Last week, the Economist argued that we should ditch the overall notion of ESG because it promises too much and is too complicated. In a special report which followed recent eye-catching incidents such as the Deutsche Bank greenwashing probe, it argued that although ESG is often well-meaning, it is deeply flawed.
This is true. Why so? It pointed out three fundamental problems. The first is that by grouping together so many different criteria, it makes it difficult for investors and firms to make trade-offs which are “inevitable in any society”. True. A mining firm which closes down its coal mines for the good of the environment risks laying off workers and damaging the local economy, earning it a plus on the environment but a minus on social. As any businessowner with experience will tell you, there is very little good that can be achieved without some aspect of trade-off.
In addition, many companies are often looked by ratings agencies at in relation to how they fare in their industry. This can lead to curious results in indices, as witnessed recently with the exclusion of Tesla, arguably the single greatest contributor towards the transition to electric vehicles in the world, from the S&P 500 ESG index. Although an environmental trailblazer, Tesla’s record on social issues (such as allegations of racism at one of its plants and reports of fatalities in trials of its autopilot system) was enough to see it booted out the index, while one of the world’s most polluting companies, ExxonMobil stays put.
The second problem they point out is incentivisation. Many ESG analysts argue that it is more lucrative for both firms and investors to work towards high ESG ratings, creating a link between “virtue and financial outperformance” which has been touted to no end. It is true that there is a correlation between perceptions of sustainability and a more attractive cost of capital, but firms which are focused on the balance sheet will not hesitate to find ways to improve their financial standing without much care for virtue. The Economist gives the example of a company selling a polluting asset to a different owner to improve its ESG score, who keeps it running exactly the same way as before. There, it is clear to see that financial materiality is what motivates firm behaviour; the sustainability element merely packaging.
The last problem is that of measurement. Despite the wide fanfare of the concept in the investment industry, there has been little homogeneity to have emerged in relation to ratings, where ESG scores tally “little more than half of the time”. It is true that if any objective criteria are to emerge for both investors and companies to rely upon, there must be agreement as to how to both measure and quantify them.
I am in agreement with the Economist that there are enormous problems in the current way ESG information is presented to investors, and that emissions should be a stand-alone risk criterion for investors to assess when examining potential companies. This is because it is abundantly clear that a link exists between long-term financial attractiveness and carbon emissions. It is certain that we will continue to see regulatory, legal and socio-political pressure to advance towards net-zero, meaning that any serious investor should be concerned about portfolio companies which fall foul of that objective.
I am not, however, in agreement that the whole category should be ditched altogether. The argument here is simple – good investors care about positive returns. That’s it. Because good investors care about positive returns, they must care about ESG just as much as they care about the investee company’s management, strategy and balance sheet. This is because ESG represents a category of risks which are financially material to the discerning investor, but they must be presented in a way which puts that concern first and foremost. That way, there can be alignment between investor and societal objectives, as capital will rightly flow away from companies which pose negative externalities to the environment.
The ESG landscape must not be dismantled altogether, but it should be set up in a way which provides accurate information about financially material risks so that investors can make their own decisions about which companies to buy into and which ones to avoid altogether. This will afford the best chance of success for the wider objectives of the “ESG revolution” to become reality.