ESG in its current “dumb and primitive” form could be doing more harm than good by causing a misallocation of capital and underinvestment in economic essentials, according to Tom O’Hara, co-manager of the Henderson European Focus Trust.
One of the major themes of governments’ economic response to the coronavirus pandemic has been that of a green recovery. The European Union’s coronavirus recovery fund is being channelled through the pre-established European Green Deal, stipulating that 30 per cent of the money must be spent on climate-change solutions.
Another sustainability-related theme that grew in prominence during the pandemic is that of deglobalisation, as the economic shutdown caused shortages of goods made abroad, which led to calls to ‘onshore’ supply chains.
However, O’Hara warned that despite the moral motivation behind these trends, they may be counterproductive.
“We are facing a backlash,” he said. “But if deglobalisation comes through, what does it actually mean?”
“Well it means less reliance on the cheap labour and questionable working conditions that go into making all of the things you own. But it means paying more for the things you own, so it means inflation.”
O’Hara said that “if you want to add some other political aspects on top of that”, the energy transition in the West away from fossil fuels and towards renewables will require massive investment in infrastructure. The only way to pay for this will be further stimulus.
“And then if you want to be a little bit cynical like me, you might add on top of that the risk that ESG in what I think is a pretty dumb and primitive current form leads to a misallocation of capital and underinvestment in essential capacities, whether that's, oil, gas or raw materials,” he added.
“You can put all that together and build a reasonable argument to say who cares what the Fed has to say next week or next month: inflation is coming back and there's nothing that it can really do about it.
“That's one of the big-picture aspects of change that we're thinking about. And if more and more evidence of that comes through, that's something that we will need to navigate with care.”
The good news however is that the clumsy implementation of deglobalisation and ESG initiatives creates opportunities for investors.
For example, O’Hara noted that plans for massive infrastructure projects should favour producers of steel such as Luxembourg-based ArcelorMittal.
The manager pointed out ESG investors would never invest in steel companies because of their large carbon footprints, while even non-ESG funds would have done well to keep away from them over the last decade; an analyst note published this week described ArcelorMittal as “a historically toxic company”.
Performance of index over 15yrs
Source: FE Analytics
Yet O’Hara said it could be one of the major beneficiaries of a carbon border tax that is being proposed on imports of steel into the European Union.
“If this comes through, it could be a real gamechanger, and we can put it in some pretty stark numbers,” he said.
“For every tonne of steel you produce, there are two tonnes of carbon emitted. And there's an EU carbon price as part of the emissions trading scheme which is currently about €50 a tonne. That would be a €100 per tonne levy that you would have to pay to import a tonne of steel into the European Union.
“And that compares with an average steel price over the last 10 years for above-standard grades of about €600 to €650.”
The low steel price can partly be explained by oversupply, with China “churning out” cheap surplus steel from its domestic builders.
O’Hara said this tough environment for steel producers can be seen in ArcelorMittal’s “violently cyclical, but always pretty measly” profit margins: these have stood at between €25 and €75 per tonne over the past decade.
“Now imagine the impact of €100 per tonne of environmental protectionism on top of those profit margins,” the manager continued.
“We think it could be transformative and allow the company to invest in decarbonisation technologies. That's exactly what the EU wants, and it’ll be throwing extra grant money on top of it to make sure that happens.”
He added: “ArcelorMittal stands to be one of the biggest beneficiaries of the EU’s climate ambitions. That’s the kind of idiosyncratic change that we look for. And it's fair to say that we approach ESG in exactly the same way.
“We don’t ask who’s winning the beauty contest today, who’s the cleanest and greenest and kindest, it's all about where is the change, where will that change come through and how: the largest delta in terms of benefiting society.”
Data from FE Analytics shows the Henderson European Focus Trust has made 225.97 per cent over the past decade, compared with 211.92 per cent from the IT Europe sector and 134.54 per cent from the FTSE World Europe ex UK sector index.
Performance of trust vs sector and index over 10yrs
Source: FE Analytics
The trust is on a discount of 9.79 per cent compared with 10.18 and 9.71 per cent from its one- and three-year averages.
It has ongoing charges of 0.82 per cent.