A Skeptical look at ESG Investing – updated

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According to its CEO Larry Fink, BlackRock, the world’s largest investment firm, will put sustainability at the centre of its investment strategy from now on. Talks and attention about Sustainable Investing/ESG Investing are positively growing worldwide. This should come as good news for everyone, especially if you consider yourself a responsible citizen and investor. While I take satisfaction in including ESG ventures in my investment portfolio, I understand many financial products risk receiving nothing more than cosmetic adjustments (social washing) to serve this new market demand. Besides the appreciation for the expected positive impact that ESG investment should promote, I feel it is necessary to maintain a constructive but critical view of this growing market. Valuing the analyses of professor of Corporate Finance Aswath Damodaran, I hereby update my sep-2020 article with his most recent insights.

 

From Sounding good or Doing good? A Skeptical look at ESG (Sep-2020)

In many circles, ESG is being marketed as not only good for society, but good for companies and for investors. In my view,  the hype regarding ESG has vastly outrun the reality of both what it is, and what it can deliver, and the buzzwords are not helpful. That is the reason I have tried to under use words likes sustainability and resilience, two standouts in the ESG advocates lexicon, in writing this post. I believe that the potential to make money on ESG for consultants, bankers and investment managers has made at least some of them cheerleaders for the concept, with claims of the payoffs based on research that is ambiguous and inconclusive, if not outright inconsistent. The evidence as I see it is nuanced, and can be summarized as follows:
  • There is a weak link between ESG and operating performance (growth and profitability), and while some firms benefit from being good, many do not. Telling firms that being socially responsible will deliver higher growth, profits and value is false advertising. The evidence is stronger that bad firms get punished, either with higher funding costs or with a greater incidence of disasters and shocks.ESG advocates are on much stronger ground telling companies not to be bad, than telling companies to be good. In short, expensive gestures by publicly traded companies to make themselves look “good” are futile, both in terms of improving performance and delivering returns.
  • The evidence that investors can generate positive excess returns with ESG-focused investing is weak, and there is no evidence that active ESG investing does any better than passive ESG investing, echoing a finding in much of active investing literature. Even the most favorable evidence on ESG investing fails to solve the causation problem. Based on the evidence, it appears to me that just as likely that successful firms adopt the ESG mantle, as it is that adopting the ESG mantle makes firms successful.
  • If there is a hopeful note for ESG investing, it is in the payoff to being early to the ESG game. Investors who are ahead of markets in assessing how corporate behavior, good or bad, will play out in performance or priced, will be able to earn excess returns, and if they can affect the change, by being activist, can benefit even more.
Much of the ESG literature starts with an almost perfunctory dismissal of Milton Friedman’s thesis that companies should focus on delivering profits and value to their shareholders, rather than play the role of social policy makers. The more that I examine the arguments that advocates for ESG make for why companies should expand mission statements, and the evidence that they offer for the proposition, the more I am inclined to side with Friedman. After all, if ESG proponents are right, and being good makes companies more profitable and valuable, they are on the same page as Friedman. If, on the other hand, adopting ESG practices makes companies less valuable, the onus is on ESG’s proponents to show that societal benefits exceed that lost value.
The ESG bandwagon may be gathering speed and getting companies and investors on board, but when all is said and done, a lot of money will have been spent, a few people (consultants, ESG experts, ESG measurers) will have benefitted, but companies will not be any more socially responsible than they were before ESG entered the business lexicon. What is needed is an open, frank, and detailed dialogue concerning ESG-related corporate policies, with an acceptance that being good can add value at some companies and may destroy value at others, and that in the long term, investing in good companies can pay off during transition periods but will often translate into lower returns in the long term, rather than higher returns.

From The ESG Movement: The “Goodness” Gravy Train Rolls On! (Sep-2021)

After one year for his last article on ESG, professor Damodaran had the time to further analyse the movement. This is his punch-line:
“I have tried my best to see things through the eyes of ESG true believers […].  More than ever, I believe that ESG is not just a mistake that will cost companies and investors money, while making the world worse off, but that it creates more harm than good for society”.
Fast forward, this is his overall conclusion:
The ESG movement’s biggest disservice is the message that it has given those who are torn between morality and money, that they can have it all. Telling companies that being good will always make them more valuable, investors that they can add morality constraints to their investments and earn higher returns at the same time, and young job seekers that they can be paid like bankers, while doing peace corps work, is delusional. In the long term, as the truth emerges, it will breed cynicism in everyone involved, and if you care about the social good, it will do more damage than good. The truth is that, most of the time, being good will cost you and/or inconvenience you (as businesses, investors or employees), and that you choose to be good, in spite of that concern.
Let’s see how he arrives at such a harsh conclusion, through 4 main points:
1) Goodness is difficult to measure, and the task will not get easier! He questions the fallacy of the made-up measures to measure goodness. For him, Goodness is not as objective as financial ratios. Goodness is in the eye of the beholder. Recent surveys show major differences among core values between different age groups, let alone religious or ethnic groups. Evidence also shows that big companies have more resources and skills to play the “ESG scoring game” that small ones.
2) Being “good” will add to value some companies, hurt others, and leave the rest unaffected! Not without a certain wit, Damodaran raises this question: If the ESG sales pitch to companies, which is that if you are a “good” company, you will be worth more, is right, why do we need such complex and demanding ESG scoring? He states that the empirical evidence that ESG has a positive payoff is weak, at best, and inconclusive, for the most. The strongest evidence that is supportive of ESG comes on the risk front, with evidence that it does not pay to be a “bad” company. However, there is very little evidence that there is a payoff to spending more money to be “good”.
3) The ESG sales pitch to investors is internally inconsistent and fundamentally incoherent.  The argument that incorporating ESG investing in your portfolio will increase your returns largely depends on the fact whether the market has already priced in the extra-value impact from ESG. If the market has already priced the ESG effect, investing in such companies won’t produce excess returns. Given any possible reduced company risks thanks to its ESG policies, there could be a reduced return due to the reduced risk involved. However, if the market has not yet priced the ESG effect of a company, investing in such “good” companies will generate higher returns, when the market corrects its pricing mistake.  Ultimately, it is still necessary to divine what social values are gaining or losing ground in the market.
4) Outsourcing your conscience is a salve, not a solution! I find this is the core message of Damodaran’s article. As such, I quote it in its full length:
Even if being “good” does not increase value or make investors better off, could it still help, by making the world a better place? After all, what harm can there be in asking and putting pressure on companies to behave well, even if costs them? In the short term, the answer may be no, but in the long term, I believe that this will cost us all (as society). The ESG movement has given each of us an easy way out of having to make choices, by outsourcing these choices to corporate CEOs and investment fund managers, asking them to be “good” for us, while not charging us more for their products and services (as consumers) and delivering above-average returns (as investors). Implicit in the ESG push is the presumption that unless companies that are explicitly committed to ESG, they cannot contribute to society, but that is not true. […] I am certainly not willing to concede, without challenge, that a corporate CEO knows my value system better than I do, as a shareholder, and is better positioned to make judgments on how much to give back to society, and to whom, than I am.
Damodaran’s article provides a final unexpected gem, by introducing and sharing “the Secret Diary of a Sustainable Investor” written by Tariq Fancy, ex CIO for sustainable investing at Black Rock, the fund of Larry Fink, with whom I had opened this article. Tariq thinking evolved from evangelizing ‘sustainable investing’ for the world’s largest investment firm to decrying it as a dangerous placebo that harms the public interest. He states we’re running out of time: we can no longer afford to answer inconvenient truths with convenient fantasies. He believes tools such as ESG data and reporting standards can be useful to monitor the side effects we need to manage better. But the narrative that these alone will matter without fixing the rules of the gamer risk rendering these efforts meaningless or even counterproductive. This is the link to his essay.
Overall, I strongly value Damodaran’s and Tareq’s views. The more we care about social good (stakeholder value) in the business and investing world, the more we need to be aware of the risks of social and greenwashing practices. ESG scoring is a new interesting tool. However, it can easily become a financial porn‘s new buzzword.  
As expressed by Goodhart’s law, when a measure becomes a target, it ceases to be a good measure. 
Until next time,  Sweat Your Assets.
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