Charlie McMillan Summons and Victor Yan
During the Dot-com bubble of the early 2000s, any company whose business or name related to the internet shot up in market capitalisation. For example, Webvan raised US$375 million in a 1999 IPO at $30 but by July 2001, the company went into liquidation at $0.06 per share.
In a broadly similar vein, investment products with ‘ethical’ and ‘sustainable’ wrapping – basically anything satisfying Environmental, Social, and Corporate Governance (‘ESG’) principles – has powered ahead returns wise. This article questions the foundations of this investing movement and its long-term future efficacy.
The Popularity of ESG
The popularity of ESG funds has been rapidly accelerating in recent years. 2019 was a record year for these funds, bringing in US$20.9 billion, quadrupling the inflow of 2018. By August of this year, these funds had received US$29 billion of new money (13% of total ETF inflows), placing 2020 as another record-breaking year for ESG funds.
Since the early 1970s, the corporate world has acted according to Milton Friedman’s business ethics by holding aloft the primacy of the shareholder. This adoption was not uniform across the globe. For example, large German companies are still required to allocate half of their board seats for worker representatives. Nonetheless, Friedman’s doctrine of shareholders being the only socially responsible stakeholders in companies due to their economic interests prevailed.
ESG’s rise today is a manifestation of the attitude shift to the primacy of many other stakeholders. Consequently, what were previously deemed externalities to business by economists, such as environmental impacts caused by carbon emissions, are increasingly being considered as material business concerns for companies. The difficulty that has arisen is that “ESG” has been convoluted as a marketing tool for fund managers promoting their themed products. ESG has transformed from a socially-conscious method of investing with the accepted caveat of below market returns to the new silver bullet for high returns.
Regardless of its indefinite ambit, ethical investing appeals strongly to younger generations and those with a strong social conscience. For instance, fossil fuel businesses are approaching the same level of social detestation as tobacco companies amongst an ever broadening stratum of society. Demand also stems from a view of the future where companies with low carbon emissions and sustainable practices will thrive.
What is ESG?
ESG is extraordinarily difficult to pin down, as is evident in the table below.
ESG is troublesome to define because it is based on qualitative characteristics for which we do not have agreed quantitative metrics to measure. This problem is further obfuscated by the many ways to slice ethical corporate behaviour. As such, the only certainty is that every ESG investment product will fail someone’s idea of what is responsible and sustainable investing. Some might believe that the fact that BHP produces most of the raw materials required to manufacture solar panels affects the carbon footprint of solar companies. Others more concerned with privacy and the protection of democracy might conceive of Facebook as worse for the world than Exxon Mobil.
The methodology of the index behind Australia’s largest ESG ETF, Betashares’ ‘ETHI’, first determines its potential universe of “climate leaders”. This is defined as companies within the top third in their industry in terms of carbon efficiency (carbon emissions divided per dollar of revenue). The universe is then narrowed by NASDAQ’s Responsible Investment Committee which excludes businesses with a “direct or significant” revenue exposure to fossil fuels, and other considerations deemed irresponsible such as animal cruelty, junk food, pornography, and lack of board director diversity.
iShares’ US-focused ESG ETF ‘SUSL’ screens to exclude companies deriving a certain threshold of revenue from alcohol, tobacco, firearms and other weaponry, gambling, and nuclear energy. You will notice that each of these index methodologies necessitate heavy subjective calls by the index providers (NASDAQ and MSCI).
Not only is ESG definitionally complex, it is similarly burdensome to implement in practice. Third party data providers might not delve deep into a company’s operational nuances and supply chains therefore lead passive fund managers into an unethical purchase. Take the curious case of Air Products and Chemicals Inc (APD). This ticker finds itself in MSCI’s ESG USA index (albeit at a tiny allocation). Thomson Reuters gave APD a score of 9/10 for its environment ranking in its ESG calculation. Compare that to Apples 7/10 or Tesla’s 6/10. However, APD is set to become the third biggest carbon emitter of all American companies if it successfully executes its plan to become the world’s largest operator of coal gasification plants in Asia by 2025.
The trouble with attributing strong recent performance of ESG-focused products is that there is a high risk that doing so omits a correlated variable. Undoubtedly, ESG has correlated with high stock returns in the past two years. But it does not follow that this outperformance was caused by those companies’ environmental and social policies.
This is most obviously seen in the top holdings of ESG ETFs. Betashares’ ETHI ETF, which tracks companies that are “climate leaders”, has as its top three holdings Apple, Nvidia, and Mastercard. Attributing the high year-to-date return of these companies to a lack of involvement in fossil fuels or other principles of responsible corporate governance entirely ignores the competitive advantage each of them holds within their respective industries.
Indeed, some have surmised that ethical investing’s recent high returns are due to this omitted correlated variable. A by-product of the ESG screens which underpin a large proportion of ethical investing ETFs are the technology and healthcare sectors. Coupled with this is an underweighting in the energy sector due to its reliance on fossil fuels. Energy has significantly lagged the market this year, in part due to collapsing oil prices from global lockdowns and travel bans.
It could be argued that ESG did not so overweight and underweight these particular sectors by happenstance. Some might say that this is a reflection of the premium markets place on sustainable business models. For instance, solar energy has vastly outperformed the whole energy sector.
However, the number of confounding variables make the conclusion that ESG policies caused this outperformance far from certain. It could be that smaller high growth companies rank highly in ESG measures due to their natural avoidance of established industries like tobacco, fossil fuels, and tend towards low carbon emissions businesses like technology.
To answer this question, it is prudent to return to first principles and examine whether or not ESG is beneficial to the value drivers of companies.
ESG and Value
Pull your average Joe off the street and ask his opinion whether a company’s implementation of ESG practices seems a sensible investment – the answer is likely yes. This may be due to the common street belief that ESG is value-accretive, or perhaps even the social pressure of coming across as iconoclastic in a social environment where ESG is the accepted mainstream.
However, as rational investors, we always have to come back to asking questions of first principles. In physics, this may be Newton’s First Law of Motion. In music theory, this may be the 7 notes in the ionian scale (if you’re wondering: Tone, Tone, Semitone, Tone, Tone, Tone, Semitone). But for the world of investing, we ask if implementing ESG practices actually enhance the value of the company?
In all fairness, the initial premise for the pro-ESG camp sounds reasonable: by being “good” and adopting ESG practices, companies may indeed enhance their value, command higher profits at lower risk, ultimately resulting in superior returns on investment.
Socially-conscious consumers may specifically seek out that sustainably made sun-lotion, and potentially may set a higher reservation price for these products above items offered by non-ESG companies.
Just as ESG attitudes may promote favourability from a company’s end markets, the same could perhaps be said for a company’s supply chains, as suppliers who maintain a ESG focus may offer cheaper ingredient prices with a similarly socially conscious counterpart. This mix of pricing power from a consumer and supplier basis, with simple math, translates to higher margins.
Those pro-ESG also argue the practice as a way of reducing the inherent risk-profile of a company. After all, we sensationalize a good scandal story that has led to the demise of many business reputations – whether that be the recent Juukan Gorge fiasco surrounding Rio Tinto (see UNIT’s article on the Rio Tinto Scandal), the banking royal commission a few years back, or the Exxon Valdez oil spill back in 1989. In this sense, it seems not the case that “there is no such thing as bad publicity”.
Or perhaps think about companies who rely on a levered capital structure, meaning they entail debt obligations. It may be that as the lending sphere rides in on the growing ESG wave, banks and financial institutions believing that ESG orientated companies generate better profits at lower risk offer better lending terms whether through lower rates or looser covenants – overall lowering cost of debt and the WACC – automatically enhancing the valuation of a company on your DCF spreadsheet.
However, we should always question theory in practice. In a more cynical reading, it may well be the case that anti-ESG companies may actually perform better. These anti-ESG companies can typically be proxied by what are known as “sin-stocks” – the exact type of companies that are flushed out by negative screening by any ESG investor or fund. Think of your tobacco, coal-mining or weapon-supply companies. Generally, we tend to view the products and services they offer as detrimental to society, and when questioned, vehemently oppose supporting the companies who produce them.
However, it could likely be the case that we do not put our money where our mouth is. Consider a scenario where there are groups of consumers who prefer “cheap and convenient” over paying a higher price premium to protect the planet. Companies who shortcut investment into sustainable processes in order to push out cheap product offerings to their end markets are likely to hold price competitiveness relative to competitors – driving up revenue growth and market share. We’ve all heard about factory sweatshops hiring child labor and grey zone practices, but the objective of most businesses is ultimately to boost profits.
To that end, lenders’ first and foremost criteria towards choosing borrowers is the repayment of principal. Arguably, nothing is a clearer indication of the ability for repayment than a scenario where companies generate superior earnings and stable cash flows from engaging in “bad” activities.
Or perhaps take an alternative view that ESG orientated firms face a much more constrained investment universe in their corporate projects, whether that means a new product venture or exploration into a potential merger or acquisition. In many respects, sometimes setting up too many rules and criteria limit do-good companies to a state of inertia where no investment checks all boxes, whereas bad companies are free to pursue opportunities with higher speed, scale and efficiency.
In the same vein as how Michael Jackson’s “Bad” may not have nearly been as successful if he had named his album “Good” instead, these companies may score low marks on the corporate responsibility scales, but ultimately ace the test for investor’s appetites towards higher yield.
What does the Evidence Suggest? The Proof is in the Pudding
Ultimately, it is an interesting exercise to ponder theories whether or not ESG is indeed value accretive. But, the efficacy and effectiveness of companies largely boil down to their bottom line so we must consider the evidence of ESG’s effect on this.
Some studies indeed suggest ESG may be beneficial towards a company’s value. For example, meta analysis on the performance of ESG companies in fact show a positive link to profitability, albeit a weak one. Even so, reviewing back to our basic statistics lessons, correlation does not necessarily imply causation. While it may be the fact that ESG causes companies to be more profitable, it could also be the case where profitable and established companies are in a better financial and strategic position to execute ESG practices than companies on the edge of failure.
Moreover, studies also suggest that “bad” companies can get punished by the market. An analysis on sin stocks have shown on average, exposure towards higher funding costs from both an equity and debt perspective – particularly in tobacco and coal-mining industries. The caveat however, is that while value may be diminished from a funding standpoint, these companies have historically outperformed their ESG counterparts, suggesting that either the loss of value has been compensated by additional value generation elsewhere, or that these industries are subject to irrationally exuberant market pricing. Given these industries are largely comprised of mature, stable companies dependent on legacy products (eg. Camel Cigarettes), it is more likely the case of the former than the latter.
In a seemingly ambiguous debate on ESG investing, research does seem to agree its tendency to limit downside tail risk. All in all, socially responsible companies are less likely to be subject to controversy or scandal episodes. This finding may serve well not only for pro-ESG investors, but also investors who may exhibit high degrees of risk-aversion in general. Yet, anecdotal impressions describe discrete PR disasters that destroy a company ultimately prove rare, as for every Wirecard or Arthur Andersen story out there, countless other scandalled companies have been able to successfully emerge in a new light from their past disgraces. Even Facebook is up almost 60% since Mark Zuckerberg testified before Congress in 2018.
Despite this, benchmark comparisons between ESG and anti-ESG investing show discouraging results to the pro-ESG camp. A comparison of two Vanguard Index funds in the Vice Fund, and the FTSE Social Index fund show that over a time frame from 2002-2015, that $1 invested in these sin stocks would have yielded around 20% more than a socially conscious index.
The above analysis is not to say that people are wrong to want to invest ethically, in fact one should always consider the moral ethicacy of any course of action, and investments should not be placed on any sort of secular pedestal . This article merely highlights some holes apparent in the story of ESG which goes against the marketing pushing this trend. The takeaway is that ESG is a broad concept which is difficult to implement in practice, and contrary to belief, ESG is not necessarily a magic bullet for high returns going forward. Investors should put their money behind the ESG cause with the realistic expectations that it might deliver more modest returns. Overall, investments should be treated on a case by case basis, hence while evidence shows a great bulk of ESG vehicles to be illusory, outstanding ESG instruments do indeed exist. As a silver lining, investors should be wary but not turned off from ESG investments, in its very pure form, they are for a noble cause, and a learning opportunity for any investor to test his/her ability to distinguish illusion from reality.
Charlie McMillan Summons is a Research Analyst for UNIT – University of Melbourne studying a Juris Doctor at Melbourne Law School.
Victor Yan is the Vice-President of Publications for UNIT – University of Melbourne, specializing in financial investments and economic policy.
Aswath Damodaran, ‘Doing good or Sounding Good: A Skeptical Look at ESG!’: https://aswathdamodaran.blogspot.com/2020/09/sounding-good-or-doing-good-skeptical.html
Massif Capital, ‘Failure to Impact: Are ESG Funds Delivering on Investors’ Ambitions?’: https://info.massifcap.com/download-failure-to-impact-are-esg-funds-delivering-on-investors-ambitions
Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.