Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is professor of finance at the Stern School of Business at New York University
Born in sanctimony, nurtured with hypocrisy and sold with sophistry, ESG grew unchallenged for a decade, but it is now facing a mountain of troubles, almost all of them of its own making.
The problems of investing with an environmental, social and governance framework start with assessing what it measures, which has changed over time and reflects its revisionist history.
ESG started as a measure of goodness, built around a UN document enunciating the principles for responsible investing, with significant establishment buy-in. As the selling of ESG to investors ramped up, its salespeople recognised that goodness had limited selling power. So they switched gears, arguing that ESG was an instrument for delivering higher returns without concurrent risk.
That case worked well through much of the last decade, mostly because of ESG investors’ abhorrence of fossil fuels and embrace of technology firms, but the Russian invasion of Ukraine changed the calculus. As sector funds underperformed, advocates moved on to claim that higher ESG scores lead to less risk and lower costs of capital. Perhaps because both risk claims are questionable, they now contend that ESG’s primary purpose is disclosure about material issues.
It serves ESG advocates to keep the definition amorphous, since, like the socialists of the 20th century whose response to every socialist failure was that their ideas had never been properly implemented, the defence against every ESG critique is that it is incorrectly defined or implemented. The truth is that ESG scores today measure everything — consequently, they measure nothing.
Consultants, trying to sell companies on their indispensability, assert that improving ESG increases value, though they are opaque about the pathways for delivering it. That assertion is false, since anyone with even a rudimentary understanding of value drivers should see that a higher ESG score can increase value at some companies, generally smaller and serving niche markets, while decreasing value at other companies where it adds to costs while doing nothing for revenues. This makes anecdotal evidence or case studies useless. And the cross-sectional evidence suggests that improving ESG makes scaling up more difficult, has little or no effect on profitability and is as likely to decrease value as increase it.
In parallel, advocates are pushing investors to bring ESG into their investment processes, arguing that this leads to higher returns, allowing them to have their cake (be good) and eat it too (earn higher returns).
Even in its nascency, the argument lacked internal consistency. If an asset is less risky, it should have lower expected returns. Thus advocates who argue that improving ESG will make firms less risky are directly contradicting other claims that investors will earn higher returns if they invest in high ESG companies. Adding an ESG constraint to investing will lower expected returns, with the only question being how much, leaving fund managers who have fallen for its charms in a fiduciary bind.
Once you strip ESG of its “good for value” and “good for investors” arguments, the only argument left for it is that it is good for society, and there too, ESG is destined to fail.
The pressures to maintain high ESG scores are selectively applied, more to publicly traded companies than to private businesses and more rigorously in some geographies than in others. This has predictable consequences, most easily seen on ESG’s E(nvironment) front.
ESG pressures have led publicly traded fossil fuel companies to reduce spending on exploration and to divest fossil fuel assets, but private equity has filled the investment void. Is it any surprise that after trillions of dollars invested in fighting climate change, we are just as dependent on fossil fuels now as we were a decade or two ago?
On the S(ocial) front, like pyromaniacs complaining about the fires around them, ESG advocates, who chose to be arbiters of social good in a world divided on many issues, protest that ESG has been politicised.
As for G(overnance), its presence in ESG has always been puzzling, since it replaces the original notion of corporate governance, where managers are accountable to shareholders, with one where managers are accountable to all stakeholders, effectively making them accountable to none of them.
ESG is beyond redemption, a testimonial to the consequences of letting good intentions overwhelm good sense and allowing the selling imperative to define and drive mission. May it RIP.
Letters in response to this article:
ESG’s role in never-ending quest for alpha is central / From Witold Henisz, Vice-Dean and Faculty Director, ESG Initiative, Deloitte & Touche Professor of Management, The Wharton School, University of Pennsylvania, Philadelphia, PA, US