All Out June 23rd: ESG, more harm than good?
A bit late again as it was my birthday yesterday :). We’ve been critical of ESG in the past. For those of you who don’t know, ESG stands for environment, social, and governance, and the idea behind it is that ESG investments follow certain guidelines that make them more environmentally friendly, socially beneficial, and have better governance. Our criticism of ESG isn’t against the concept, we’re all for investments which help the environment, socially responsible and with good governance. Our gripe has been with the way it is implemented (in public markets at least), and the way it has been marketed. Coincidentally this week we heard a podcast which goes into detail on the whole ESG issue and has some very interesting conclusions.
So how do ESG proponents claim ESG makes an impact? Let’s illustrate it with an example, let’s say you want to help fight climate change. What ESG advocates would tell you is to buy an ESG fund focused on this topic. There are several types of ESG funds, but all the types essentially change how much they invest in companies depending on their ESG scores. So you might have a fund that excludes all oil and gas companies, or gives them less weight than the non-ESG index, or others might give more weight to renewal energy companies. The theory is that divesting, or investing less in these companies, will drive up their cost of capital, and this will make them become more environmentally friendly (we’re using the environmental example but it applies equally to the S and G). There are several holes in this argument:
- The first is that for this to actually work everyone would have to do it. If I sell my Exxon shares, Exxon won’t even notice. Even if I had a $100 billion portfolio It wouldn’t make a difference. Exxon has a market cap of $412Bn, if I had $100Bn invested in the S&P 500, I would have $1.14Bn in Exxon. Exxon on average this year has traded $16.1B per day. So even if I wanted to sell it all in a day, I could probably sell it without having much of a market impact (assuming you know how to trade well). And even if I didn’t know how to trade it properly and I did impact the stock, the drop would eventually reverse; since price movements based on liquidity (as opposed to fundamental reasons) tend to mean revert.
- The second (related to the first) is that if a company has a higher cost of capital (higher interest rates, or lower valuations), it means the investor will earn a higher return. So let’s say everybody started selling Exxon bonds en masse, and the interest rate they pay on their bonds goes up to 10% (from ~4.82% today). Eventually the returns will get so attractive that someone will step in to buy. Either an investor that doesn’t care about ESG, or someone like us that thinks there’s better ways of affecting change. We would rather buy that 15% bond and donate some of the profits.
- The third is that when you sell your shares, the company isn’t affected directly in any way. The way a company raises money is by selling shares itself (either in the IPO or a secondary offering). But these events are few and far between in a company’s history. Nearly all trading in public markets is between investors and doesn’t involve the company in any way (with the exception of IPOs and secondary offerings). When you sell your Exxon shares, it’s not like you’re taking that money away from Exxon, but rather another investor is buying it from you. In any case if you did believe it had an impact it would be better to do it with bonds, since bonds are issued way more often than equity.
Another argument used by ESG proponents is that ESG investments should have higher returns. This is in direct contradiction to the argument above. If you want a company to change its ways by divesting and driving up their cost of capital, then by definition that stock will have higher returns. If it’s more expensive for a company to issue debt, then the people that buy that debt will earn a higher return. Of course this assumes no defaults, but if your argument is to sell all non-ESG stocks to make them go bankrupt then that is a real stretch. Not only will someone eventually give capital to a good business, but then think about all the jobs lost (social?) and the impact it would have on the economy as a whole if oil and gas drillers, refiners, etc. didn’t exist (hint: it would cease to function).
There’s an interesting podcast which goes into depth on all these topics. If you’re interested please go and listen to it since they go much more into depth than we do here. Here is the link. The guest on the podcast has a recent paper out (found here) in which she argues that ESG investing does more harm than good. Her main points are:
- A reduction in financing costs for “green” firms leads to small improvements in impact at best
- Increasing financing costs for “brown” firms leads them to be more short term oriented which makes them increase their negative impact on the environment
- Her conclusion is that investing more in green firms and less in brown firms leads to the opposite desired effect. Green firms can do little to improve the environment, while brown firms can do a lot. Therefore, giving money to green firms doesn’t cause much impact. What would cause much greater impact is to give money to brown firms to get them to change their ways. What it actually causes is a net increase in negative impact on the environment.
This is a very interesting take since all the ESG investing may be doing more harm than good (previously we thought it didn’t really make a difference). She suggests that the best strategy would be to engage with brown firms instead of simply divesting away from them.
The other issue with ESG is how do you define what exactly is a good score on ESG? What I think and what you think would make a good ESG company will be different. I think there are universal things we can agree on are bad (child labor, slavery, etc.) but the details get tricky quickly. The other day we were in an investment committee meeting of a non-profit (part of our company’s ESG efforts!), in which a large US bank was touting their ESG capability to screen out stocks based on something like 50 different factors. One that stood out to us was nuclear energy. It stood out because it was something that would get screened out, but nuclear is one of the cleanest energies there is. We don’t want to get into an argument on the merits of nuclear, but we can summarize our take with a paraphrased quote: if nuclear energy was discovered today, it would be heralded as the savior to our climate problems. Is it better to sell Exxon because it drills for oil and gas which contributes to global warming? What if Exxon is developing the green technologies of the future? Shell is using its profits from oil and gas to fund the development of next-gen technologies for example.
Where ESG investing might make a difference is in the private equity or venture capital space. Here we think it does make a difference because the investment by a PE of VC fund into a company directly leads to money flowing into the company. We coincidentally listened to another podcast this week dealing with investing in climate focused companies. His whole take is he’s looking to invest in companies that are helping the environment and he wants to make money doing so. Their slogan is: “[f]ixing the planet is just good business. Shame and guilt won’t get us there, markets will.”
So what can you do if you want your investments to actually make a change? First of all we think the most powerful dollar is not your investment dollars but rather your consumption dollars. If I sell my Amazon stock, Jeff Bezos won’t even notice. However, if I decide to stop buying from Amazon, the company will feel it in its revenues directly (irrespective of how small my spending on Amazon is relative to the $524Bn of revenue). The problem with ESG is that it gives investors a false sense that they’re doing something to fix an issue. It’s easy to say I sold Exxon, it’s not easy to say I’m going to stop buying gasoline (or anything plastic related, or with nylon, or imported, or like a million other things which are derived from or impacted by oil or gas). If you want to have the most impact, change your consumption patterns (not easy to do). Easy to see at the World Economic Forum at Davos all of them talking about climate change with 200 private jets parked in Zurich. If you want to help with your investment dollars then have your money managed by a company which follows ESG principles. Instead of investing in companies that score well on ESG, make sure your investment manager scores well on ESG. Or simply make the best investment you can and then donate some of the profits to whatever cause resonates with you. We’re all for ESG and helping affect change, but if you’re going to do it make sure you do it in a way that actually makes an impact. Just buying the whatever ESG fund won’t cut it.
