What is ESG Investing: The Good, the Bad & the Ugly?
It was during the Dot-com boom of the early 2000s that any firm with internet-related business or a name rose in market value. For instance, many companies worth over US$400 million in a 1999 initial public offering (IPO) at prices of over $33, just to file for bankruptcy a few years later at a price of $0.05 per share or below
A similar trend has been observed in investment goods labelled ‘ethical’ or ‘sustainable,’ i.e. anything that adheres to Environmental, Social, and Corporate Governance (ESG) standards. It is argued in this article that there are serious concerns about the long-term sustainability of this investing trend. Hence the question What is ESG Investing? was born.
ESG’s Widespread Adoption
Since their inception, environmental, social, and governance (ESG) funds have grown in prominence. The inflow of US$20.9 billion in 2019 was four times more than in 2018, setting a new record for these funds. After receiving US$29 billion in fresh money in August this year, these funds are on track for another record-breaking year of record-breaking ESG fund inflows.
As a result of Milton Friedman’s business ethics, the corporate world has held the importance of the shareholder in high regard since the mid-1970s
The spread of this adoption was not global in nature. There are still a lot of German companies that have to give half of their board seats to workers who work there, for example.
Due to their economic interests, shareholders are the only socially accountable stakeholders in corporations, according to Friedman’s ideology.
The emergence of ESG nowadays reflects a shift in perspective towards the importance of many other stakeholders. As a result, economists who previously considered environmental problems caused by carbon emissions to be “externalities” to industry are now seeing them as “material business concerns.”
When it comes to promoting themed products, “ESG” has become a marketing tool for fund managers. In the past, ESG investing was seen as a socially responsible means of investing with the understood proviso of lower than market returns.
Ethical investing has a tremendous attraction to younger generations and those with a strong sense of social responsibility, regardless of its limitless scope. Fossil fuel industries, for example, are becoming as despised as tobacco companies by a growing segment of society.
Demand is also driven by a belief in the viability of low-carbon emission and environmentally friendly businesses in the future.
What exactly is ESG?
What is ESG Investing?: Environmental, social, and governance (ESG) is a difficult concept to define since it is dependent on sensory attributes for which there are no agreed-upon quantifiable metrics to gauge. This dilemma is further complicated by the numerous ways in which ethical corporate behaviour can be sliced up.
So the one certainty is that every ESG investment product will fall short of someone’s conception of what constitutes truly sustainable investing. That’s the only constant. BHP, which supplies most of the raw materials used to build solar panels, may be seen as a factor in the carbon footprint of solar businesses by some.
Facebook may be considered worse for the environment than Exxon Mobil by those who are more concerned with privacy and the safeguarding of democracy.
The technique underlying the index that underpins Australia’s largest ESG ETF, Betashares’ ‘ETHI,’ first identifies the potential array of “climate leaders” that could be included in the index. Companies that rank in the top third of their industry in terms of carbon efficiency are considered to be among the most environmentally friendly (carbon emissions divided per dollar of revenue).
A second filter is applied by the NASDAQ Responsible Investment Committee, which excludes companies with “direct or significant” earnings disclosure to fossil fuels as well as other factors deemed insensitive by the committee, such as animal cruelty, junk food, pornography, and a lack of diversity on the board of directors.
Companies that earn more than a particular amount of money from the sale of alcohol, cigarettes, firearms and other weapons, gambling, or nuclear energy are barred from inclusion in iShares’ US-focused ESG ETF “SUSL.” Notice how the index providers have to make a lot of subjective decisions for each of these index approaches (NASDAQ and MSCI).
Beyond being complicated, implementing ESG in practise can be extremely time-consuming. It is possible that third-party data suppliers will not dig deeply into a company’s operational complexities and supply networks, resulting in passive fund managers making an inappropriate investment decision.
Think about the bizarre situation of Air Products and Chemicals, Inc. (APD). Currently, this ticker is included in the MSCI ESG USA index (albeit at a tiny allocation). In its ESG calculation, Thomson Reuters gave APD a score of 9/10 for its environmental performance, based on its environmental ranking.
In comparison, Apple received a 7/10 while Tesla received a 6/10. However, if APD succeeds in its goal of being the world’s largest operator of coal gasification plants in Asia by 2025, it will rank third among all American corporations in terms of carbon emissions.
ESG: The Factor Exposure
If you attribute recent great performance of ESG-focused products to a single factor, you run the danger of leaving out a connected component that is important to the whole picture. ESG has unquestionably been associated with positive stock returns over the past few years. However, this does not imply that the environmental and social initiatives of those corporations were the reason of their earnings growth.
As evidenced by the top holdings of ESG exchange-traded funds (ETFs), this is particularly prevalent. Apple, Nvidia, and Mastercard are the top three holdings in the ETHI ETF, which follows companies that are “climate leaders” and is managed by Betashares. By justifying their strong year-to-date returns on a lack of engagement in fossil fuels or other aspects of responsible corporate governance, these companies are completely overlooking the competitive edge each of them possesses inside their respective industries.
It has been speculated that the recent strong performance of ethical investment is attributable to the omission of this associated element. The technology and healthcare industries are a by-product of the environmental, social, and governance (ESG) filters that drive a major part of ethical investing ETFs.
In addition, the energy sector has been underweighted as a result of its reliance on fossil fuels. As a result of global lockdowns and travel bans, oil prices have plummeted, causing the energy sector to lag behind the rest of the economy last year. Now that the price of oil is heading towards $100 per bbl, what is the answer?
It might be claimed that ESG did not over- and under-weight these specific industries by chance, but rather by design. Some may argue that this is a reflection of the high value that markets place on long-term company models.
For example, solar energy has outpaced the entire energy sector by a significant margin.
The large number of influencing factors, on the other hand, makes the conclusion that ESG measures were responsible for this outperformance increasingly unlikely. It is possible that smaller high growth companies perform well in ESG measures as a result of their natural avoidance of established industries such as cigarettes and fossil fuels, as well as their natural preference for low carbon emission sectors such as technology.
But are technology sectors really low carbon emission industries? In order to address this question, it is prudent to return to first principles and assess whether or not environmental, social, and governance (ESG) factors are advantageous to the strategic drivers of organisations.
What is the Difference between ESG and Value Investing?
To get an honest assessment of whether a company’s ESG procedures are worth the investment, you may just ask a random person on the street.
In a society where ESG is widely regarded as the norm, it may be difficult to stand out as a rebellious individual if you don’t believe ESG to be value-enhancing.
For investors with a logical mindset, this means revisiting fundamental concepts over and time again for confirmation. For example, Newton’s First Law of Motion may fall within this category in physics.
However, in the world of investing, do ESG practises genuinely increase a company’s value?
People in the “good” camp say that by being “good” and adopting ESG practises, businesses can improve their value and make more money at a lower risk, which leads to better returns on investment.
Sustainable sun lotion may be sought after by socially concerned customers, who may be willing to pay a premium for it over comparable products sold by non-ESG manufacturers.
Suppliers who retain an ESG focus may offer cheaper ingredient pricing with an equally socially responsible counterpart, just as ESG attitudes may encourage favorability from a company’s end markets.
Higher margins can be achieved by combining price power from both a customer and supplier perspective.
People that support ESG argue that it is a technique to mitigate risk in an organisation. Many companies’ reputations have been tarnished as a result of good scandal stories, such as the Rio Tinto/Juukan Gorge fiasco, the banking royal commission from a few years ago, or the Exxon Valdez oil spill from 1989. These scenarios all spelt out near disasters for the company’s reputation.
In this light, it appears that the adage “there is no such thing as negative publicity” may not be entirely accurate.
Alternatively, consider organisations with a leveraged capital structure, which means they have debts. To keep up with the rising tide of ESG-oriented companies, banks and financial institutions may offer better loan terms by decreasing rates or loosening covenants, which would cut the cost of debt and the WACC and so raise the DCF valuation of those companies.
Theoretically, this is a good thing, but we should always challenge it in actuality. Companies that are anti-ESG may actually perform better in a more cynical perspective of events.
A proxy for these “bad-boy stocks” — the precise types of companies that are weeded out via unfavourable filtering by any ESG investor or fund – is often known as an anti-ESG company.
Just think of the corporations that produce tobacco products, coal mines, or armament supplies. In general, we believe that the products and services that these corporations provide are harmful to society and, when confronted with the issue, we strongly object to financial support for the businesses that manufacture them.
There is a good chance, though, that we aren’t putting our money where our ideals are. Assume there are segments of the population who would rather pay a lower price to help the environment than pay a greater price.
In order to maintain price competitiveness relative to competitors, companies that cut investment in sustainable processes in order to deliver low-cost products to their end markets are likely to increase revenue growth and market share.
The use of child labour in sweatshops and other grey zone practises are well-known, yet the ultimate goal of most businesses is to increase their profit margins.
To that reason, lenders use principal repayment as their primary consideration when selecting borrowers.
Debtor enterprises that generate high profits and steady cash flow from “bad” operations may be the clearest evidence of their ability to repay their debts.
Alternatively, an ESG-oriented company may face a more limited investment horizon in its corporate undertakings, whether it be a new product venture or an investigation into a possible m&a.
Having too many guidelines and standards can often keep the strong organisations stuck in a state of stagnation where no investment is able to satisfy all the requirements, while allowing the bad ones to take advantage of new developments with faster velocity, size, and profitability.
A company’s corporate social responsibility score may be low, but investors’ desire for higher yields is high, much like Michael Jackson’s “Bad” record might not have been nearly as successful if it had been named “Nice.”
Are ESG Indeed Value Accretive?
In the end, speculating about whether or not ESG adds value is an interesting exercise. However, the effectiveness and efficiency of firms are mostly determined by their bottom line, thus proof of the impact of ESG on this must be taken into account.
The value of a company may benefit from ESG, according to certain research. As an example, a meta-analysis of ESG businesses’ financial results shows a favourable correlation between profits and ESG performance, albeit modest.
When it comes to basic statistics principles, it is not always the case that correlations mean causality. While ESG may lead to increased profitability, it may also be the case that well-established and financially secure organisations are better positioned to implement ESG practises than those on the verge of collapse.
Studies have shown that bad businesses can be penalised by the industry, as well. Generally speaking, sin stocks are exposed to greater equity and debt finance expenses, especially in the tobacco and coal mining areas.
That said, these companies have historically outperformed their ESG counterparts, showing that either the value loss has been accounted for by extra value development someplace, or these sectors are vulnerable to illogical market values.
The former is more plausible, given that these industries are mostly made up of mature, stable firms depending on legacy products.
Research seems to agree that ESG investment has a tendency to reduce adverse tail risk in an apparently confusing argument. In general, companies with a strong social conscience are much less likely to be involved in scandals. Pro-ESG investors, as well as those with a general aversion to risk, may benefit from this finding.
Subjective perceptions about PR disasters that kill a firm are rare, since for every Wire card or Arthur Andersen story out there, countless more organisations have been able to effectively re-emerge in a positive light from their previous shames. Since Mark Zuckerberg’s testimony to Congress in 2018, the stock price of Facebook has increased by about 60%.
Comparing ESG and anti-ESG benchmarks, however, shows disappointing results for the pro-ESG party.
Two Vanguard Index funds, one of which is the Vice Fund, reveal that $1 invested in these companies would have yielded roughly 20% more than a socially conscious index during a period of time from 2003 to 2016.
Conclusion
What is ESG Investing has a different meaning to different people you asl. Ethical investing isn’t wrong. People should always think about the morals of what they do, and investments should not be put on an enlightenment podium.
The purpose of this paper is to draw attention to certain obvious flaws in the ESG tale that run counter to the marketing that promotes this movement. As a result, we have learned that ESG is a wide concept that is difficult to put into reality, and that, contrary to common assumption, ESG is not a sure fire approach to ensure strong future earnings.
As long as shareholders are expecting modest returns, they should put their money behind ESG initiatives. Even while the evidence reveals that the majority of ESG vehicles are really phantoms, there are a few standouts among the rest.
While ESG investments might be risky, they can also provide investors with a chance to test their abilities to discriminate between fiction and fact.
