only thing I would say is that, obviously, if you have a regulatory impetus to move your cash flows into particular assets, that's also going to have some kind of an impact. But I'm not an economist, so I couldn't comment.

Kothari: We say that often: "I'm not a lawyer." [laughter] I think this will kind of resonate. We have a number of questions. One is: "An early example of SRI in the '70s and early '80s, was the disinvestment in South Africa. Are there any lessons there on the power of divestment for social change?"

Starks: I have an answer to this because I have an article from last year in the Financial Analysts Journal that looks at the articles in the Financial Analysts Journal over time that have studied that divestment. The arguments from most of those articles were that the pressure did not come from the stock market divestments. I think that's kind of the bottom line.

The costs, they vary in terms of how much cost they thought there was, but there wasn't a large cost unless people were going to divest from the US firms that had any business connected to South Africa. Then it would have a big cost on the portfolio. I think it's similar to fossil fuel. If you only divest the worst, then there's not a big cost. If you divest the whole sector, then there's going to be, and if you divest utilities, which arguably have higher emissions than the fossil fuel producers, then you're going to have a big hit to your portfolio.

Kothari: Lukasz?

Pomorski: It's such a difficult question. I completely agree with Laura. I will say that there's certain global questions when asset owners...the stock markets of the world can only do so much, and maybe can be marginal. Certain questions are, in my view at least, better addressed by policy. There's so much to talk about. I won't take up too much time but let me just highlight a couple of things.

If you think, for example, that the financial sector can meaningfully prevent climate change, you need to think about channels through which it happens. To Laura's point, if everybody, or a large fraction of investors out there actually acts this way, then perhaps they can move things on the margin, but you very quickly get into very awkward trade-offs. The fact that you want to change the world, have impact this way, will eventually move prices. We just talked about this a few times already, in this session and in the private sessions. What it means is that at some point, some of the really dirty, fossil fuel-heavy assets will become really cheap. Think about the coal mine. Maybe we don't want to have coal mines, if you really care about emissions. Maybe you want to close them down. You may not like it, but there's a lot of demand for, really good reasons for, coal. At some point, even if you believe that a coal mine will go out of business in whatever it is, 5, 10 years, put in your forecast here, that coal mine probably has positive cash flows over the next few years, at least. There is a price at which this coal mine becomes a really attractive investment.

If you really expect the financial market to, on its own, solve some of these issues, then you basically effectively are imposing a cost on the market, on market participants. Many market participants will be actually very up front about this, and they will tolerate some decrease in their returns because of this. We have at least some survey evidence to that effect. Eventually, that cost might be just too large to accommodate, not to mention that you probably will have less constraint on investors who may want to take these companies private and so on, because they just don't care about those social, environmental issues as much as others. It's a really difficult question, but bottom line for me is just like Laura. There's some things, but not a whole lot, that the financial market in isolation can do.

Kothari: The question asked about South Africa. Let me ask what happened in a more recent example and far more concentrated action with the Russian market in the context of Ukraine. There the activity, from the rest of the world at least, has been far more intense. It's too recent, and you may not have, but maybe you have the finger on the pulse of what goes on in the marketplace, Lukasz?

Pomorski: I think that the primary effect here is actually from the policy side. I don't think that what we're seeing is a huge output from Russia because they're just not allowed, for example. We're not seeing a lot of activist investors stepping in because in many countries that's just not allowed. I think we are seeing some effects, or maybe some...I'm going to call it, "some effects on the market, on the prices"...but I would attribute them primarily to policy choices rather than to individual investors. This is still really early. I'm not aware of any more systematic evidence. If people in the audience are, I will be very keen to consult that, but at least my impression is that this is policy at work.

Starks: I think it's coming from the businesses, not the stock market.

Kothari: Nice. Mikhaelle, anything thoughts?

Schiappacasse: The one thing I could say is, I agree. It's mostly driven by regulation. It's driven by, frankly, US sanctions or European sanctions that are being imposed on the companies. A couple of clients are looking at the knock-on impact on other, say, oil and gas companies, so it's causing some movement there. The interesting side of things, and once again this is not so much related purely to market movements, is that a lot of companies are deciding that they cannot be associated, for reputational matters, and are pulling out. That's a little bit different, and it also depends on what sector they're in, and what kind of exposure they have. I don't know about it in terms of pure financials, but from a reputational standpoint you've seen it even in law firms, where they're saying, "We need to cut back on our representation of Russian clients" which has ethical issues as well for the industry.

Kothari: I was just struck by the latest Economist, which says that the economy over there more or less has gotten back to the precrisis level. That's what prompted me that if it was not so effective in South Africa, because there wasn't as concerted an effort to divest, whereas here there seems to be a lot more concerted effort on the part of many nations. What we are concluding is that even that doesn't have as much impact, at least directly. Anyway...

Pomorski: I will reserve judgment until we see a little bit more evidence going forward. It's only been a few months.

Kothari: We have only 12 minutes. We don't have that much time to wait for that. [laughter] I will move on to the next question: "If governments want to put some cost on unfavorable industries or companies, shouldn't that be done directly to the companies instead of putting restrictions on investors?" What do you think? Maybe this is, Mikhaelle, your...

Schiappacasse: Well, I suppose. I mean, this is really a policy point, and I'm a lawyer, once again, not a policymaker. I think that if you want to have the most impact, you actually go after the money, fundamentally. I think you can't do it alone, so ideally you pair it. There are restrictions on the operations of the business that make it less desirable to do that as a business, but ultimately, it's how the business is funded. Where does the money come from? I think you also have to approach it from the financial flows. I don't know. Do you think it's different?

Pomorski: I would say, but it's multiple prongs of attack, if you will. Certainly, financing has a role to play. I don't think anybody debates this, but at least my view is that alone is probably a little bit more marginal than an outright policy. Take climate change, for example. A fairly popular view, among the economists at least, is that a carbon tax is, if you'll forgive me a horrible pun, a clean solution to the problem. Whether it's politically feasible or not is a separate question, but I think that would be probably a simpler or more direct way to address this than to try to, let's say, increase the cost of capital for those companies that emit a lot of C02. That may end up being the same thing in the sense that those companies will need to pay more for carbon allowances and whatnot.

I think it's a little bit cleaner at the policy level than at the level of effectively investment. If you are a policymaker and you want to achieve those policy goals overall, you probably may want to look for multiple levers. Hopefully this is also aligned with broader constituents, who may also vote with our feet, for example, in the product market and such. I think there's many actors, and some of the problems we're talking about, particularly climate for example, in my view again, the problem is just too large in scope to rely on a single actor to resolve it.

Kothari: Laura, anything?

Starks: I don't have anything to add. I think they handled the question beautifully.

Kothari: All right. "At security selection level, where does the traditional automaker fit in the ESG spectrum? At what point do we know when the company becomes green from brown—to perhaps use LS [long-short] approach rather than long only?"

Schiappacasse: I think this is you, Lukasz, and I'll add some thoughts.

Pomorski: It really depends on your definition of "green." It's, how do you compare, I assume, an internal combustion engine to an electric vehicle. How do you account for the fact that, we mentioned this, a lot of those companies are actually in transition or actively deploying new technologies?

To me, an inferior way of answering that question would be to delegate it to a third-party provider and just take the single number, the face value. Maybe you drill deeper. Maybe it's not a top level ESG score. Maybe it's a climate preparedness score. I'm with Anna, that there are things you can do by aggregating across multiple providers, but it's a very noisy way to identify this.

I think at the end of the day, it just depends on the investment beliefs of the investor. I will say, at a very, very high level, I think it makes sense, if this is your goal, to overweight or long...let me take the "long only" case...overweight companies that are geared towards electric vehicles. Why? They're not zero emissions. There are emissions in supplies, electricity that you put into those vehicles, but ultimately, they have a much lower carbon footprint, at least after some years of usage, than an internal combustion engine would have.

When you underweight within that industry, let's say those producers that are primarily internal combustion, if you think about overweight and underweight, this is basically the same logic as longs and shorts. The only difference is that you put overweights and underweights on top of the benchmarks. Longs and shorts are, in a way, unadulterated, pure overweights and underweights.

Kothari: Mikhaelle, you had some comments, too?

Schiappacasse: I just wanted to point out, it's a spectrum. It's all relative in terms of how green you evaluate it to be. This just becomes an issue when you start holding yourself out as having green investments, how you speak about it. If it's only worth 10 percent of the revenue of the company that you're investing in, it might not be terribly green but it's still contributing because it's not 100 percent. Whereas once you start getting into the 50, 60, 70 range, then you're probably shifting across.

Of course, you have to not only think about, is it using electricity or combustion engine? You actually have to think about the inputs into the production. The question is, are you evaluating it purely on an environmental basis, or are you doing the full spectrum ESG analysis? In which case you have to sit down and go, "Is the company well governed? Does it have good policies and procedures? Does it have good HR policies? What is the social impact? Is it making parts in some obscure part of the world, where maybe child labor is an issue?" It's not a simple analysis purely on a spectrum of, "is it electric or is it combustion?"

Kothari: Laura, anything?

Starks: Yes, I would also add, and this gives me a chance to dispute something Lukasz said, I would also add that engagement becomes important in this. Although he doesn't think engagement helps much, we've known for years that engagement has changed problematic governance structures for companies. We do have empirical evidence on that. There is also some empirical evidence that engagement helps with environmental issues in particular, for example, by lowering downside risk. I think engagement is an important part of deciding on a company's greenness.

Pomorski: If I may just respond to this. Laura, I completely agree. In fact, if anybody is interested in academic evidence on this, there is tremendous evidence from activist investors who actually do change the underlying reality of the underlying companies. This is probably the one place where the evidence for skill and being able to outperform is, I would argue, the strongest.

However, and this is really important, think back to my comments about making an impact. What it means is that you need to, initially at least, hold your nose and buy those companies that maybe today scored really poorly on all these ESG dimensions, because this is where you make impact. This is where you make impact. Your traditional activist investor would identify a really poorly governed company, step in, initiate a proxy fight, and actually improve the value of the company by improving governance. So, fantastic. I will leave it to Mikhaelle to decide whether this counts as articulated or it doesn't, but you see where I'm going. It's going to be very difficult for many ESG investors to actually follow that process. In terms of impact, fantastic. If we can all agree on that.

Kothari: Last question. "The new SEC document is about 500 pages. It is on years due disclosure. How are the rules expected to be implemented in any reasonable timeframe?" Mikhaelle?

Schiappacasse: I wonder if this isn't one for you? I have to admit, I haven't read all 500 pages, and I practice as a European regulatory rather than a US regulatory lawyer. From what my colleagues have said, the reality is that the process will probably be delayed through industry action because it's too burdensome for it to happen at the speed that it's expected to. I think that with all regulation, there's a sort of best-efforts approach that companies need to make. They've put time frames in, in terms of the level of compliance or the quality of compliance that needs to be in place over the next couple of years and the extent to which it needs to be verified by an outside auditor, essentially. I think that would be my two cents on that. I think it will probably be delayed. The problem is, there's obviously a political reason that it's being pushed in such a time frame, and that will probably continue to be pushed for that reason.

Kothari: Okay. Lukasz, Laura, anything on that? No?

Starks: No but if you go and read the letters to the SEC, comment letters, which I've been reading, there's a lot of pushback.

Pomorski: With permission, I won't comment on ongoing regulations sessions.

Kothari: All right. Well, this was really entertaining. Very diverse viewpoints, and a number of important issues. Thank you for listening, and a round of applause to the presenter and to the discussants. I have never come across a discussant who is more in agreement with the presenter than in this case, [laughter] but that would be it, you know. Thank you, thank you.