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Time to separate hype from the reality of ESG investing

Legendary Investor Phil Fisher is said to have remarked that there are fads and styles in stock markets just as there are in women’s clothes. Notwithstanding his misogyny, there is more than a kernel of truth in his statement. A current fad that has struck the fancy of asset managers and regulators is environmental, social and governance (ESG) investing. Whether this will endure to become a staple in inancial markets or go the way of bell bottoms and floral shirts is something that time will tell, but, given the fact that ESG funds hold $2.7 trillion globally and about 12,500 crore in India, a dispassionate analysis of the theory and empirics around ESG investing is in order.

The theory behind ESG investing is quite straightforward. Its basic premise is that the market is inefficient and does not price risks associated with ESG factors. ESG investors seek to correct this mispricing by directing capital towards firms that score highly on ESG criteria and away from firms that score poorly. The objective is to drive up the cost of capital of undesirable projects such as coal mines and reduce that of desirable projects like solar/wind farms. In a more extreme case, ‘dirty’ projects may be starved of access to public markets, while innovative firms focused on ‘clean’ projects will wallow in an abundance of capital that will help them solve the world’s most pressing environmental and social problems. Enlightened finance will thus act as a tool for positive change.

But, as the famous saying goes, “In theory there is no difference between theory and practice, in practice there is.” So it goes for the theoretical foundation of ESG investing. Even if we accept that markets underprice or fail to price ESG risk, starving offending firms of capital will not dissolve or dissuade their operations. This is because the fundamental rule of financial markets is that a price, like love, changes everything. As the price of these assets is driven down, at some point they will become attractive enough for private capital to own and fund them. Thus, as long as there is demand for ‘dirty’ fuels and mining them is financially feasible, they will continue to be mined. The only thing ESG investing can change is drive down their price and transfer operations into private hands. Hardly a solution to save the world from the climate crisis. This is exactly what has happened globally in coal mining, where major assets have been transferred to private players who continue to operate and even expand these mines. Many major listed firms like BHP and Exxon have also been forced to divest ‘dirty’ assets, but pollution goes on.

Another homily deeply enmeshed with the ESG discourse is the idea of doing well by doing good. Larry Fink recently remarked that “We focus on sustainability not because we are environmentalists but because we are capitalists.” ESG aficionados are convinced that ESG investing generates superior risk adjusted returns because it corrects ‘mispricing’ in the market while saving the planet. Many studies, notably by firms supplying and selling ESG ratings, show that stocks which score highly on ESG criteria outperform stocks that do poorly. While this manner of naïve performance analysis is reassuring, prima facie, it is hardly rigorous enough to be convincing. For one, better managed companies tend to be more transparent with ESG disclosures. This transparency helps them score highly on ESG ratings. Therefore, these studies confuse correlation with causality to arrive at the conclusion that ESG ratings drive the stock performance of these companies, while it is more likely that a better-quality business and more capable managers drive both stock performance and ESG ratings.

More rigorous analysis of the performance of ESG as an investing strategy shows that it falls far short of its promise on returns. In a fascinating paper, Patrick Bolton and Marcin Kacperczyk (‘Do Investors care about carbon risk?’, Journal of Financial Economics, 2021) show that firms with higher carbon dioxide emissions earn superior risk-adjusted returns. Moreover, firms that increase their emissions also earn higher risk-adjusted returns. This is impossible if markets are inefficient and underprice ESG risks, as claimed by ESG investors. However, much to the disappointment of ESG advocates, this is possible in an efficient market that is pricing carbon risk and therefore yielding higher returns to those who assume this risk by investing in carbon emitting companies. A practitioner paper by Bruno, Esakia and Goltz (‘Honey I Shrunk the ESG Alpha!’, 2021) also shows that ESG portfolios, constructed by overweighing stocks that have high ESG scores, do not generate superior risk-adjusted returns, nor do they offer downside protection as claimed by many ESG investors.

Although ESG investing has attracted significant attention and capital flows, its ability to actually ameliorate the problems that it claims to solve rests on shaky foundations. Moreover, a key attraction of ESG investing, the idea of being able to profit by improving society and enriching human civilization, does not manifest itself in empirical analysis of data and has actually been repudiated in many studies.

While taking ESG factors into account in making individual investment decisions is not undesirable, a stampede of lemmings investing purely on the basis of ESG scores has birthed several negative externalities and second-order effects, ranging from a bizarre inconsistency in measuring ESG performance to the predictable exploitation of ESG for fee generation by the financial services industry. The second part of this article will tackle these issues in greater detail.

Diva Jain is a director at Arrjavv and a ‘probabilist’ who researches and writes on behavioural finance and economics.Her Twitter handle is @DivaJain2

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