Generate and The Moral Bankruptcy of ESG

Dr Robert Howell

September 2021

In May 2021 The Economist crunched the numbers on the world’s 20 biggest ESG (environmental, social, and governance) funds. On average, each of them holds investments in 17 fossil-fuel producers. Six have invested in ExxonMobil, America’s biggest oil firm. Two own stakes in Saudi Aramco, the world’s biggest oil producer. One fund holds a Chinese coal-mining company.  ESG investing is hardly a champion of social virtue either. The funds we looked at invest in gambling, booze and tobacco ⁱ.

Introduction and Summary

This article describes and evaluates the claims of Generate to be a responsible and ethical investor. The characteristic of its reliance on underlying funds is described, as well as its Exclusion Policy, an Active Ownership Policy, and its reliance on the definition of responsibility and ethical on a ESG process.

The Generate Kiwisaver Focused Growth Trust Fund is described with International Equity 66.5% dominating the investments. One of these Funds (T Rowe Price Global Equity Fund) is examined. The Fund has embedded environmental, social, and governance analysis into the investment process, but it mainly relies on their own proprietary framework, RIIM, to help the integration of ESG factors. Because of the proprietary nature of this tool, it is not possible to say how the T Rowe Price Global Equity Fund defines ethical or responsible.

A description and evaluation of the companies included in the T Rowe Price Global Equity Fund is made. It was found that the banks, Wells Fargo and Morgan Stanley, are included. These banks are on the list in the top ten major bank investments in fossil fuels since the Paris Agreement. Bank Central Asia is one of the financiers of APP. According to the Environmental Paper Network, APP is a conglomerate connected to 30 years of deforestation, forest and peat fires, and the destruction of wildlife habitat in the 2 million hectares of land under their control in Indonesia. HDFC Bank is India’s largest private sector bank by assets and by market capitalisation as of April 2021. Its Environmental Policy is outdated and minimalist. A Fund cannot be ethical or responsible when banks mentioned above are in its portfolio, unless it has chosen those in order to engage to change them.

Albemarle Corporation is a global developer, manufacturer and marketer of highly-engineered specialty chemicals. According to Violation Tracker, Albemarle has had 22 environmental-related offences penalties of ($772,108) and 8 safety-related offences ($78,403).

Mondi is a packaging and paper company. 76 % of Mondi’s wood is sourced from PEFC or FSC certified forests. Russia and Bulgaria are particularly high risk countries. Mondi has a number of policies and practices that should take it to be a fully responsible company. However, Generate should be reporting on its Mondi investment that Mondi is not yet a fully sustainable company with regard to wood and pulp sourcing.

Because of the heavy reliance on six funds (underlying funds) and by handing over the responsibility of the selection, management, engagement and reporting to these funds, Generate has lost control of what is to be included in the amorphous definition of ESG and the adequacy and extent of engagement and reporting. This is a systemic failure and means Generate cannot meet the basic requirements of being an ethical investor.

In the Discussion below, evidence is given to show that the more basic problem Generate faces is common to any investor that relies on an ESG process: the ESG process is morally bankrupt. Instead an ethical investor needs to adopt a statement of its values that uses ethical language. These need to be comprehensive (they include both human-human and human-Earth responsibilities) and deep enough to generate the secondary concepts, schema and sets of obligations to be able to define a relationship that guides behaviour. Some possible choices are given for key ethical concepts, as well as examples on how to implement these.

A recent report states that vast majority of fossil fuel reserves owned today by countries and companies must remain in the ground if the climate crisis is to be ended. There needs to be a strategy for ethical investors collectively to contribute to the purchase of these assets and then write them off by leaving them in the ground.

Generate

Generate is a New Zealand based fund investor. It claims to be a responsible and ethical investor. It is able to offer Kiwisaver options. Its funds invest in an actively managed diversified portfolio of underlying funds; international equities properties and infrastructure assets, and cash. The underlying funds are

• T Rowe Price Global Equity Fund;

• The Magellan Global Fund;

• Berkshire Hathaway Inc;

• Worldwide Healthcare Trust;

• Platinum International Fund;

• Jupiter European Opportunities Trust Plc ⁱⁱ.

Exclusions

The fund states it will not invest in

• the manufacture of cluster munitions;

• the manufacture of anti-personnel mines;

• the manufacture or testing of nuclear explosive devices;

• the processing of whale meat; or

• the manufacture of tobacco.

Generate states that there is a risk that Underlying Funds may hold excluded investments from time to time. They say that as they are not part of the Underlying Funds investment making decision process, they are unable to know exactly what Underlying Funds are investing in on an ongoing basis.

ESG

Generate states that they prefer investments that have positive findings regarding ESG issues where all other factors are equal. Investments will not be excluded solely based on negative findings regarding ESG issues. However, as they rely on boards and management to make positive decisions regarding ESG issues, they may engage with organisations who they consider have high risk ESG issues or concerning behaviour as identified during their investment analysis. This engagement will be to encourage the organisation to adopt better ESG practices and encourage disclosure of these practices.

ESG issues include but are not necessarily limited to:

• the quality and functioning of the natural environment and natural systems

(including excessive and harmful pollution, resource depletion, use of toxic chemicals, and the endangerment of animal species).

• governance issues including strong governance structures, appropriate executive control and high levels of transparency.

• Social issues including the rights, well-being and interests of people and communities. (such as human rights, health and safety, child labour, community relations and respect for the rule of law).

Active Ownership

They say these activities include: –

• Governance and voting (to encourage high governance standards across markets and asset classes);

• Monitoring and engagement (dialogue with companies and Underlying Funds over significant breaches of standards and to encourage best practice);

• Substantial owner (engagement on material ESG issues with companies and Underlying Funds in which we have a significant interest).

Details of portfolio holdings are accessible by clients via their online accounts. This information is regularly updated and contains a breakdown of direct investments and Underlying Funds. Information on investments held by Underlying Funds and respective responsible investment policies are available on the Underlying Funds’ own websites.

Generate Kiwisaver Focused Growth Trust Fund

As at 31 March 2021 this Fund included International Equity 66.5%; Australian equities 18.4%; Property 9.9%. The number of investors was 61816 with a total value $1,429,552,549 ⁱⁱⁱ. The top ten investments were

1. T Rowe Price Global Equity Fund 10.64%;

2. Berkshire Hathaway 8.89%;

3. Platinum International Fund – A Class 6.03%;

4. Diversified fund Australia Magellan Global Fund 5.85%;

5. Infratil 5.18%;

6. Worldwide Healthcare Trust 5.09%;

7. ASB NZ Dollar Cash Account 3.90%;

8. Alphabet 3.36%;

9. Facebook 3.20%;

10. Microsoft 3.16%.

T. Rowe Price

T. Rowe Price manage USD 1.47 trillion of assets predominantly in actively managed portfolios. They have embedded environmental, social, and governance analysis into the investment process: the responsibility for integrating ESG factors into investment decisions lies with their analysts and portfolio managers. They have ESG and public policy research specialists within their investment teams. They have developed their own proprietary framework, RIIM, to help their portfolio managers and analysts more easily integrate ESG factors into their investment process. On page 11 of their report ESG at T Rowe Price, they give an indication of some aspects of what this analysis is, but there is not a full description of the dimensions that go to make up the components of what constitutes an ESG analysis. Examples are given of their engagement with Amazon, Samsung, State of California Bonds, and First Rand ^iv.

They state that with their RIIM assessment, they consider their investments’ environmental characteristics holistically and their key areas of focus include:

• energy transition;

• physical risk;

• biodiversity impact;

• circular economy contribution;

• land use;

• water use;

• track record on environment;

• accountability and transparency for ESG (including climate change).

In 2020, the T. Rowe Price portfolios voted on 1,431 shareholder resolutions across all markets. Of those, 500 were situations where shareholders were nominating directors to a company’s board. Another 585 were resolutions asking companies to adopt a specific corporate governance practice. 346 were social and environmental resolutions. They engaged with companies on 1,002 separate occasions, sometimes more than once with the same company. The most common topics of their environmentally focused engagements were disclosure, greenhouse gas emissions, product sustainability, and general environmental management.

They state that they work with an imperfect data set when it comes to environmental analysis. This is partly a problem of limited disclosure and lack of universal reporting standards. Issues of disclosure and standardisation are gradually being resolved and new sustainable finance regulations will accelerate what had been a largely voluntary trend from corporates, but there is still a long way to go. For example, carbon emissions is one of the most widely available statistics, but disclosure levels for scope 1–2 emissions cover less than half the investible universe and disclosure for scope 3 emissions is even lower. They purchase a data set from Sustainalytics that provides carbon emissions and intensity for a universe of more than 11,000 companies, of which nearly 75% of the companies have estimated data.

T Rowe Price Global Equity Fund

This is described as a highly-diversified portfolio with approximately 150-200 companies ^v. It claims the flexibility to invest in developed, emerging and frontier markets e.g. Philippines, Indonesia, Peru. It is made up of

• information tech 22 %;

• consumer discretionary 18%;

• financial 15%;

• health care 13%;

• industrials and business 10%;

• materials 4%;

• communication services 9%;

• real estate 2.39%;

• utilities 2%;

• consumer staples 4%;

• energy .03%.

The Investment Manager states that he currently does not intend for the Fund to invest in or hold any securities of companies in the tobacco industry ^vi. In addition, the Investment Manager integrates ESG factors into its investment research process and focuses on the ESG factors it considers most likely to have a material impact on the performance of the holdings in the Funds’ portfolio. As at 30 June 2021 the following companies were included in the fund: Wells Fargo; Morgan Stanley; HDFC; Bank Centra Asia; Albemarle Corporation; Mondi; and Orsted ^vii.

Evaluation of T Rowe Price Global Equity Fund

There are two major criticisms of this Fund. First, a number of the companies that the fund invests in cannot be called responsible or ethical. Second, the hands-off approach by Generate means that they have lost control of what is to be included in the amorphous definition of ESG and the adequacy and extent of engagement.

Inclusion of Unethical Companies

A group comprising Rainforest Action Network, BankTrack, Indigenous Environmental Network, Sierra Club and Oil Change International have identified major bank investments in fossil fuels since the Paris Agreement. This includes Wells Fargo and Morgan Stanley ^viii.

Bank Track have identified Bank Central Asia as one of the financiers of APP ^ix . According to the Environmental Paper Network, APP is a company that has been boycotted by most major brands, as the conglomerate is connected to 30 years of deforestation, forest and peat fires, and the destruction of wildlife habitat in the 2 million hectares of land under their control in Indonesia.  Such peat fires, and the company’s peat development, have caused extensive greenhouse gas emissions. There are also many reports of conflicts with local communities related to land grabbing, forest clearance, and pulpwood plantation development in Sumatra and Kalimantan, Indonesia ^x.

HDFC Bank Limited is an Indian banking and financial services company, headquartered in Mumbai, Maharashtra. HDFC Bank is India’s largest private sector bank by assets and by market capitalisation as of April 2021. Its Environmental Policy is outdated and minimalist ^xi.

Albemarle Corporation is a global developer, manufacturer and marketer of highly-engineered specialty chemicals. The Company operates through three segments: Lithium, Bromine Specialties and Catalysts. The Lithium segment develops lithium-based materials for a wide range of industries and end markets. According to Violation Tracker, Albemarle has had 22 environmental-related offences penalties of ($772,108) and 8 safety-related offences ($78,403) ^xii.

Mondi is a packaging and paper company ^xiii. The say

We are committed to zero deforestation and no use of illegal or controversial wood fibre sources. We do not use tropical tree species, species listed by the Convention of International Trade on Endangered Species (CITES) or the Red List of International Union for Conservation of Nature (IUCN). We also do not use wood from genetically modified (GM) trees. Beyond our direct supply chain, we support multistakeholder platforms to address the root causes of deforestation. We believe a key part of the solution to preventing deforestation is ensuring the long-term sustainable management of existing forests by securing their resilience and functionality as forests, while protecting areas of high value for biodiversity and ecosystems, livelihoods and communities.

We support the setting of global standards for environmentally appropriate, socially beneficial and economically prosperous forest management. At the same time, we engage with certification schemes at international and national levels to support a relevant and effective approach in different regions. Mondi is an international member of both FSC and PEFC. In 2020, we actively engaged with the PEFC International Secretariat and its International Stakeholder Members liaison group to contribute to strategy discussions. The focus is on preserving credibility, integrity and transparency of PEFC and identifying ways to address global challenges at scale, while maintaining PEFC’s strengths for small forest owners. We engage with FSC primarily at a national level, focusing on Russia and South Africa where we have our own forestry operations. In 2020, we worked with WWF and FSC to investigate the experience of key stakeholders in implementing the new FSC standard requirements in Russia and South Africa.

76 % of Mondi’s wood is sourced from PEFC or FSC certified forests. Russia and Bulgaria are particularly high risk countries. Mondi appears to be acting responsibly towards wood and pulp sourcing. However, Generate should be reporting on its Mondi investment that Mondi is not a fully sustainable company with regard to sourcing, and there is still work to do.

Also in the portfolio is Orsted, a Danish renewable energy company ^xiv. The company transformed itself in about a decade to become the first major energy company to move from an oil and gas to a renewable energy company. They claim to be on track to become carbon neutral by 2025. (This paragraph is included to show that there are investments in the portfolio where companies can transform themselves.)

Selection and Oversight of the ESG Process

Generate claim to exercise active ownership of the underlying funds. These funds in the case of Generate Kiwisaver Focused Growth Trust Fund, constituted 66.5% of the Fund with T Rowe Price Global Equity Fund comprising 10.6% of the Fund. If the rest of the underlying funds were in any way like our analysis, then Generate have abdicated responsibility for just under 70% of the Fund. By handing over the responsibility of the selection, management, engagement and reporting to the underling funds, they have opened themselves up to funds which do not fit with their exclusion selection. They have ignored their responsibility for engagement activities and the reporting of their activities, which for the Underlying Funds constitute a small portion of the companies that funds are invested in. For Generate to claim that they are a responsible and ethical investor is false and deceptive.

Discussion

Joly, one of the co-Chairs of the Expert Group of the United Nations Principles of Responsible Investment (UNPRI), when reflecting on the 2008 financial crisis, lamented in 2012 that the adoption of the Principles made no difference in practice ^xv. The problem with the UNPRI is that it advocates taking ESG factors into account, but never defines what social behaviour, environmental impact, or governance behaviour is morally right or wrong. As a result, according to the Reporting Exchange there were more than 1700 different ESG related guidelines worldwide in 2019 ^xvi. Is it any wonder that the Economist (quoted at the head of this article) should find no real difference between an ESG and a non-ESG Fund? Is it any wonder that Generate should fail so badly? As such the ESG framework is morally bankrupt ^xvii.

If Generate wants to become an ethical and responsible investor it needs to follow these four steps:

1 define its values;

2 identify what types of investment that are to be excluded from selection;

3 engage with companies and investments where there are differences in desired performance;

4 report on the results of that engagement.

In regard to the first step, it needs to adopt a statement of its values that use ethical language. These need to be comprehensive (they include both human-human and human-Earth responsibilities) and deep enough to enough to generate the secondary concepts, schema and sets of obligations to be able to define a relationship that guides behaviour. The Earth Charter uses the concepts of respect, ecological integrity, care, equity, justice ^xviii. New Zealand’s Climate Change Commission uses the He Ara Waiora framework which included the concept of manaakitanga – having a deep ethic of care towards people and the whenua (land) ^xix. Other concepts include fairness, harm, rights, obligations, duty, integrity. Treasury’s four capitals – – financial/physical, natural, human and social – are potentially possible ^xx. Whatever is chosen, it should be validated ^xxi.

As part of this validation should be an identification of the secondary concepts, schema and sets of obligations that guide behaviour. For example, Generate states that ESG issues that it is interested in include social issues such as human rights. If this is the case then Generate should be identifying rules such as the Universal Declaration of Human Rights and the International Labour Organisation conventions, and requiring the companies they invest in to observe these. If they do not, then Generate should engage with them to change. It should report on that activity. An ethical investor should know if the companies they invest in pay a living wage to its staff and workers in its supply and distribution chains.

In addition to selecting a validated ethical statement and identifying ways of assessing whether the companies are measuring up to these through robust standards, an ethical company needs to put in place effective engagement processes, and the report on them. By relying on its Underlying Funds for a substantial portion of its investments without requiring them to inform Generate of their selection, assessment and engagement, Generate is unable to meet this requirement for it to an ethical investor.

Engagement is important because divestment by itself is not sufficient. Example: the Denmark-based company Ørsted, has transformed from a fossil-fuel based energy company to a global green energy company in the past decade ^xxii. Divesting when it was still a fossil-fuel based company excluded the chance to support it to change. Divesting means someone else buys. Currently some of the world’s biggest oil and gas companies are putting around $140 billion worth of assets up for sale ^xxiii. But INEOS and others are buying up unwanted fossil fuel assets. (INEOS is a financial sponsor of the All Blacks.)

So in this case divestment is simply shifting the problem elsewhere. A recent report states that vast majority of fossil fuel reserves owned today by countries and companies must remain in the ground if the climate crisis is to be ended ^xxiv. There needs to be a strategy for ethical investors collectively to contribute to the purchase of these assets and then write them off by leaving them in the ground. As an investor, I would be very happy to contribute a portion of my investment income to a fund that purchases fossil fuel assets with the purpose of writing off the cost so that the fossil fuel assets remain in the ground and the other assets are used in transforming to other sustainable and ethical activity.

In May 2021 The Economist crunched the numbers on the world’s 20 biggest ESG (environmental, social, and governance) funds. On average, each of them holds investments in 17 fossil-fuel producers. Six have invested in ExxonMobil, America’s biggest oil firm. Two own stakes in Saudi Aramco, the world’s biggest oil producer. One fund holds a Chinese coal-mining company.  ESG investing is hardly a champion of social virtue either. The funds we looked at invest in gambling, booze and tobacco ⁱ.

This article describes and evaluates the claims of Generate to be a responsible and ethical investor. The characteristic of its reliance on underlying funds is described, as well as its Exclusion Policy, an Active Ownership Policy, and its reliance on the definition of responsibility and ethical on a ESG process.

The report from Dr Robert Howell is available as a PDF here , and is reproduced below.