October 23, 2021

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Team ESG fights back

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Welcome back. My piece about Tariq Fancy and the case against ESG generated a great deal of mail. At least half of it was positive, mostly in the “thanks for pointing out that the emperor has no clothes” vein. A small minority made ad hominem attacks, which is even more encouraging for a journalist than praise. I’ll respond to the most popular counterarguments in the remaining letters below. 

As always, you can get your two cents in at: robert.armstrong@ft.com

If you are sympathetic to Fancy’s view, check out Moral Money’s interview with him.

ESG: replies, and my replies to the replies

To recap, I (following Fancy) have nine bad things to say about the ESG investing industry:

ESG investing, if it changes the world, does so by affecting the cost of capital. That implies ESG investors can expect lower returns, but the ESG industry disingenuously promises outperformance.

If ESG investing does provide higher returns, then we can just call it “investing”, and it changes nothing.

The biggest problems ESG investors claim to tackle have time horizons much longer than any investor, so purpose and profit rarely overlap where it matters most.

Funds investing or not investing in a given company in the secondary market doesn’t change much for the company itself, except for its cost of capital, and the market sometimes arbitrages that change away. 

Telling people that where they park their retirement savings is going to help save the world (it won’t) distracts them from doing things that actually will save the world.

Green bonds are a capital arbitrage opportunity.

To change the financial calculus of the corporate world, ESG investing would have to be measured in the many trillions, and it ain’t getting there. Because the effect of ESG investing is weak, there will never be enough of it.

Corporations have been designed over centuries as profit-seeking organisations with a responsibility to increase shareholder wealth. Trying to turn them into stakeholder organisations on the fly will fail.

We do not want Wall Street people deciding what is good for society.

Here are the main lines of reader response:

ESG investing is a form of risk management. This is by far the most common response. It says: ESG strategies outperform because they bet on companies that are prepared for risks that other companies miss.

This argument drives me absolutely nuts. Money managers are in the risk management business. Do we think they have not noticed that, say, California is on fire? That they are closing their ears to a set of risks that are front-page news every day? Do they need a reminder from the ESG team that, say, Exxon has some questions to answer about the sustainability of its business model? If managers are ignoring risks in this way, it is probably because the risks don’t match their clients’ investment horizons (see 3, above), not because they are nitwits. 

There are companies in the world that have embraced sustainability, and they are prospering. They are indeed, and that is a great thing. But what does that have to do with the ESG investment-industrial complex? Customers want products that fit with their values, and companies do well to provide them. This does not imply that ESG investment funds have caused companies to see this (obvious) point, or will outperform, or anything else. It just means that, thank goodness, some people try to do the right thing when they make purchases. 

Along this line, several readers noted this interesting article by Michael Porter, George Serafeim, and Mark Kramer. It points out that years of effort has not produced evidence that high ESG ratings correlate with outperformance. But this may be because many companies make the mistake of not thinking about how ESG priorities can be integrated into a differentiated competitive strategy. Where companies get good results is by using an ESG edge specifically to beat peers and make more money. This solves problem 8 above neatly, and maybe it’s true?

ESG will have more impact when we better define what it means and what we expect ESG-compliant companies to do. The problem of defining and measuring companies’ success in meeting ESG standards is every ESG investment consultant’s favourite problem, because it seems solvable and is sure to provide long-term employment.

Indeed, there are no uniform standards. The insightful Duncan Lamont of Schroders recently tweeted this chart, showing the lack or correlation in judgment among different ESG scoring systems:

Yes, well, that is bad, but if we solve this problem, I still don’t want some consultant deciding what is good for society (problem 9). That’s what democracy is for.

I just don’t want evil companies in my portfolio, so I choose ESG funds. Fair enough. But remember, if your ESG fund invests in secondary markets, the companies involved are not using your capital either way, and the effect on those companies of the fund’s buy/sell decisions are very moderate. Don’t feel too good about yourself; vote, call your senator, boycott, donate, purchase carefully, and then feel too good about yourself. 

In other words: don’t fall into trap 5, above.

You trust the politicians, not business people, to get big things done? HA HA HA. Government does get things done, when citizens drop their cynicism. And while I’m at it, I’ve met a CEO or two I wouldn’t let babysit my dog.

There are many investors who have very long holding periods — pension schemes, sovereign wealth funds, foundations — and their time horizons are a good match with society’s big problems. This is a good point. But the mechanism by which they act will still be cost of capital, which is a gentle force. Public companies that divest “brown” assets to improve their cost of capital will find eager private buyers for those assets; this is happening now. The subset of investors that take the long view are unlikely to change much on their own. 

I work for a big asset manager, and when we tell companies and fund managers that they need to get their ESG act together, they damn well do it. This sort of response, of which I got two or three, was the most convincing. One exec at an asset manager wrote that:

Something changed around 2016 . . . RFPs (request for proposals) for mandates started to screen fund managers on whether or not you were a UN Principles for Responsible Investment signatory — and it quickly became in Europe a binary decision point for them. Then they started to ask for copies of the firms’ written responsible investment policies. Next came the grilling of CIOs and portfolio managers during client reviews on how closely they adhered to that policy, with documented evidence they did so in internal records. Obfuscation, eye rolling and dismissive waves of the hand from investment team members were replaced by requests for training, buying of new research tools and the arrival of more qualified voices.

Another asset management exec argued that the fluffy marketing does not matter. What matters is driving down cost of capital for “green” companies and up for “brown” companies: 

It doesn’t matter that clients fail to understand the point on cost of capital and there is no need to stress this in marketing materials. The point is that ESG investing will make clients feel good about themselves or look good towards the asset owners they represent and the disclosure regulation gives the necessary push for ESG investing to become mainstream. The more ESG factors will be integrated in the investment process the larger the impact on the average cost of capital and returns and the speed of the adjustment, the bigger the incentive for companies to change their ESG practices. 

I am happy to read this (although asset managers should not even hint that ESG investments will outperform over the long run; they have no reason to think this). But relative costs of capital are not anything like a full solution to society’s big problems. And it may create a dangerous distraction from the real solutions, which all involve political action. 

One good read

My take on what we will be wearing when we finally go back to work: whatever the hell we want, for better or (probably) worse.

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