In a recent video for the “Moral Money” section of the Financial Times, reporter Brooke Fox took on the question “What does ESG-friendly really mean?”. Using environmental, social, and governance (ESG) factors in investing is controversial and complex, so it’s no surprise that the FT’s editors decided their readers could use a primer. Unfortunately, like so much coverage of ESG theory, this explanation allows vague terminology to gloss over fundamental contradictions.
The video tells us that there are multiple different motivations behind ESG investing, but that the unifying consideration is that “all ESG investors want to make a return on their money.” Well, yes, because if they didn’t they’d be donors rather than investors. However, that doesn’t mean that all ESG investors want what most other investors want: the maximum risk-adjusted return. In fact, some investors are willing to accept lower returns in exchange for social objectives. As one academic paper put it (using appropriately academic jargon):
If investors derive non-financial utility from investing in [socially responsible investing] funds or in companies meeting high standards of corporate social responsibility (CSR), then they care less about financial performance than ‘conventional’ (non-SRI) investors. [Vanderbilt University Business Professor Nicolas] Bollen (2007) argues that investors may have a multi-attribute utility function that is not only based on the standard risk-reward optimization but also incorporates a set of personal and societal values.
The Knowledge@Wharton blog, published by the University of Pennsylvania’s famed business school, put it more bluntly last November: “Why ESG Investors Are Happy to Settle for Lower Returns.” Reviewing a recent study by Lubos Pastor of the University of Chicago’s Booth Business School and Wharton’s Robert Stambaugh and Luke Taylor, the post acknowledges that “green assets have low expected returns,” which can only be expected to change when firms see “unexpected shifts in customers’ tastes for green products” and ideologically motivated increases in “investors’ tastes for green holdings.” In other words, the main product of green investing is … more green investing.
The FT’s analysis also addresses how ESG criteria are assessed, pointing out that the decision to invest in, say, Tesla, includes weighing the company’s electric—less polluting—drivetrain against the environmental impact of the nickel mining necessary for its batteries. This is an important example of how even one seemingly “environmental” technology can have complex trade-offs. Are we more worried, in this case, about first world air quality or developing world water quality?
The video also acknowledges that even the professional ratings agencies that study these issues rarely agree with each other. A recent paper by Florian Berg, Julian F Kölbel, and Roberto Rigobon of MIT’s Sloan School of Management blows apart the assumption by many that ESG scores are objective.
Yet, despite briefly addressing these problems with ESG theory and methodology, the FT breezes past them, assuring viewers that “the beauty of ESG is that, in general, investors don’t need to worry about sacrificing performance for doing good.” But what if analysts and asset managers are already assuming that a certain investor class is willing to accept lower returns? What if an ostensibly environmental investment strategy does more harm than good? What if the ESG ratings fail any tests of rigor or reproducibility?
Individual investors understandably want some guidance when it comes to trendy concepts like ESG theory. But much of the current reporting on it glosses over fundamental problems before arriving at a reassuring conclusion that everything in the world of responsible investing is fine. ESG theory as it is being currently applied has serious underlying flaws that that must be addressed before any such feel-good verdict can be rendered.