INVESTING
ESG Investing Might Not Accomplish What You Think
Even though it means well.
The gist of environmental, social, and (corporate) governance—ESG for short—is to concentrate capital among firms that do good, or at least do a lot less bad.
You may not be surprised to hear that ESG funds have seen unprecedented inflows this year. Whether we’re collectively dismayed at the state of the world, or we’ve just grown contemplative during our excess time at home, the trend is clear.
What’s less clear is what this accomplishes. Not in terms of investment returns—that’s a piece of cake to analyze—but in terms of net societal good that wouldn’t have happened otherwise.
I’m going to argue that we can’t expect much…at least not compared to the impact of living the ideals we want our investments to support.
That’s not because ESG is a bad idea, but because it entails ambiguous criteria, far-reaching but unexamined trade-offs, and even perverse incentives that may not lead where we’d hope.
I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.
ESG criteria are surprisingly subjective
Picture a hypothetical firm whose operations consist solely of emitting carcinogenic smoke and publicly humiliating junior employees—all paid for by foreign dictators and warlords—and cooking its books to convince investors it’s an actual business.
We can agree they belong on the ESG naughty list.
But short of this caricature of a big, evil corporation…it’s not as clear as you might think (or as ESG fund managers would like you to think).
What if they’re responsible for for vast environmental degradation, and they enable others to cause orders of magnitude more…but they provide many communities’ sole source of affordable, dependable energy?
Perhaps that justification is a stretch. So be it. But let’s continue down that line of thought.
What if they develop life-saving and life-enhancing drugs…but have taken liberties with safety information?
What if they’re a vocally, visibly, proactively inclusive firm…but seem to treat labor laws as out-of-sight, out-of-mind?
What if they invent physical and digital infrastructure that will create novel, even epochal opportunities for the betterment of humanity…but aren’t keen on rightful compensation?
Or—back to hypotheticals—what if their business consists solely of good deeds and warm fuzzies from top to bottom, but outside the office, every single manager is a vicious sociopath who funnels earnings into loathsome causes?
How in the world do we draw the line?
In other words, it’s not that simple. The good and the bad are inextricably linked, and even dependent upon each other.
Tinkering with parts of a complex system has unexpected results, often good and bad at once.
Even if ESG criteria are well-intended, they cannot reflect enough real-world complexities to provide a framework that’s useful beyond the obvious.
But what if they were objective and universally agreed-upon? What if every conscientious investor concurred on which firms belong in an ESG portfolio?
Unfortunately, it would probably be self-defeating. Here’s why.
Incentives undermine goals
Some people just wanna make a buck. Where does it come from? Irrelevant.
That’s an unfortunate but intractable human characteristic, with an all-important implication.
If there’s consensus that a certain firm isn’t ESG-friendly, and capital allocation follows that consensus, then the “dirty” firm would have a much higher cost of capital.
“That’s right! Hit ’em in the checkbook!”
Not so fast. Remember how some investors just aren’t concerned about ESG?
Well, that’s why the rising cost of capital will eventually create…wait for it…higher returns for their investors.
(Not to mention how the influx of capital may eventually lower returns for ESG-consensus firms.)
So, to the extent that ESG investors seek to make dirty businesses cost-prohibitive, it’s probably a self-defeating goal.
A note on greenwashing
If—and that’s a big if—ESG consensus raised the cost of capital so dramatically that a firm can’t operate, it would also create a powerful greenwashing incentive.
Not greenwashing in the sense of feel-good PR, or even social-media astroturfing, but at a more insidious, almost systemic, level.
In other words, there’d be an incredible incentive to hide the “dirty” part of the business.
- Shove it down the memory hole. (“Oh, that was ages ago! Let’s talk about the future!”)
- Spin it off to clean up the parent firm’s image. (“Oh no, you’ve got the wrong company. It’s those guys over there!”)
- Move the polluter or labor-exploiter to places that can’t or won’t interfere. (“We defer to our esteemed foreign partners on all compliance matters in their jurisdiction.”)
- Shift the filth so far up the supply chain that consumers can’t easily know, or at least won’t bother to check. (“Don’t worry, they don’t even know where the parts come from.”)
If a firm has gotten this far through dubious or destructive actions, something tells me it can also find a way to conceal them.
There’s an alternative. But it’s you.
We cannot simultaneously give money to firms while absolving ourselves of their wrongdoing.
I’ll be the first to acknowledge my moral qualms about certain long-term holdings in my own portfolio. As both disclosure and confession, I’m long BP as of publication.
And that’s h̶y̶p̶o̶c̶r̶i̶t̶i̶c̶a̶l a tension I need to resolve.
But buying an ESG fund or going down someone else’s list of “good” companies won’t do the trick.
In the (quite debatably) ideal scenario, where ESG investing is clear-cut and actually drives bad companies out of the market, it’s still on me to be the change I wish to see.
True, it can’t hurt to put our money into better firms rather than worse ones. Subjective and perhaps ineffectual, but well-intended.
Investing in clean energy is nice. So is riding my bike. Investing in non-GMO food producers is nice. So is eating less. Investing in companies that donate generously is nice. So is giving my time to someone in need.
Of course these aren’t mutually exclusive.
It’s just that markets as we know them abstract away human beings into economic units. Markets as we know them require a degree of destruction to create. Markets as we know them feed as much on envy as on innovation.
Markets as we know them are our collective tendencies writ large.
Good and bad alike, commingled, obscured behind layers of conflicting incentives and information.
They can’t fix our tendencies since they’re the aggregation of our tendencies.
To be clear, I’m not saying ESG investment is bad generally or individually. Just that it probably achieves less than we hope.
Conversely, our deeds may do even more than we hope, both in immediate and visible good as well as nudging others’ preference in the right direction.
While we can quibble about priorities, ESG does mean well on the whole. And it reminds us to consider the far-reaching consequences of our investment decisions, undoubtedly a good thing.
But that line of thought can only take us so far. It leads into complexities too great, too rooted in our troublesome nature, to resolve with screening criteria and an ETF.
That pill, no matter how ethically sourced, might be a hard one to swallow.
