tutor2u | Environmental, Social & Governance Investing - The Next…

Enrichment

Environmental, Social & Governance Investing - The Next Financial Crisis?

Geoff Riley

10th February 2021

Year 12 A-Level economics student Phil Repin-Millard provides this overview of some of the key risks surrounding the rapid growth of ESG investment.

ESG has been heralded as a solution that supposedly reconciles the pursuit of returns with the alleviation of negative externalities. In the first 3 quarters of 2020, responsible investment funds saw a record net inflow of $7.1 billion, nearly quadrupling 2019’s net inflow of $1.9bn for the same time period.

ESG refers to an area of investing which seeks positive returns and impact on society, by measuring how environmentally friendly (environmental), socially acceptable (social) and well run a company’s practices are (governance). In theory, owning a portfolio which aligns with your supposed values might be conducive to achieving the dual ends of financial returns and effecting social good.

If your sole motive is profit, then it would be imprudent to only invest in ESG funds. Over the last 10 years, ESG funds have underperformed compared to the S&P 500 by an average of 576 basis points annually . Furthermore, the average actively-managed ESG fund in Europe has underperformed its benchmark by 1.2 percentage points annually since 2000, and leading American ESG stocks have also underperformed their benchmarks over the last decade . Contrary to popular belief , ESG also fails to sufficiently explain returns during the COVID-19 pandemic. Instead, innovation related assets offered greater immunity to unanticipated market declines .

For a stock to outperform, it either sees greater-than-expected growth or is bought at a lower-than-expected price. By regulating and pushing investors away from ‘unethical’ or ‘un-environmental’ stocks, the ESG movement is creating an opportunity for those stocks to be bought at a lower price. The law of supply and demand states that if demand shifts inwards, then, the new market-clearing price will be lower, ceteris paribus. This artificially lower price sets these ‘unethical’ stocks up to outperform ‘ethical’ portfolios. Thus, the unintended consequences of promoting ESG funds diminish their supposed market outperformance in the long run.

An ESG score comprises of a combination of environmental, social and governmental factors. Based on a company’s ESG score, provided by third party rating firms, an investor can evaluate what kind of impact his investment will make, not only for himself, but for society in the long-term. Combining 3 such broad and subjective metrics is imprecise, misleading and not meaningful investment analysis. Depending on how a ratings firm weights one of the metrics, an ESG score can vary significantly. As such, ‘aggregate confusion’ is caused; where a company has wildly different ESG scores, which confuses the investor. When different rating agencies rank the same company across ESG metrics, their scores only align 61% of the time . For example, Tesla is rated in the bottom 10% by JUST Capital yet receives an ‘A’ rating from MSCI . This is because JUST Capital weighs workers’ rights more heavily in their scoring metrics than MSCI.

Also, investors have different judgements of what they consider to be socially or environmentally responsible. This informational asymmetry between parties requires shrewd investors to determine exactly what a rating firm deems to be ESG. Notwithstanding these conceptual ambiguities relating to ESG, rating firms often do not offer complete and public information on the criteria and assessment process used to evaluate an ESG score .

A more insidious complication surrounding ESG investing is the inadequately regulated presence of ‘greenwashing’. Often firms deceitfully claim to be improving their ESG score whilst not implementing any meaningful practice to support their claims or materialise their alleged ambitions. For example, McDonalds’ paper straws debacle; Volkswagen’s infamous ‘clean diesel’ scandal and EasyJet’s ‘less CO2’ fiction. These were all marketing ploys and mechanisms to simply attract capital and/or keep the regulator happy. In particular, The latter claim doubts the sincerity of ESG practices and suggests the extent to which ESG is artificially driven by government regulation; no more than a regulatory box-ticking exercise for firms to satisfy. Very few PRI signatories (firms who commit to integrating ESG factors into their practices) actually made visible changes to their ESG score, and rather, they exploited the process to attract investment .

The recent 2020/21 EU Disclosure and Taxonomy Regulations seek to address these concerns by enforcing more standardised criteria with respect to the disclosure and classification of ESG related assets. However, as with any government intervention, especially at the supra-national level, efficiency, effectiveness and enforcement concerns apply. It is too early to tell how and if this legislation, practically, manifests.

A slightly less nefarious ‘greenwash’ involves ‘net-zero’ commitments. But, this often relies upon ‘offsetting’, whereby firms compensate for an unethical practice by ‘offsetting’ it with an equally ethical one. Evidently, such insincerity fails to solve the issues which ESG investing purports to address; it merely ‘offsets’ the problem. JP Morgan for example, vowed to cut lending for oil and gas drilling in the Arctic, yet also took part in Aramco’s IPO - the largest in oil and gas history.

Another form of ‘greenwashing’ prevails in the realm of Exchange Traded Funds (ETFs). Here, deceptive marketing combined with a misrepresentation of ‘unethical’ firms deceive the investor. ETF.com ranks XLU as one of the top ESG ETFs . However, not only does this ETF have no mention of ESG in its description, it, ironically, tracks utility stocks. MSCI, who also gave XLU a high ESG score, ranks the utility sector as the highest carbon-emitter . This is just one of many examples where an ETF’s ESG score is disproportionately affected by large holdings in ESG companies, whilst neglecting holdings in contrasting companies with vastly unethical practices.

A further example is the Vanguard ESG ETF, a very popular and successful investment mechanism, which, since 2018 has had a 28% return; compared to a 17% return seen in the broad market ETF. Yet, a brisk examination reveals that its top six holdings, containing one quarter of the total funds invested, include: Apple, Microsoft, Amazon, Facebook, Google and Tesla . The unifying factor is, unsurprisingly, not their ESG performance (all 6 have much controversy surrounding ESG scores), but their dominance in the Technology sector. This apparent ‘techwashing’ should concern any ESG investor. Many technology companies, especially the ones mentioned, face scrutiny for data privacy, labour practices and monopolistic behaviour. This undermines the social impact investors are (or at least claim to be) seeking to achieve with ESG ETFs.

The frenzied growth of ESG, in no small part artificial due to regulation, has inevitably uprated mediocre and loss-making companies in the hope of them becoming the next ‘unicorn’ . The largest threat to ESG is investors impulsively following the trend, without proper due diligence and research into the underlying assets of a company. As with any bubble, such an indiscriminate inflow of money causes a rapidly increasing share price which detaches itself from its fundamental value. If this were the case, then, with ESG-driven assets reaching $40 trillion and the information asymmetries plaguing this area, the script for economic disaster is all too familiar. There is clearly something to be said for ESG, but this contribution recommends a more sober and thorough analysis of its value.

A referenced version of this article can be downloaded here

Esg The Next Financial Crash

Geoff Riley

Geoff Riley FRSA has been teaching Economics for over thirty years. He has over twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.

Recommended

Exam support for 2022

Online Grade Booster Courses for A-Level Exams in May & June 2022

Exam technique, advance information support, live revision and more from the tutor2u subject specialist teams

Enrol now

© 2002-2022 Tutor2u Limited. Company Reg no: 04489574. VAT reg no 816865400.