So-called sustainable investment funds make a dizzying list of promises, including higher returns, lower risks, combating climate change and even supporting diversity. And many believe them: investments in ESG (environmental, social and governance) funds are on their way to passing £34 trillion almost double their £18.4 trillion in 2016 by the end of 2022.
But sustainable investing has also attracted a lot of criticism. Tariq Fancy, former chief of sustainable investing at BlackRock, labeled ESG as a “dangerous placebo”, and the Wall Street Journal published a week-long series of rebuttals to the trend, with their opening piece titled “Why the Sustainable Investing Craze is Flawed.”
No matter which side you are on, there are always incentives to make your claims extreme. Asset managers who promise that their ESG funds will save the world are seeing new companies pour in and being heralded as the saviors of capitalism. Critics have also become famous by appointing themselves whistleblowers who have exposed a financial scandal.
If you’re new to investing and trying to decide where to invest your money, it can be difficult to know who to believe. So if we take back the hyperbole and examine the evidence, is sustainable investing worth the hype? To answer this, let’s look at the three objectives investors have when buying ESG funds.
This article is part of Quarter Life, a series about issues that concern us in our twenties and thirties. From the challenges of starting a career and looking after our mental health, to the excitement of starting a family, adopting a pet or simply making friends as an adult. The articles in this series explore the questions and provide answers as we navigate this turbulent period of life.
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Does sustainable investing make more money?
The first goal is, not surprisingly, financial. By investing in sustainable companies you increase your return, and by avoiding unsustainable companies you reduce your risk. Industries like electric cars are the future of transportation, while ditching fossil fuel companies makes you immune to a carbon tax.
There is evidence that certain dimensions of ESG are paying off. One of the my studies finds that companies with high employee satisfaction, a ‘social’ dimension, deliver shareholder returns that outperform their peers by 2.3%-3.8% per year over 28 years. Other research shows that companies with superior returns earn higher returns management and those that link CEO compensation performance.
But ESG is plagued by confirmation bias. Because we want to believe that ethical companies perform better, we cling to studies that say so, even when the evidence isn’t that strong.
This highlights how the financial case for sustainability depends on the ESG dimensions you consider. Striking articles every day persevere that “investing in ESG pays off”. But debating whether ESG helps or hinders returns is as fruitless as whether food is good or bad for you: it depends on the food.
Does sustainable investing change the behavior of companies?
The second objective is the impact of the fund on the behavior of companies. Divestment campaigns The aim is to encourage shareholders to sell the shares of certain companies and discourage new investors from buying them. By divesting (say) fossil fuel companies, the argument goes, we deprive them of capital and prevent them from causing even more pollution.
But investor boycotts don’t deplete a company of resources, because you can only sell if someone else buys. They are very different from customer boycotts, which deprive a company of revenue.
Maybe divestiture won’t immediately pull the plug on a company, but won’t it make it harder to sell shares in the future? Not necessary. “Brown” companies Just as fossil fuels and tobacco don’t generate much capital to begin with – they are yesterday’s industries with little growth opportunity. And there are indications that the costs of raising capital have increased little effect about business expansion.
Share price can matter for many reasons other than the cost of capital. Even if a company doesn’t raise capital, a low price worsens the CEO’s reputation and demotivates employees. But if so, my research suggests that the best strategy is actually tilting (leaning away from a “brown” sector but still being willing to own companies that are ESG leaders in that sector), not exclusion (avoiding that sector outright).
If a fossil fuel company knows it will be divested no matter what it does, there is no incentive to develop clean energy. But if its shares are bought when the industry is leading in sustainability, it will motivate the company to step up and invest more heavily in reducing emissions.
Many accuse ESG funds with interests in brown industries of hypocrisy and praise the funds that won’t touch a troubled sector like oil, but the reality is much more nuanced. And owning brown businesses is the only way to hold them accountable. The investment company Engine No. 1 received the famous three climate-friendly directors appointed to Exxon’s board of directors because it owned stock in the company.
Claiming that you are a truly sustainable investor because you only invest in green companies is akin to a doctor crowing that all her patients are healthy – when a doctor’s job is to treat the sick.
Is sustainable investing the right choice?
The ultimate motive is moral: you believe that it is morally right to invest in certain companies. For example, even if several companies do not perform better, it is reasonable to invest in them expression of your values.
But identifying “moral” companies is difficult because many important dimensions of morality are difficult to observe. A company might put minorities on its board to check the diversity box, but… do nothing to create an inclusive culture.
Is sustainable investing worth the hype? It has the potential to improve performance, but only if you focus on certain dimensions. It can change the behavior of companies, but through tilt and involvement rather than through exclusion. ESG is neither the panacea that proponents claim nor the scandal that detractors claim. But shades of gray are lost in the shadows when we look only for black and white.