The ESG Juggernaut and Points of Pushback

ESG is dominating the investment business.

According to Bloomberg’s count of headlines from all of the news sources it monitors, the monthly total of those including “ESG” is up ten times since January 2018.  Google searches are up by a factor of five over the same period.

Your inbox is flooded with articles and papers from asset management firms, academics, industry organizations, consulting and advisory firms, etc.  And, there’s another flood going on, of money into products that carry the ESG label or promise to operate within the precepts it represents.

On this site, we’ll be part of that deluge and will aim to provide content that makes sense of it all.  This posting is a start.

Beliefs

Investment beliefs form the foundation of the philosophies, principles, and processes that lead to decisions in portfolios.  They interact with organizational beliefs (the how of culture and structural choices) and mission beliefs.

For example, the mission beliefs for institutional asset owners include economic targets like meeting pension promises, delivering a desired portion of an operating budget, or maintaining the purchasing power of a portfolio for perpetuity.  But the broader mission of an organization (or the interests of some of its stakeholders) can be at odds with the investments held in the portfolio.  In part, the march to ESG reflects changes in the balance between investment and mission beliefs by asset owners.  (Individuals have been making similar choices.)

No matter where you are on the spectrum of beliefs regarding ESG, informed and engaged debate about it are essential.  The ideas below are intended to sharpen that debate.  If you are a skeptic regarding ESG, the points surfaced may feel like vindication, but that’s not the purpose of providing them here; it’s to suggest a platform for further analysis and discussion.

If you are a proponent of ESG, consider Charlie Munger’s famous dictum:  “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.”  These are arguments that you will need to understand deeply to effectively communicate with others about how ESG should inform investment decisions.

Seven myths

Below you’ll find “Seven Myths of ESG,” based upon a paper released by the Stanford Corporate Governance Research Initiative.  Each of the myths appears in italics.

We agree on the purpose of ESG.  The authors point out that “little consensus exists about what ESG is and the problem ESG investment is expected to solve.”  They outline three broad philosophies:  one for which “ESG investment is offered as a solution that reduces long-term risk,” another where the goal is “to find an equitable balance between investor and societal interests,” and the last, which “sidesteps the economic implications of the decision and is essentially a normative (values-based) argument.”  As a starting point:

The distinction between these viewpoints is very important because without agreement on the fundamental problem that ESG is addressing, corporations, investors, and stakeholders will not be able to agree on what ESG activities to pursue, how much to invest in them, and what outcomes to expect.

ESG is value-increasing.  In a business obsessed by bottom-line performance, everyone wants to know whether ESG leads to better or worse performance.  According to the authors, “the evidence is extremely mixed and very dependent on the setting.”

Early research in this area almost always showed lagging performance for “social investing” of various kinds.  But in recent years, the trend has changed and the authors’ conclusion is that “ESG investing has on average been indistinguishable from conventional investing.”  (Some other analyses show ESG outperforming.  An important question left unanswered is whether the huge asset flows of late into ESG have produced a relative price effect that is transitory.)  At the corporate level, there is uncertainty too, leading to this:  “In summary, we do not know the financial impact of ESG.”

We can tell whether a claimed ESG activity is actually ESG.  Some examples are provided which illustrate that advertised ESG efforts by companies may just be “standard business decisions to maximize shareholder value.”  Such “greenwashing” is also an issue at investment firms that promote their vehicles “as sustainable without engaging in a rigorous process to evaluate ESG quality.”  Of broad concern:  “A deep body of research demonstrates the economic damage of greenwashing.”

One of the footnotes provides this reminder to those charged with evaluating companies (or doing due diligence on investment managers) regarding their ESG efforts:

It is almost certainly the case that companies promote their positive ESG attributes while burying their negative attributes.  ESG ratings developed by third-party rating agencies rely heavily on this selective disclosure.

A company’s ESG agenda is well-defined and board-driven.  Speaking of beliefs and related actions, not much is understood about how companies are making decisions about ESG.  The evidence is hard to pin down, but “most companies appear to develop ESG priorities and investment in reaction to internal and external pressure.”  The authors cite another Stanford study that “companies are highly reactive to advocacy by a range of constituents and most respond to social and environmental pressure by taking some form of action.”

G (governance) belongs in ESG.  Some excerpts:

A puzzling aspect of ESG is why governance is included as a third pillar, alongside the environment and social issues.

A company can have good governance quality and be strictly focused on shareholder maximization.  Alternatively, a company can have good governance quality and adopt a stakeholder-centric view that balances profit with other societal objectives.

The need for governance quality is universal among organizations.

ESG ratings accurately measure ESG quality.  There are an ever-increasing number of providers of ESG ratings.  “Unfortunately, the ratings assigned by these providers have an unproven correlation with performance and are also not correlated with one another.”  One analysis of three ESG ratings providers demonstrated that the “methodologies differ in most every relevant aspect:  input metrics, how metrics are evaluated relative to peers and the industry, how missing data is treated, and the treatment of specific companies.”

“The number of input variables is daunting.”  Here is MSCI’s framework, which is included in an appendix in the paper:

The authors’ take:  “Rigorous measurement of each dimension constitutes a significant research challenge.  Measuring all of them accurately and combining them into an overall composite ESG score that is predictive of outcomes is likely not possible.”

Mandatory disclosure will solve the problem.  There will likely be calls for increasing disclosure requirements, but while “the output of this effort might increase information quality at the margin, the cost of doing so will not be trivial.”  For example, twenty years on, there are uncertainties regarding the costs and benefits of Sarbanes-Oxley, which mandated greater corporate disclosure.

Divest or engage?

Another paper, “The Impact of Impact Investing,” investigates the question:  Is divestment from low-quality ESG firms effective?

It attempts an evaluation of “the quantitative impact of ESG divestitures.”  The abstract ends:

We conclude that current ESG divesture strategies have had little impact and will likely have little impact in the future.  Our results suggest that to have impact, instead of divesting, socially conscious investors should invest and exercise their rights of control to change corporate policy.

(An article from Knowledge@Wharton gives a very good overview of the the paper.)

This gets at an important distinction in the ESG debate.  Is it better to improve the worst companies on any of the dimensions at play or to favor the best companies?  Those are completely different approaches, illustrating the challenges that exist at the intersection of investment and mission beliefs.

Divestment feels right, but it ignores the fact that it likely has very little effect.  Engagement has the potential to lead to positive change — genuine impact, the stated goal — but, realistically, can one owner, even a sizable one, make that happen given how corporate governance works?

In fact, avoiding investing in something — let’s use fossil fuel as an example — doesn’t mean it is going away.  As the title of a Matt Levine piece said earlier this year, “Someone Is Going to Drill the Oil.”  He explores the gap between economic and non-economic frameworks for thinking about the issues, and quotes from a Financial Times article about “the investors cashing in on Big Oil’s push to net zero”:

Yet despite the intense spotlight on the energy sector, there are potential buyers for these assets — from smaller private players such as Ineos, independent operators who are backed by private equity, opaque energy traders and state oil companies.

Some recent headlines:  “Private Equity Funds, Sensing Profit in Tumult, Are Propping Up Oil.”  “Hedge funds cash in as green investors dump energy stocks.”  “Long smog . . . and short ESG.”

We are seeing in real time a transition in the ownership of assets.  As one of the co-authors of “The Impact of Impact Investing” said:

If you sell stocks in a dirty company, somebody else will buy them.  That person clearly doesn’t care about the ESG aspect of it, making it less likely that investor pressure could force changes in the company.  The question in that case is, have you done something good?

Much more to do

Does your organization have clarity about where it stands on these cornerstone issues?  Do your actions reflect those choices?  Do your clients and/or stakeholders understand your beliefs and why you hold them?

There is much more work to be done.  Don’t let the need to do it get washed away in the flood.