Despite a historic surge in popularity, ESG investing won't tackle our generation's urgent environmental and social challenges According to estimates, humanity will need to invest an average of $3.5 trillion annually over the next 30 years. These trillions are not the same as the trillions that are currently invested in assets managed according to ESG investing, which are dedicated to assuring returns for shareholders, not delivering positive planetary impact.
By design, the separation of profit and planet is done. The impact of the changing world on a company's profits and losses isn't the reverse. Natural boundaries are not connected to them. Esg ratings don't measure a company's impact on the Earth They look at the impact of the world on the company and its shareholders.
It is hard to blame casual observers for believing that investing in an ESG investment fund is saving the planet. The fine print of marketing materials shows that the real goal is to assure shareholder profits. A prior statement from State Street mentions the need to encourage a transition to a low-carbon, more sustainable, resource- efficient and circular economy, but later it defines ESG issues as "events or conditions that, should they occur, could cause." Most individuals, institutional investors, and even some portfolio managers are confused by ESG doublespeak.
It has proven convenient to confuse people when marketing some products. A record was set when the U.S. Carbon Readiness Transition fund was launched by BlackRock. The fund promised to expose large and mid-capitalization U.S. companies to those that are better positioned to benefit from the transition to a low carbon economy. That sounds good, but there is no mention of driving the transition and the fund holdings are pretty standard. If you read some of the prospectuses for ESG funds, they use the word sustainable a lot, but you don't have any idea what the criteria are.
There are many problems with ESG investing. Clarifying and acknowledging all of ESG investing's flaws will help pivot to more productive and urgent endeavors.
The funds are based on ratings that aren't regulated. Comparative rankings of industry peers not on universal standards are used to build ESG ratings. Fossil fuel companies have better ESG ratings than electric vehicle manufacturers. The underlying data is incomplete and often dated. Even those who are responsible for the data don't have a lot of faith in it. More than 70% of executives surveyed across multiple industries and regions said they lacked confidence in their own non-financial reporting. It is nearly impossible to attribute results or make impact claims if you don't have access to comparable, accurate measures.
Securities that trade in secondary markets are usually invested in by ESG fund types. Even if planetary welfare were a principal objective, measurement of impact would not be possible. It is necessary to demonstrate additionality in order to determine if each fund's investments are making an impact. Most economists agree that it is virtually impossible for a socially motivated investor to increase the beneficial outputs of a publicly traded corporation by purchasing its stock.
The potential for ESG investing to deliver superior financial returns is being promoted by asset management firms. They cite a number of reasons for potential out performance, including that high ESG firms boast better managers, have lower costs of capital, and deliver better margins and attract and retain a more engaged workforce. Is this correct? Thousands of studies have been done to prove the relationship between high ESG companies and equity returns. More than two thirds of the studies show a correlation between the two. A paper by one of us (King) that found that there is little reason to infer that there is a link between ESG and out performance was recently published.
Fees associated with ESG products are one of the reasons Wall Street oversells planetary impact. Over the past five years, asset management revenues have fallen due to the growth of passive funds. Fees for ESG funds are 40 percent higher than for traditional funds. The higher fees are unwarranted because the funds often mirror one another. The largest and longest standing ESG fund was correlated with the S&P500.
The impression that trillions of dollars needed to finance the transformation to a low carbon economy are on the way is created by the boom in Esg investing. The massive public private partnerships that are needed to avert building threats to environmental and social welfare are likely to be alleviated by this misconception. This deferral would be the latest in a series of 50 years in which market based voluntary action can replace public regulation of private externalities. One example of the limits of voluntary action is Coke's voluntary efforts to reduce water usage. Coke declared itself water neutral in 2015, five years ahead of its self-selected target, after years of effort and partnerships. Coca-Cola is a market leader because of its ESG rating. Coke uses less than 90 percent of the water it estimates to use in its agricultural supply chain for irrigation in the fields, but that is not the boundary for water neutrality.
The investment community has been criticized due to confusion about Esg. "ESG for most managers is greenwash and investors need to wake up to realize that their asset managers talk but don't actually do." More than 1,200 Esg funds managing over $1 trillion in assets were removed from the Esg tag because they didn't integrate Esg factors into their investment selection. The removal ofTesla from the S&P 500 ESG index led to Musk calling it the devilincarnate. Critical supporters of ESG seem to be rethinking their support. According to the expert, we would be better off if non financial considerations were included in the traditional investment research process.
There is a lot of confusion surrounding ESG investing. Thousands of EU public companies have been mandated to measure non-financial factors, and the SEC has proposed for carbon emissions for U.S. public companies. Scrutiny will lead to regulation of ratings. Positive developments will amplify the quality of non-financial inputs. When the greatest risks of the day, such as climate change, are at stake, integration of ESG data into stock valuation models and portfolio risk management isn't enough to drive systemic change. Climate change is different from climate risk to a firm's profits.
It is not possible to advance planetarysustainability by measuring risks to corporate cash flows. Spending time on the following would advance decarbonization and planetary welfare.
The asset managers are bound to maximize their client's returns. Corporate executives and investors should not expect to put public interests ahead of private interests. Fifty years of evidence and mounting environmental challenges should be enough to end fantasies that voluntary market pressure will adequately address externalities. Shifting incentives to align private profit and social welfare is needed to accelerate meaningful Wall Street engagement.
The proposed disclosure requirement for carbon emissions has been the subject of thousands of comments. Eight years have passed since the European Union finalized its Corporate Sustainability Reporting Directive. We don't have enough money to pay for more dithering. Regulatory action needs to shift from input-based disclosures to outcome-based impacts in order to achieve reductions in carbon emissions. California has a carrot and stick policy to shift heavy duty transport from diesel to electric and the Netherlands has a cap on flights at 12% lower than pre-pandemic levels. Investment and innovation in lower carbon solutions will be stimulated by this.
In the first half of 2020 the U.S. has invested more in climate tech than it did last year. Investments in essential and uncertain technologies are increasing. The current scale of global investment required to make the transition to a low carbon future is insufficient. Transitioning away from fossil fuels in hard to abate sectors will require unprecedented and creative public private partnerships.
Equal efforts by all companies will not result in the same result. Investment by a software company to reduce emissions won't make much of a difference. Corporate leadership could throw in the towel on a 30-year failed strategy of addressing climate if they knew that cleaning up the home office wouldn't solve the problem. It would be unjust for the Chamber of Commerce and the Business Roundtable to publicly oppose the Biden administration's bill to address climate change. It wouldn't make sense for asset managers to oppose the Scope 3 climate disclosure provisions.
These recommendations are not easy to understand. Without concerted civic engagement, global coordination, and redistribution of power, none will happen. No one relies on convenient confusion to oversell voluntary solutions. The investment is not the devil incarnate. It will not save the planet if investors are allowed to better predict returns and risks. It's like asking an electrician to make a gourmet meal. Setting appropriate boundaries for capitalism and letting the best of the market innovate is what we should be focusing on.
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