A user's guide to the ESG confusion

Investing based on environmental, social and governance criteria is all the rage, but it comes with necessary trade-offs.

  • By James Mackintosh,
  • The Wall Street Journal
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It’s hard to move in the world of investment without being bombarded by sales pitches for running money based on “ESG,” or environmental, social and governance criteria. The trouble is that few involved seem to agree on how it works (or, more to the point, doesn’t). Investors should be clear about what it is they’re trying to achieve, and the trade-offs they make along the way. Here are four ways to use the E and S parts (the G is a major part of ordinary fund management already), typically confused by investors:

Make money. Much of ESG is about what economists call externalities: things such as carbon emissions that are free to the emitter, but costly to wider society. Making money from pricing externalities is a matter of identifying which ones will lead to government, consumer or worker action, and which ones won’t. Some seem easy, because they are so obviously only temporary advantages: treating your workers badly might help your profits but it is likely to backfire in the long run as they leave for other employers. Using cheap ingredients that poison your customers, even if it seems to be legal, eventually leads to expensive lawsuits or government crackdowns.

The trick is to tell when it will happen. It took decades for government to act on evidence that tobacco was killing people, but just a few years to move against vaping. Alcohol, meanwhile, remains a great business in spite of the damage it does. Exploitative companies might be able to carry on for a long time, or be found out tomorrow, and there’s no simple way to predict which a stock is.

The biggest externality of all is carbon, pumped out at zero or close to zero cost. If a left-wing Democrat wins next year and cracks down on emissions, it could be catastrophic for oil companies and heavy industry, and potentially for the wider economy. But that’s a big if. Without action, the companies will continue to make stuff for less than the true economic cost. Some companies might face a consumer backlash, but in principle being able to pollute for free should boost profits.

Reduce risk. The good news for investors who worry about the environment is that lower-carbon companies are only a little more expensive than other stocks. As a result, says Lasse Pedersen of AQR Capital Management, it is possible to hold a moderately less carbon-intensive portfolio and sacrifice only a small amount of expected return after adjusting for volatility. Having a lower-carbon portfolio should (if done right) provide some insulation against new carbon rules or taxes that other investors aren’t pricing in, without much cost while waiting for government to act.

Do good. It’s not obvious that selling shares to someone else changes how a company behaves. In principle if enough people sold it could hurt the price, pressuring management to change, while raising the valuation of the “good” companies. But there’s little sign of that happening so far. Depending how you measure it sometimes the higher-scoring ESG companies are more expensive, and sometimes cheaper, according to FTSE Russell, and it changes over time. If good stocks did become consistently more highly valued, their future returns should be lower; being willing to sacrifice money to save the planet is, on one level, the point of ESG investing.

Of course, some might make money from trading the change, buying “bad” stocks and hoping (or agitating for) better behavior to turn them into higher-valued “good” companies they can then sell on to those taking a moral stand.

Propaganda. For some, ESG is part of a broader push against the political power of Big Oil. “It has a very modest economic effect but it also has a propaganda effect,” says Jeremy Grantham, founder of Boston fund manager Grantham, Mayo, Van Otterloo & Co. “If you make them [oil companies] pariahs, eventually Congress can feel more comfortable about acting.”

Investors can mix and match these approaches, but they should be clear what they’re doing. And it’s hard, because the data is poor and doesn’t go back very far, limiting the value of the academic research, which in turn is oversimplified and misrepresented by those pushing ESG. Those selling ESG scores differ wildly in their assessments of stocks, and even if they did agree, it’s hard to know if it is what you actually want. Take the S&P 500 ESG index, designed to adjust for ESG scores while keeping closely to the sector weights of the blue-chip index. Its components together currently emit 5% less carbon per dollar invested than the normal index, which sounds good. But, as it happens, those companies also have much higher fossil-fuel reserves, exactly the sort of potentially stranded assets those worrying about climate change want to avoid.

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