ESG Investing: For and Against

Over the last year, the debate about ESG Investing (that is, considering Ethical, Social and Governance factors in investing) has increased in prominence. In particular, the reduction in capital available for fossil fuel investment has arguably constrained the supply response to rising fossil fuel prices, thus increasing the cost of energy worldwide.

This essay will consider two questions; are ESG practises good for shareholders, and are they good for society?’. 

While I don’t actually have a strong opinion on either, I personally find the debate interesting because this debate comes down to goals and ideals. Arguably, there is no correct answer to the questions I have posed.

What is ESG Investing?

ESG investing is a framework for making investment decisions based on companies policies and business decisions regarding environmental, social and governance issues. I concede that governance is always quite important for investors, so the far more interesting questions for me, are around the environmental and social aspects.

Put simply, the environmental factor of ESG involves aiming to invest in companies that implement positive policy for the environment and not invest in those that are harmful to the environment. The focus of this is usually surrounding climate change and renewable energy, however this can apply to any environmental issue such as pollution or deforestation.

The social factor of ESG investing instead involves investing in companies that are good for society, while avoiding those that aren’t. The classic examples of this are tobacco and gambling companies, which are very profitable but probably don’t offer any net positive contribution to society.

The Impact of ESG Investing

While ESG Investing has various impacts for both companies and shareholders, the core effect of ESG investing is around price. People are more willing to pay higher prices for positive ESG companies and lower prices for negative ones. The first important question is around the impact of ESG on returns. It should be noted that our data for this isn’t fantastic as returns are impacted by many different factors and we don’t actually have that many long term cycles to examine. However, the data does seem to demonstrate an outperformance of anti-ESG companies vs ESG companies.

What a lot of people miss is that this isn’t a bug of ESG investing, it’s a feature. 

When a company’s price is low and its expected return is high that also implies that its cost of capital is high. At its core, this means that companies that are good for the society or the environment find it easier to access capital, and can justify good projects with lower returns and vice-versa. 

For example, a low cost of capital has played a significant role in increasing global solar capacity as companies can justify investing in lower return projects. In contrast, it’s become much more difficult to get financing for a new coal plant or coal mine. Furthermore, companies are incentivised to act in a more ESG conscious way in order to command a higher market valuation (whether through a higher share price, or by accessing ESG conscious capital in a capital raise)..

Therefore, when people make the argument that ESG investing doesn’t do anything, they are just demonstrably incorrect. 

That said, the more important question is whether this impact is actually positive. So next, I’ll break down the core arguments on either side of this debate.

The first and biggest issue with ESG investing is the question of ‘what is ESG?’, especially around the social side. 

We all know morality is subjective and for most companies there is an argument to be made for either side. For example, many helpful businesses source products and materials from unethical sources and use unfair labour practices, while many damaging businesses still make significant contributions to some external stakeholders, such as coal mines supporting local small businesses. 

When judging the morality of these companies, oftentimes both sides have a valid argument and much of the judgement just comes down to personal ideals and perspectives. When reduced to a standardised checkbox, ESG investing is arguably painting morality in black and white, when in reality most things fall into a moral grey area. How does an ESG investor judge what actually is good for society and the environment? How do they apply their framework across many large, complex businesses?

ESG Investing And Check-Boxes

Given the effort of making the judgement, and the inevitability of errors, many investors are forced to either simplify or outsource the decision making. And as this scales, it systemically tends towards a check box approach, lacking the nuance to accurately screen companies.

Companies that check off arbitrary ESG criteria get disproportionately rewarded while those that don’t get punished, which leads to “greenwashing” and “virtue signalling”. While these terms get thrown around a lot and are arguably overused, they are a legitimate issue within the corporate world where companies have the most to gain and often the least genuine intentions behind them.

Another key argument relates more specifically to the environmental factor. How do you balance doing good for the environment and doing good for society? 

Most harmful environmental projects are done for the economic benefit of the consumer (and shareholders). The obvious example of this is around hydrocarbons such as coal, oil and natural gas, which have historically provided cheaper, more reliable energy. With a higher cost of capital you get fewer projects approved, which means less efficient markets.

The fact is that oftentimes these environmental harms do lead to lower prices, today. And inevitably, increasing prices harm the poor, more than the rich.

ESG Investing And Class Warfare

When we make a decision to drive up the cost of capital for anti-ESG projects, we are de facto asking the working class to pay for it disproportionately (impact relative to their total income). There is arguably an element of classism with regards to how we often discuss the societal cost of decarbonisation as the lower class suffers an unfair brunt of the cost, yet the decisions are being made by investors and policymakers who are generally better off. Furthermore, we in developed countries grew our economies off the back of environmentally harmful but profitable processes. Similarly, we are asking poorer developing nations to forgo the opportunity for economic development that we already took.

ESG Investing As Democracy In Action

On the other side, while morality is often grey, a pro-ESG investor would argue that doesn’t prevent you from advocating for change. If others disagree with your view on society they are welcome to advocate for their perspective.

That’s what makes a functioning market, democracy and society.

Just because we can’t make an objective moral decision doesn’t mean we can’t strive to improve society. If ESG investing works to promote good corporate behaviour (which as outlined earlier, it does) then we arguably we should use it as a tool in the same way we use any tool to promote positive outcomes, despite its limitations.

Regarding the social-environmental tradeoff, Pro-ESG investors need to grapple with the moral tightrope they walk and do it in a way that considers those who will be affected most by ESG decisions. Anyone arguing for pro-ESG investing should do so within a framework that doesn’t disregard those most impacted by it. 

ESG Investing Has Shortcomings And Strengths

Concessions and compromise are essential in any ideas presented, as you are inherently asking these groups to sacrifice personal wealth and stability for a greater good. However, there is a broader argument to be made that poor environmental outcomes will impact that same demographic disproportionately. Geographically, many poor nations are the ones most impacted by climate change and other forms of environmental harm.

Furthermore, once climate change begins to impact the economy and our supply chains, it is working class people that will be hit the hardest. Most ESG advocates aren’t advocating to overhaul the economy overnight, just to make consistent improvements in policy and business practices.

Finally, it’s fair to say that many systemic methods of enforcing morality are woefully inefficient. Not all ESG investors have the same approach, but as any one approach scales, it tends towards a check box system.

And flaws in any checkbox system will scale, along with the rest of it.

Meantime, corporations are incentivised to influence policymakers in order to create loose regulatory conditions, with examples in almost every sector. Reliance on regulation as the sole motivator for good behaviour is insufficient when the people making the regulations can’t always be relied on to act in the best interests of society. 

Corporations benefit greatly from the stability, systems and services established using public funds. It would follow from this that (ethically, not legally) companies have a moral duty to act in the best interests of society, or at least not actively act against them. Through this lens it is totally fair for investors to advocate for companies to enact positive ESG policies.

I hope this article has been helpful to whoever is reading this. I want to reiterate that I’m not trying to sway anyone in any particular direction on the argument. Your view on ESG investing comes down to your own moral framework and what you value. 

I hope by sharing my thoughts on the subject others might also reflect on whether they wish to consider social and environmental stakeholders in their investing decisions. 

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