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Roula Khalaf, editor of the FT, selects her favorite stories in this weekly newsletter.
The writer is a professor of finance at New York University’s Stern School of Business
Born into sanctity, fed on hypocrisy and sold on fallacies, ESG has gone unchallenged for a decade, but now faces a mountain of problems, almost all of it of its own making.
The problems of investing with an environmental, social and governance framework start with assessing what it measures, what has changed over time and reflects its revisionist history.
ESG started as a measure of goodness built around a VN document proclaiming the principles of responsible investing, with significant buy-in from the establishment. As ESG sales to investors increased, sellers realized that goodness had limited selling power. So they switched, arguing that ESG was a tool to achieve higher returns without the associated risks.
That business has worked well over the past decade, largely due to ESG investors’ turn away from fossil fuels and embrace of tech companies, but Russia’s invasion of Ukraine has changed the situation. As sector funds underperformed, proponents argued that higher ESG scores lead to less risk and a lower cost of capital. Perhaps because both risk claims are questionable, they now argue that the primary purpose of ESG is to disclose material issues.
It is in the interest of ESG proponents to keep the definition amorphous, since, like the socialists of the 20th century, whose response to every socialist failure was that their ideas had never been properly implemented, the defense against any ESG criticism is that it is incorrectly defined or implemented. The truth is that ESG scores today measure everything – and therefore measure nothing.
Consultants trying to sell companies on their indispensability claim that improving ESG increases value, although they are opaque about the paths to achieving this. That statement is flawed, as anyone with even a rudimentary understanding of value drivers should recognize that a higher ESG score can increase value at some companies, which tend to be smaller and serve niche markets, while it can decrease value at other companies where it increases costs while doing nothing. for income. This makes anecdotal evidence or case studies useless. And the cross-sectional evidence suggests that improving ESG makes scaling more difficult, has little or no effect on profitability, and will reduce as well as increase value.
At the same time, advocates are pushing investors to integrate ESG into their investment processes, arguing that doing so will lead to higher returns, allowing them to eat their cake (be good) and enjoy it (earn higher returns).
Even in its early inception, the argument lacked internal consistency. If an asset is less risky, it should have a lower expected return. Thus, proponents who claim that improving ESG will make companies less risky directly contradict other claims that investors will earn higher returns if they invest in companies with high ESG values. Adding an ESG restriction to investing will reduce expected returns, the only question being how much, leaving fund managers who have fallen for their charms in a fiduciary bind.
Once you strip ESG of the ‘good for value’ and ‘good for investors’ arguments, the only argument left is that it is good for society, and on that level too, ESG is doomed to failure.
The pressure to maintain high ESG scores is being applied selectively: more on listed companies than on private companies, and more stringent in some regions than others. This has predictable consequences, most clearly seen on the E(nvironment) front of ESG.
ESG pressures have pushed publicly traded fossil fuel companies to reduce their exploration spending and divest fossil fuel assets, but private equity has filled the investment gap. Is it any surprise that, after trillions of dollars invested in fighting climate change, we are now as dependent on fossil fuels as we were a decade or two ago?
On the S(ocial) front, ESG advocates, who have chosen to be arbiters of social welfare in a world divided on many issues, like pyromaniacs who complain about the fires around them, protest that ESG has been politicized .
As for G(overnance), its presence in the ESG field has always been puzzling because it replaces the original notion of corporate governance, where managers are accountable to shareholders, with an idea where managers are accountable to all stakeholders, thus in fact they are not accountable to any of the stakeholders. them.
ESG goes beyond redemption and testifies to the consequences of letting good intentions overwhelm good intentions and allowing the sales imperative to define and drive the mission. May it RIP.
Letters in response to this article:
The role of ESG in the endless search for alpha is central / Van Witold Henisz, Vice Dean and Faculty Director, ESG Initiative, Deloitte & Touche Professor of Management, The Wharton School, University of Pennsylvania, Philadelphia, PA, USA
Don’t judge ESG through the investment lens / From Onur Dalliag, Geneva, Switzerland