Thursday, September 2, 2021

ESG catch 22

The point of ESG investing is to lower the stock price and raise the cost of capital of disfavored industries, and therefore slow down their investment. It's a form of boycott. The cost of capital is the expected return. If it works, it raises expected returns of disfavored industries, and lowers the expected return of favored ones. 

Yet ESG advocates claim that you do not have to trade return for virtue, that you can even make alpha by ESG investing! 

If that is the case, it means ESG investing does not work! Take your pick. 

Why do ESG advocates care? It seems perfectly normal to say, "Look, this little boycott is going to cost you something but it's worth it to save the planet and other social goals." The problem is, most funds are handled by intermediaries who are not allowed to lose a little money on your behalf in return for their idea of virtue, for the simple reason that it may not be your idea of virtue. A mutual fund marketed this way cannot sell to a pension fund, even if the mutual fund and pension fund managers all agree completely on what environment, social, and governance criteria are valid, because neither knows that the recipients of pension fund money have the same preferences. Our laws and regulations occasionally do make some sense! 

But if you don't lose money on ESG investing, ESG investing doesn't work. Take your pick. 

(HT, thoughts resulting from Jonathan Berk and Jules van Binsbergen's paper on ESG returns.) 


  1. Isn't the thesis of ESG investing to not invest in companies that are likely to face regulatory action on climate and instead to invest in those that might be favored by govt subsidies / tax policy / regulation? If you think the likelihood of govt action on climate is higher than market expectations, then you could get alpha through ESG investing.

    1. There are an infinity of explanations for any fact. Yours is a particularly clever one. Might work. I doubt it.

    2. ESG investing reduces the cost of capital for ESG industries meaning more ESG projects will be done, and this should be good (according to ESG investing supporters) for the planet.

      ESG investing supporters cannot claim that they are helping the planet thru subsidies, tax policy or regulation. Politicians, taxpayers, or voters should take the credit for that (if you think it works).

      What ESG investing does is increasing the cost of capital for non-ESG industries and by doing so, they reduce the number of non-ESG projects in the future (compare with a world with no ESG investing).

      But reducing the cost of capital is the same than reducing the expected returns (and vice versa).

      So, you can claim to be helping the planet by lowering the expected returns of ESG complying projects. But you can not be increasing the returns on ESG projects AND helping the planet.

      In other words, the idea behind subsidies, taxes and regulation should be having "more" ESG friendly projects (more allocation of capital to this kind of projects) no, by any means, increasing the returns for a constant amount of money invested in these projects (the increase in returns will not help the planet in any way). The potential "virtue" of this "increase in subsidies" should be given to whoever decide on these subsidies, not to the ESG fund managers.
      ESG fund managers can only "help" by reducing the cost of capital (the returns) on this kind of projects. They can be "green virtuous" or "fiduciary virtuous" but not both.

  2. I assume the missing (and unspoken) link is that the favored industries are so inherently virtuous they'll consistently produce positive cash flow shocks and so earn the promised extra returns that way. Incoherent (and dishonest) I know, but it's the only way I can think of that makes the two claims simultaneously 'possible'.

  3. One potential answer:
    We are at the beginning or the ESG trend, and expected returns for ESG and non ESG are similar. As more people adopt ESG, expected returns will fall, generating alpha in the process.

  4. There is technically a way to "have it both ways". Suppose you thought that industry XYZ was murdering puppies and likley to be banned in the near future (but this consensus is not shared by the general public). A fund that avoids investing in XYZ both avoids murdering puppies and (if it is right that industry XYZ will be banned in the future) earns a higher return.

    Similarly, if you think business run by members of [ABC minority] are unfairly discriminated against by credit giving institutions, then investing in businesses owned by [ABC minority] should provide an above-average return.

  5. John, completely agree that ESG investing leads to an ex-ante "brown" or "sin" premium caused by either preferences/tastes or risk (low rated ESG stocks have more risks, including tail risks). However in the short term you have a conflicting force as the market shifts to a new equilibrium. All the cash flows into ESG stocks has raised their valuations and created ST K gains (of course lowering future expected returns), so you can have ESG outperforming in short term. Also highly rated ESG stocks do have less tail risks and thus risk-adjusted returns might not be lower. And finally you could adjust an ESG portfolio to account for factor exposures and then have your cake and eat it to as factors explain ESG performance.
    I discuss all this in my new book coming out at end of year Your Essential Guide to Sustainable Investing which provides a history of Sustainable Investing and a review of the academic papers, covering findings from about 60 studies
    The expectation then might be that at least for next decade perhaps as the trend toward ESG investments continues, ESG investors indeed might outperform ex post even if ex ante they should expect lower returns (unless adjust factor exposures).

  6. I don't get it - yes the cost of capital (and expected return for investors who remain) will be higher for the boycotted industries, which will presumably force them to adjust their behavior, no?

  7. As they say in their paper, the alternative approach would be the opposite: ESG investors should buy up and gain control over 'dirty' companies. This would allow them to effect internal governance changes which could force these firms to "come clean."

    Have not seen this proposed yet but maybe that's coming.

  8. The cost of capital would be the "required return", not the "expected return".

    By raising the required return on disfavored industries (vice versa favored), their expected return (which is fixed by their performance) may no longer meet the new required return, or at the least it will make it a less desirable investment.

    There is no contradiction.

  9. The point of investing isn't to maximize wealth, it's to maximize utility. What people have found is that wealth gained from unethical sources affects the utility of the investors differently.

    Thus, many investors will accept a lower return when those returns will lead to higher utility because the investor thinks they are gained ethically.

    1. And if the investors do so, then the investors will be the "virtuous ones". Not the ISG Funds managers.

      If the ISG Fund Managers sell the funds are a “great investment” because of their future rosy returns they are only not being virtuous but just lying ... and, by the way, taking the virtue out of the investors that are not "expecting lower returns and leading to higher utility" but just expecting higher returns (just like the horrible "unethical" guys)

  10. There you go again with logic and facts... Listen here once and for all: Our feelings don't care about your facts! We are leftists!

  11. The arguments in support of ESG reminds me a bit of the arguments in favor of enhanced Beta: add a little magic and presto change-o, the results will somehow be better. Unfortunately, enhanced Beta, strategic asset allocation and other such strategies have not proven to be all that effective. ESG is a nice idea, but seems mostly to have been conceived by the marketing folks, looking for a bit more sizzle in order to justify their fees. There is no free lunch in investing: if there were, its likely that few of us would need to read investment & economic blogs anymore.

  12. I agree. Indeed, if ESG is a path to alpha, you don't need to call it ESG. Just call it smart investing.

    One exception, however. There is a potential, temporary momentum effect where the number of ESG-focused investors grows, and favored stocks outperform. This must be temporary, but could last long enough to generate attractive returns, and support fund marketing efforts.

  13. As others said, ESG investing might make money by betting in industries which will be favored by regulation in the future. Other explanation is that many ecological technologies might have increasing returns to scale after a threshold and ESG will facilitate getting to that point. I think the first argument can be true, while the second is probably just wishful thinking.

  14. Don't want to put down the paper, but I've always thought that if the number of investors who don't like a high return to capital is small, their actions will be irrelevant. [Small country assumption. :-)]

    If their number is large, they will drive down returns in the disfavored industries and thereby attract non-ideologically motivated investors who see the asset prices as undervalued for non-ideologues from other industries. Then, the overall return on investing in corporations is driven down.

    Then, the non-corporate sector becomes more profitable, and more investment will flow there than otherwise.

    All this last would take one hell of a lot of ideological investors. Good luck with that! :-)

    1. And, oh yeah, the authors' suggestion that the environmentally engaged buy corporations to make business decisions that lower the return to investing in these companies. Excellent: The environmental types fulfill their wishes at a cost only to themselves and other investors stay away from such firms. Makes everybody happy! :-)

  15. Yes, Cliff Asness pointed out this inherent tension several years ago, but ESG proponents don't seem to want to acknowledge it:

    Securities laws are pretty clear in prohibiting misleading information when talking about a fund, so I'm not sure how many ESG fund providers would actually claim in their marketing materials that they seek to both make a positive social impact by raising capital costs for non-ESG firms and do so without sacrificing risk-adjusted expected returns. It would be ironic for ESG funds to knowingly or negligently (by being unaware of the inherent tension) mislead investors.

  16. "The point of ESG investing is to lower the stock price and raise the cost of capital of disfavored industries, and therefore slow down their investment. It's a form of boycott. The cost of capital is the expected return. If it works, it raises expected returns of disfavored industries, and lowers the expected return of favored ones."

    There is a certain element of truth in this statement, but it is conditional on who or 'what' is promoting ESG as an alternative investment criterion, and why they are promoting it.

    At its basic level, ESG is principally a selection criterion for constructing investment portfolios. Application of the criteria and the construction of the portfolio is an idiosyncratic exercise--the application differs by individual investor, portfolio manager, and/or portfolio investment advisor.

    The results are typically what one would expect: for those who index against a published Index (e.g., "FTSE 4Good US Select Index" or "MSCI USA Select ESG Select Index" or the "S&P Global Clean Energy Index") the investment returns and systematic risk of the ESG portfolio/fund differ slightly, if at all, from the broad Equity Indexes ("S&P 500", DJIA, NASDAQ 100, etc.) The indexed portfolio fund will seldom if ever realize a positive "alpha".

    A number of investment funds pursue an active management style, selecting equity and fixed income investments that meet specific "ESG"-like criteria and limiting holdings to 30 to 60 "names". These funds search for listed firms that meet specific criteria (e.g., firms that "management believes will improve human well-being and increase economic efficiencies while reducing environmental risks & ecological scarcities", or firms that are "broadly consistent with achieving UN Sustainable Development Goals".) Actively-managed funds will achieve investment returns that depend in large part on the fund managers’ ability to juggle firm-specific and industry-specific risks in an attempt to realize consistent positive "alpha" on portfolio investments while fulfilling select ESG criteria. Rates of return are seldom reported on a risk-adjusted basis, and depending on the selection criterion, portfolio risk may be elevated. Nonetheless, for certain investor categories, the risks are deemed acceptable for the qualitative benefits holding the investments bring (e.g., peace of mind, virtuous signalling, etc.)

    The broad macro-economic and overarching sociopolitical risks from “climate change” give rise to a supra-national organizing principle that does seek to draw attention to certain out of favour industry sectors believed to be contributing to “climate change”. From the perspective of a certain former governor of the Bank of England, ESG investing, in the larger macro-economic view, is about avoidance of terminal value risk--i.e., the risk that the investee's terminal value will be zero at some point in the not-too-distant future. The term "stranded assets" is usu. used to convey this concept. The focus is not on the individual investor or fund, but on the national and sub-national financial sector regulator or governor. The term “systemic” risk is applied to connote the risk to the national and international financial sector from the sudden “stranding of assets” when government regulation is adopted to “fight climate change”. Banks and financial companies that invest in industry sectors with exposure or potential exposure to abrupt changes in the cost of operations and compliance with regulations are expected at some future point in time to be at higher risk of default on their statutory capital compliance. The effect is to make it increasingly risky for regulated bank and financial entities to lend to firms in those industry sectors.

  17. Whether ESG investing turns out to be a good or bad strategy depends largely on the future prices of stocks (both those in the ESG portfolio and those excluded) -- which are subject to risks and are unknowable. Time will tell!

    ESG-popular investments mostly rely on politically-driven subsidies and mandates, eg wind power, solar power. That raises two particular risks for those ESG investments:

    1. What happens when today's governments, which are mostly running unsustainable budget deficits, are faced with the necessity either to cut subsidies or (eg) to reduce pensions? How long can Germany mandate expensive "renewable" power before external economic competition forces it to back down?

    2. What happens when political fashion changes? For example, Electric Vehicles and solar panels are trendy industries for ESG investors today; but that could change (eg) if some NGO starts to focus on abuses of Black child labor in African cobalt mines -- making EVs and solar panels untouchables.

    Given the political risks, it seems that a prudent fund manager would have to demand higher expected returns from ESG-favored investments to compensate.

  18. Interesting perspective. I thought I was investing in ESG because I don't feel comfortable in investing in companies which kill people (tobacco companies) or the environment (carbon extraction companies). Perhaps I'm missing something.

  19. The whole ESG craze is ridiculous. Since many "dirty" companies provide essential products such as oil and natural gas, an increase in their cost of capital only provides a better investment for non ESG investors (such as me) since all these companies need to do is raise prices to compensate for higher money costs. This will allow for higher dividends for their investors even if there is less stock appreciation. Try living without fossil fuels for a week and you will see that you will pay drastically higher prices than we currently pay if necessary.


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