Why blindly investing in ESG is a bad idea (2024)

ESG: Environmental, Social, and Governance.

It’s become one of the hottest buzzwords in recent years — not just in the finance industry but world at large. PwC estimates that the assets under management (AUM) of ESG-related assets reached US$18.4tn in 2021, and is projected to grow to US$33.9tn by 2026.

Yet it’s also a buzzword turbocharged with controversy. ESG has been labelled by conservatives as woke propaganda, with 15 US states enacting — and 12 more planning to enact — anti-ESG laws. It’s been so politicised that Blackrock CEO, Larry Fink, often considered to be the face of the entire ESG movement, has outright stopped using the “weaponised” term. The increasing politicisation from both conservatives and liberals has left the term caught in the midst of brutal culture wars and the battle over “wokeism”.

I think this is wrong. ESG is merely a set of factors — mostly qualitative ones — that should help investors make investment decisions: no more, no less. In that regard, it should be treated no differently from other qualitative factors such as customer satisfaction and employee morale.

Why?

To understand the ESG debate, we first have to understand its detractors and proponents.

ESG detractors argue that rigidly adhering to ESG metrics risks compromising the performance of the business as a whole. They may argue that the ESG-driven need for companies to invest in new technologies, change production processes, or adhere to stricter environmental standards, will compromise revenue and profit figures. Self-proclaimed “diehard capitalists” may also argue that such an approach risks corrupting the very nature of capitalism, as managers will be forced to sacrifice business performance to adhere to ESG standards.

For proponents, I’d argue that there are two main camps. First, there are those who believe that ESG is simply an avenue to drive shareholder return. Let’s call these group Type A proponents. They argue that adherence to ESG standards is required for companies to be able to sustain their business over the long-term. They point to arguments that sustainable business practices can contribute to longevity, stability, and resilience. They argue that companies with strong ESG performance will attract more socially conscious consumers, a group that will broaden in size and influence as younger generations begin to yield greater sway over the economy.

In my view, Blackrock’s Larry Fink falls under this camp. In his 2022 Letter to CEOs, he argues the following:

“Stakeholder capitalism is not about politics. It is not a social or ideological agenda. It is not “woke.” It is capitalism, driven by mutually beneficial relationships between you and the employees, customers, suppliers, and communities your company relies on to prosper. This is the power of capitalism.”

Meanwhile, the other group of ESG proponents believes that ESG is a trend to sacrifice some shareholder return for the greater benefit of society. Let’s call this group Type B proponents. While Type A proponents argue that ESG is a means to an end — driving shareholder value, Type B proponents instead argue that ESG is an end in itself, which should be pursued alongside shareholder return as a separate goal altogether. As such, they believe two core beliefs. Firstly, ESG pursuits will sacrifice shareholder returns as companies strive to meet the needs of other stakeholders such as consumers, employees, and the general public. Second, that this sacrifice should take place.

Here’s a short table summarising the perspectives of all three groups:

It’s important to note that these groups aren’t fixed labels, and are merely a significant oversimplification of the existing ESG debate. Many individuals, investors, firms, and experts will fall on a spectrum somewhere between these three groups.

The first point of conflict surrounds ESG’s potential to drive shareholder returns. In this debate, detractors believe that ESG compromises shareholder returns, type A proponents believe that it enhances long-term shareholder returns, and type B proponents reject this debate altogether.

What’s more important is that none of these groups are completely right — and for the same reason. They have placed ESG on a pedestal compared to other qualitative factors, and in doing so have needlessly corrupted and politicised the investment process.

Instead, ESG are simply some out of the many factors that contribute to companies’ long-term value. This means that they are important, as they may affect a company’s reputation and relationships with other stakeholders such as suppliers and customers, which will in turn impact long-term sales and profits. But this also means that they are not special: they are important in the same way as a myriad of other factors are, such as consistency of product quality and its relationship with suppliers.

This has two implications. First, on a purely financial basis, pro-ESG groups shouldn’t prioritise ESG over other qualitative factors. Second, anti-ESG groups shouldn’t dismiss ESG factors as “woke” over other qualitative factors either. The mere consideration of other qualitative factors isn’t deemed “woke”, and that should be the case with ESG too.

Further, much of the ESG factors (especially the “Social” and “Governmental” aspects) are already encapsulated in the “Quality” style already popular in mainstream finance, which emphasises high, sustainable profitability, with good management and relations with stakeholders. In this regard, ESG could simply be viewed as a more hyped, less precise, and less numerical alternative to the Quality style, while not providing anything new to the table.

Moreover, the notion that only companies whose stocks have high ESG ratings have inherently higher potential for shareholder return than those with low ESG ratings is not true. This ignores one of Wall Street’s oldest — yet still most relevant — pieces of advice: “it’s already priced in.” The same way that companies with high debt or low growth potential will generally be valued at lower multiples than those with low debt or high growth potential, it can be expected that the market will value companies with poorer ESG ratings lower than those with stronger ESG ratings, so as to account for the difference in long-term value that ESG will cause.

But how about non-pecuniary (i.e. not related to money) reasons? Isn’t that the main draw of ESG in the first place?

Perhaps so. But even then, ESG fails to deliver on its promises. This is largely due to the inconsistent, binary, and reductive nature of the metrics that underpin ESG.

First, the metrics are vague and inconsistent. ESG scores come from different providers with their own rubrics and ranking schemes, with no centralised body to standardise them. What makes this worse is that ESG in itself is quite poorly defined. Though it was originally meant to cover all three factors — Environmental, Social, and Governance — in roughly equal proportions, nowadays most of the time people just attribute it to the “Environmental” component. The definition is also not helped by the fact that each attribute is extremely broad: below is just a sample list of factors taken from Investopedia.

Environmental

• Carbon footprint
• Energy efficiency
• Renewable energy usage
• Water usage
• Pollution
• Waste management
• Biodiversity impact

Social

• Labour practices
• Pro-diversity efforts
• Human rights
• Community relations
• Health and safety

Governance

• Board diversity and structure
• Executive compensation
• Shareholder rights
• Business ethics
• Risk management
• Supply chain management

Now consider all those metrics (without even considering how such qualitative factors can be quantitatively measured), being assigned various weightages (which differ between ratings providers), and all being summed up to give a single numerical value. All that nuance, all that complexity, all reduced to a single figure (which isn’t standardised either: some ratings agencies use 0–100 scales, while others use a letter grade scoring system).

Now imagine yourself as an investor, considering various ESG ratings from different ratings providers, all with varying ratings methodologies, metrics, and weightages for those metrics. And keep in mind that the methodologies are often extremely complex, and while information might be present on it online, rarely do ratings providers disclose the full list of exact metrics and weightages of their ESG calculations. All this makes it virtually impossible to create a comprehensive, standardised, ranking for firms.

And this is reflected in ratings providers’ wildly inconsistent metrics. For example, Vale S.A., a mining company, received an ESG rating of 91 (Excellent) from Refinitiv, but a B (Laggard) from MSCI. Similarly, Meta Platforms received an ESG rating of 67 (Good) from Refinitiv, but a CCC (the worst tier of Laggard) from MSCI. These aren’t isolated examples either. One study found that correlations between ESG ratings range from 0.38 to 0.71. This is compared to the 0.99 correlation figure for credit ratings cited in the same study.

With such inconsistent ratings between providers, discerning what truly aligns with ESG remains a difficult task for inventors.

Moreover, practically all the ESG metrics used today reflect current/historical figures. Given that the entire point of ESG is forward-looking (either by improving long-term business performance / improving ESG standards in the future), ESG’s reliance on current/historical metrics is flawed.

But what’s the alternative? Technically, forward-looking estimates could be used as metrics. But that’s not a good idea either, given the proven unreliability of analyst’s forecasts: studies have found that the average accuracy for 12–18 months price targets is 30%.

In aggregate, the current metric-based ESG framework is extremely flawed, with vague, inconsistent, and backward-looking metrics that are often boiled down to a single number that tells investors next to nothing. In order to make ESG analysis more relevant and helpful, the investing world must decrease the emphasis of such metrics and increase the emphasis on the specific qualitative factors that will have significance to each individual company.

Moreover, ESG funds have a patchy track record of success, in both financial and non-financial terms.

Let’s start with financial terms. A paper published in the Journal of Finance analysed the performances of 20,000 mutual funds with a total of over $8 trillion in assets under management. It found that funds with high sustainable ratings attracted $24 billion in net inflows, while those with low sustainable ratings suffered net outflows of $12 billion. However, the researchers did “not find evidence that high-sustainability funds outperform low-sustainability funds”.

Moreover, ESG funds have been found to have poor ESG performance too. In one paper by researchers from LSE and Columbia University, researchers found that ESG funds hold portfolio companies with: A) worse track records for compliance with labour and environmental laws, B) higher carbon emissions per unit of revenue, and C) little subsequent improvement in compliance with labour and environmental laws. In fact, the researchers found that the only significant factors where portfolio firms beat non-portfolio firms was higher average ESG scores and a higher likelihood to provide voluntary ESG-related disclosures.

Still, ESG has been proven to effect some changes in the real world. For example, activist investor Engine No. 1 led an activist campaign against ExxonMobil in December 2020. With only 0.02% of Exxon’s shares, Engine №1 courted the three passive investing titans — Blackrock, Vanguard, and State Street, who held about 20% of Exxon’s shares — to support its proposal. Eventually, Engine No. 1 succeeded in installing three directors on ExxonMobil’s board, and urging a shift towards renewable energy. As a result, ExxonMobil pledged substantial clean energy investments and set ambitious emission reduction targets.

And so far, the initiatives have been rewarding to investors: ExxonMobil’s stock is up 135% since Engine No. 1 launched its campaign.

However, it’s important to note that Engine No. 1’s campaign was less about environmental values, and more about shareholder return. Engine No. 1’s first letter to Exxon’s board cited factors such as low return on capital employed, highest debt, measly shareholder return, and poor capital allocation. Its main argument wasn’t that Exxonmobil’s fixation on fossil fuels was jeopardising the planet, but rather shareholder value and future dividends.

It’s no clear how willing — and able —ESG investors will be to compel companies to actively sacrifice shareholder returns for public benefit in the future (like diehard ESG proponents will advocate for). And until that day comes, investors shouldn’t recklessly chuck their money into ESG portfolios without knowing fully well what they’re getting into.