No, ESG is not beyond redemption
Some big improvements need to be made in all areas of ESG, but it might be useful to stop trying to reconcile it with how markets function.
The 30-day countdown to the next COP has begun – and so has the cynicism about environmental, social and governance: what it means and whether it works.
After all, a climate conference presided over by an oil company chief executive should surely prompt a few questions about what exactly the market-approved definition of sustainability might be.
In the era of socially responsible investing, very little progress has been made towards reaching sustainable development goals. News of the struggling global economy is sandwiched between worsening geopolitics and a record-breaking number of climate shocks.
Meanwhile, investors who have been told for over a decade to start allocating capital to assets with high ESG credentials are seeing returns dwindle.
Ratings agencies are now well versed in attributing ESG scores to companies, although there is still a lot of confusion about how that differs from the metrics that quantify the relevance of ESG factors on creditworthiness.
Maybe that is because ESG investing is becoming less about how firms perform on ESG factors and more about their exposure to ESG risks and how vulnerable that makes them.
The ratings agencies have started to respond to this.
According to Fitch Ratings’ first batch of Climate Vulnerability Signals (Climate.VS) – which capture the agency’s view of a company’s credit profile exposure to a rapid low-carbon transition between 2025 and 2050 – over half of global corporates that may be exposed to a climate-related downgrade of one or more notches by 2035 have investment-grade ratings.
In other words, ‘good’ ESG companies may not necessarily perform well financially, and companies with good credit scores are also not immune to environmental shocks.
Woke investors can hardly be blamed for wondering if responsible investing is worth the effort.
But the question we should be asking ourselves isn’t whether ESG investing is failing in the market but rather why the market keeps failing on ESG.
In a Financial Times column last week, NYU Stern School of Business professor Aswath Damodaran wrote that ESG was “beyond redemption”.
The piece had echoes of the infamous presentation in June 2022 by Stuart Kirk, who was at the time HSBC’s head of responsible investing (but not for much longer afterwards).
Damodaran argued that advocates of ESG investing are guilty of an internal consistency, because the notion that you could generate higher returns while lowering risk by improving ESG metrics goes against one of the basic rules of a market-based economy, which is that lower risk means lower reward.
When ecosystems break down, it is just as bad for portfolio returns as the exclusion of high-performing stocks purely because of ethics
If investing within an ESG framework were to lower the riskiness of assets by factoring in their ‘goodness’, those assets should logically have a lower return profile – assuming they are being priced correctly.
Damodaran added that reputational pressure has led publicly traded companies to reduce spending in brown activities like fossil-fuel exploration and energy assets, but that this financing gap has instead often been filled by private capital.
He also argues that advocates of ESG investing have kept their definitions purposely vague so that they can counter criticism of underperformance by blaming poor definition or implementation. Such an approach damages the credibility of ESG strategies.
ESG, he concludes, is “a testimonial to the consequences of letting good intentions overwhelm good sense and allowing the selling imperative to define and drive mission.”
What Damodaran misses is the fact that ESG investing doesn’t just collide with the rules of market-based economies but must also reflect basic truths of environmental and social science.
There comes a point when investors cannot ignore the E, the S and the G in their investment strategies because there will be companies, business models and even entire industries that will no longer function if global temperatures exceed 1.5 degrees over preindustrial levels, or if socio-political crises escalate, or if corporate mismanagement scandals multiply.
The anti-woke investing movement is fond of pointing out that asset managers have a fiduciary duty to their clients to generate the highest possible returns. But when ecosystems break down, it is just as bad for portfolio returns as the exclusion of high-performing stocks purely because of ethics.
The only counter argument to that is that long-term exposure to ESG risks might not matter to short-term investments. However, this implies a narrow view of ESG risk as the likelihood of an environmental or social shock impacting a company within the time that someone has made a capital commitment to that company.
It ignores the bigger picture, which is that the current poor health of the global economy – and its companies – is at least partly tied to the worsening health of the planet. And the risks are already there for all to see.
Remember the target
Damodaran’s point about the rules of risk and reward is of course accurate. But instead of concluding that we should therefore throw out the practice of ESG investing, we should consider how rules might be adapted to help it succeed.
Regulators and governments need to step in and establish a system of incentives that make it financially attractive for investors to put capital into assets with high ESG scores precisely because they contribute to the creation of a sustainable economy that protects the environment, and which is therefore less risky on an existential level.
As regards credibility, if the market cannot be trusted to decide what is an appropriate use of socially responsible investing labels because it will always prioritise financial return over non-financial factors, let others do it.
The European Union’s Sustainable Finance Disclosure Regulation (SFDR), the UK’s Sustainability Disclosure Standards regime and other public-sector initiatives that seek to clarify what counts as responsible investing and what doesn’t all contribute to this goal.
This might be too interventionist for advocates of a free-market economy, of course, but if humanity has any desire to meet sustainable development goals, we should stop trying to make a round ESG peg fit into a square capital market hole.
A purely returns-driven conception of how ESG factors should fit into a market-based economy that understandably rewards risk simply doesn’t work, because it ignores the fact that climate risks cannot be rewarded.
In its place must evolve a system that incentivises ethical investing because it aligns with the higher-level reality that ecological preservation is good for business.