Businessman pushing the world uphill. Vector illustration
Both interest in and backlash against ESG are at all-time high. Recently, leading asset managers and academics alike are making the case that contrary to being a political act, ESG integration, or incorporating environmental, social, and governance factors into investment and ownership decisions, is no different from other investment approaches that create long-term financial and social value.
Investors globally are parsing through BlackRock
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First, let’s more closely examine Larry Fink’s comments and the conclusions of the Pitchbook research. Larry Fink explained that he still believes in “conscientious capitalism” and that he had evolved from embracing the term “ESG” to instead taking a more nuanced approach, talking “a lot about decarbonization…governance…or social issues, if that’s something that we need to address.” Similarly, the Pitchbook research found no evidence that private market funds that are Principles of Responsible Investment (PRI) signatories, meaning that they committed to incorporate ESG factors into investment and ownership decisions, differ in performance from their peers in a statistically meaningful way. This is not surprising, as the collective AUM of PRI signatories at just over US$121 trillion represents the vast majority of globally managed assets. Analysis using a dataset comprising funds with ESG strategies meeting more robust minimum requirements than those of PRI may also yield different results.
Applying Economics to ESG Investing
World-class academics write seminal investment textbooks and publish widely cited papers in academic journals. World-class investors rarely have time to read them. Alex Edmans’s new research applies the insights of mainstream economics to overturn conventional wisdom on ESG integration. Some of these insights may help institutional investors better balance fiduciary duty with honest integration of ESG.
Sustainability risks generally lower expected cash flows, rather than increasing the cost of capital. PRI research notes that some investors adjust the discount rate used in valuation models to reflect ESG factors. Greater precision is warranted: the main effect of an ESG risk is generally to change the expected cash flow. Sustainability risks affect the discount rate only if they both affect the broader market and are more likely to manifest in down markets. By contrast, many ESG scandals are company-specific, and they are no more likely in a down market than in an up market. That being said, idiosyncratic ESG risks can affect the credit spread in the cost of debt.
Sustainable stocks may not earn higher returns: sustainability may already be priced in; tastes for sustainable stocks may lead to lower returns. ESG factors may lead to superior shareholder returns if they are unanticipated. In some instances, ESG factors may be overpriced, if investors overestimate the value of ESG, or tastes may shift away from ES stocks given the current backlash, leading to lower returns. There also could be no mispricing if investors fully recognize the value of ESG and their tastes are stable.
Like many economic factors, ESG factors exhibit diminishing returns, and trade-offs exist. Some ESG factors, such as employee satisfaction, have diminishing returns to scale but linear costs. Other ESG factors have hump shape relationships and ultimately negative returns. Also, firms pressured to improve environmental performance do so at the expense of social status, committing more compliance violations related to employment, healthcare, workplace safety, and consumer protection.
A company’s ESG metrics are an incomplete measure of its impact on society. A company can improve its ESG metrics at the expense of its peers, leading to a zero or negative effect on aggregate externalities. Investors and companies should be mindful of whether making their own numbers look good actually worsens the general problem. For example, selling assets to less responsible owners reduces portfolio emissions, but generally increases real world emissions, and outsourcing carbon emissions does not reduce them.
The most common measure of climate risk, carbon emissions, are incomplete at best. There are two types of climate risk: physical risk, the risk that a company experiences from a warming planet, and transition risk, the risk that a company faces from a move to a low-carbon economy, such as a carbon tax or customers boycotting emitting companies. It’s reasonable to argue that physical risk is even more important to investors than transition risk, given the limited government action of climate change and the little attention paid to climate change mitigation. Without government regulation, climate transition risk is an unpriced externality, not an investment risk. In the absence of regulation, like a carbon tax, there is no loss in risk-adjusted return from investing in brown companies. Indeed, carbon emissions are a poor measure of climate risk.
More strategic engagement is not always better: investors may be uninformed or may undermine managerial initiative. Strategic engagement, or the investor-investee dialogue, is the most reliable form of sustainable investing for investors seeking impact, in the sense that it has been clearly demonstrated empirically. Nevertheless, different shareholders may have different ESG preferences, and some shareholders may launch shareholder proposals even when they are uninformed. Some investors define success by how many firms they can persuade to adopt their issue, irrespective of whether it’s material to their long-term performance or a significant externality for that particular company.
Paying for ESG performance does not always improve ESG performance: paying for some ESG dimensions may cause firms to underweight others. 92% of US companies and 72% of UK firms now use ESG metrics in incentive plans, and a third of companies implemented ESG-linked pay for the first time in 2022. This may lead to prioritizing initiatives that are easier to measure. For example, the most common ESG metric in executive pay is demographic diversity, but pay is rarely linked to inclusion. Investors must also be clear-eyed about the tradeoffs between environmental and social issues. As an alternative to navigating these ESG issues, research shows that paying CEOs with shares that they are required to hold for five to seven years and retain beyond their departure improves both financial performance and environmental and social performance.
Going Beyond Enthusiasm
Despite slightly underperforming traditional funds in 2022 for the first time since 2018, sustainable funds saw net positive fund flows of $115 billion (around 3% of 2021 year-end assets under management), while traditional funds saw sustained outflows in 2022, according to Morgan Stanley
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