It has been a bruising spell for ESG investing. Not only has the war in Ukraine brought into sharp contrast some of the potential trade-offs involved (fairly and unfairly), but it has faced numerous stinging criticisms. Tariq Fancy – formerly CIO of Sustainable Investing at BlackRock – labelled it a ‘dangerous placebo’, Stuart Kirk made his now infamous ‘Miami underwater’ speech and Aswath Damodaran – probably the pre-eminent scholar of business valuation – suggested people working in ESG were either ‘useful idiots’ or ‘feckless knaves’. As is symptomatic of the world today, ESG investing has become another polarised debate. It is either unimpeachable and essential, or little more than an asset management confidence trick. This lack of nuance is incredibly unhelpful and makes a complex topic even more problematic. How can investors successfully navigate these issues?
Why Has Criticism of ESG Investing Increased?
There are two central factors that have driven the increasing level of criticism faced by ESG investing. First is some of the unsubstantiated claims that arose from the asset management industry. When companies in the ESG sweet spot were enjoying prodigious performance tailwinds, it was easy to make naïve yet compelling assertions about how we can ‘do good’ and outperform. This was a potent marketing cocktail – not backed by robust evidence – that created entirely fanciful expectations. It was just a matter of time before the backlash arrived.
The second catalyst was the pronounced style rotation in markets, which has seen high-growth companies (including many ESG darlings) fall back down to earth, whilst much-maligned resource stocks have surged. In financial markets it is performance that creates narratives (not the other way round). When something is underperforming it becomes open season for disapproval.
And much of the opprobrium has been warranted. Greenwashing is rife, trades-offs and difficult questions about fiduciary duty are roundly ignored and the industry is in danger of measuring everything and achieving nothing. Yet valid criticisms do not render the entire endeavour meaningless or defunct. It just means we need to step back from the noise and think clearly about what ESG investing is and why it matters.
How Should We Think about ESG Investing?
One of the central problems with ESG investing is its sheer complexity. Investors of all guises are inevitably discombobulated by a seemingly endless array of measures, metrics, initiatives, regulations, acronyms, initiatives, bodies, reporting requirements, pathways, targets and even genuine issues. Amidst all this, it is easy to lose sight of its underlying purpose.
At its core, ESG investing is about three elements – values, value and valuations. Any ESG-based decision we make should consider these aspects:
Values: These are issues that we care about. What matters to us outside of pure financial considerations?
Value: These are factors that we believe impact the worth of a company. Do they create or destroy long-term business value? *
Valuation: This is how an ESG related factor or business is priced. Is it expensive or cheap?
With any ESG based judgment or decision, an investor should be asking – is this about values, value or valuation?
Let’s take each element in turn:
Values are the ESG-related choices that we make because of our beliefs on the issues or subjects we care about. The most obvious example of a values-based ESG decision is a portfolio exclusion. For example, we decide that we do not wish to invest in tobacco stocks because of the harmful and addictive nature of the product.
The flip side of exclusions is investing in thematic ‘impact’ strategies – here we might wish to invest in companies that are engaged in activities that we believe are positive for society or the environment. Investing in such a way makes us feel good or at least better.
The distinguishing feature of a values-based choice is that we are agnostic about the return effect of such decisions. We are willing to accept a financial cost. Green bonds are a good example of where there is some evidence of investors accepting inferior returns (in the form of a lower spread / yield) to ‘directly’ fund certain types of activity with an expected positive environmental impact. Investing due to our personal values will not always result in a loss but we have to accept the possibility that it might.
The problems arise when investors are unclear about what is driving a decision. Most investors in heavily thematically tilted sustainable or ESG funds are not doing so under the apprehension that performance will be poor (despite the historic evidence of thematic fund performance). Asset managers also frequently muddy the water by applying minor exclusions at the margins of a fund (such as controversial weapons), but without being transparent about whether this is an investment view or values-based choice.
This is a messy and highly subjective area. Not only because of the personal and somewhat opaque nature of values, but also the different ways we might be willing to express them. Two investors with a similar set of values might behave in an entirely different way – one might exclude a certain industry; another might believe that engagement is a far more effective approach.
There are few right answers when it comes to values, but if we are making a values-based decision it is critical that we admit we are doing so and understand the potential implications.
The question that investors need to ask to ascertain whether an ESG-related decision is values based is – am I willing to accept a financial cost to make a decision that is consistent with my values?
If the answer is no, then we need to provide a coherent, evidence-based explanation as to why the decision is instead about value or valuation.
Value is about the ESG issues that impact the value of a business. These will be specific to companies and industries, and should be considered alongside other relevant factors that impact the long-term worth of a business.**
The crucial point here – as Alex Edmans’ highlights in his excellent recent paper – is that if there are ESG issues that are vital to the value of a company then it should be a focus of all investors, not simply those running ESG or sustainability orientated strategies.[i] ESG factors and risks that are central to a business and will impact shareholder returns should be considered alongside a host of other aspects. The job of any fund manager or analyst is to understand the factors within a business that are likely to create or impair long-term shareholder value.
The logical extension to this idea is that there is no need for sustainable or ESG-orientated funds because all competent investors should be doing it anyway. There is some truth to this, and this is hopefully the direction in which the industry moves. There are, however, two caveats:
First, ESG funds may cater to certain investor values (as previously covered), but if this is the case then we should be willing to incur a potential cost. Second, ESG funds are likely to believe that these issues are more material than others and therefore weight them more highly in their analysis of a company’s worth. In such a scenario we need to be transparent that this is a stark investment view that will have meaningful implications – we are stating that most mainstream funds are neglecting the importance of ESG factors and underweighting them in their investment decisions. There is nothing wrong with holding this perspective – although it would be helpful to understand the evidence supporting it – but we need to be clear that it is a position that will have performance implications.
Even if we correctly identify the ESG issues that are relevant to a company and can assess their materiality, there is one other aspect to consider – valuation.
Identifying the long-term drivers of value within a business is imperative for making sound investment decisions, but we cannot ignore how that business is priced. What we pay for a security or asset matters greatly to the returns that we receive.
Let’s assume we have identified an ESG factor that has a material impact on the creation of shareholder value and a company that scores particularly well on this metric (amongst many other non-ESG characteristics). Is it a good investment? It depends on the price. Positive ESG or non-ESG characteristics do not result in good investment outcomes if they are more than reflected in the price that we must pay for it. ***
There will almost inevitably be times when stocks with a particular set of ESG credentials become very expensive. What do we do in that situation? 1) Hold them for so long that the price paid pales into insignificance relative to cash flows and growth (few people have a time horizon of this length). 2) Become a values-based investor and say that we are willing to endure a lower return because of the positive ESG traits. 3) Not hold the companies because they are not attractively or even fairly priced. The third option seems the obvious one but becomes problematic if we had made commitments about the ESG metrics of our fund, which limits our flexibility. If we hold expensive assets to maintain some score or meet an ESG threshold – we become implicit values-based investors.
In the future we may see strategies that are explicitly willing to sacrifice potential returns by investing in companies with positive ESG characteristics irrespective of the price. But for most existing funds this creates question marks around fiduciary duty – this is a discussion that not many people want to have but will have to happen at some juncture.
For any ESG orientated investment decision we should be able to ask whether it is driven by values or value. If the latter, there should be a significant evidence base supporting why it impacts the long-term value of the business. We can then consider how that company is priced relative to those attributes and all the many other facets that feed into an assessment of its valuation.
What about externalities?
If we think about ESG investing through a values, value and valuation lens, where does that leave negative externalities? Where and how do we incorporate a cost created by a company that is not fully borne by them? Let’s take an example.
Imagine there is a large social media company that we believe creates a profound societal cost due to its negative impact on the mental health of teenagers. How do we integrate that into a values, value and valuation framework?
If we believe that costs of this are not currently incurred by the company but may be in the future, we can absorb this into our valuation. Even though it is currently an externality we can price for its future internalisation. It is in such situations that engagement is likely to prove particularly powerful and can combine values and value effectively. (I care about the issue deeply and think the company value will increase if it alters its behaviour).
If we believe that either costs are unlikely to ever be fairly levied on the company, or that we simply find the activity of the company unpalatable then our decision (perhaps to exclude the company from our portfolio) will be a values-based choice.
The major difficulty with externalities is when we think from a portfolio perspective rather than how they impact an individual business. We may suffer the cost of the negative externalities of a company we hold because it has broader consequences on, for example, economic growth or asset class performance. A polluting company we own may benefit financially (particularly in the near term) from avoiding the full internalisation of external costs, but it could still be to the detriment of our overall, long-run returns (amongst other things).
If we make decisions based on the potential ‘universal’ impact on our investment returns it can still be considered value-led, just through a different lens. The critical aspect is to be open about how we arrive at such judgements.
Trying to simplify how we think about ESG by using a values, value and valuation framework doesn’t make a complex and subjective area easy. Being clear about the drivers of our ESG-influenced decisions will, however, help in both setting realistic expectations and allow for reasoned debate about the quality of our choices.
* This could also apply at a portfolio or market level.
** This is obviously messier and more complicated than it sounds. There will be (many) scenarios where company executives are incentivised based on short-term profitability / share price performance and rational behaviour for them may be to maximise this, perhaps at the expense of long-term shareholder value. Engagement should play a crucial role in such situations.
*** The reverse of this situation is a company that scores poorly on the ESG metrics that are relevant to it but is incredibly cheap. Here we can decide not to invest (which becomes a values-based decision) or look to invest and engage.