What/How Series (2b of 6): How do we move beyond ESG (Environmental, Social and Governance) Investing?
“I “attended” the Citi 2020 Investment Management Industry Evolution Conference today. The floor fan gently stirring the humid drafts around my legs and hearing the complacent snores of my aged dog, reminded me how I didn’t miss the travel and challenge of pre-COVID and how much I liked the efficiencies of working from home. As the financial experts shared their insights and expert views of the capital markets across Zoom – I exclaimed my frustration. Nola, our geriatric Newfoundland dog didn’t stir a muscle in response to my outbursts!”
Four weeks ago, a man was killed violently and slowly by a peace officer – tearing another rent in the fabric of American society. During the last weeks many of us have questioned how we are going to meet three enormous challenges: a global climate crisis, a pandemic that won’t “just go away” and a 400 year old crime of structural racism in the United States that is reflected in the social inequities we confront today. The Citi conference, representing some of the smartest people in the global investment industry offered some perspectives that warrant our attention. These comments build on the frame of our June 1st critique of ESG investing – let’s dig a little deeper into ESG today.
One of the conference’s big “ahas!” was the power of ESG investment themes pre-COVID and during-COVID – in particular the current uplift in “S” with a focus on employees and people generally. The global focus on “S” (social) follows the US/Asian market focus on “G” (governance) and the European’s obsession with “E” (environment.) With the world’s attention on all three: Environment, Social and Governance – does anyone think that “all will be well?” Experts observed that ESG funds had performed well, relative to non-ESG funds, in the first quarter market correction. The rhetoric, the conviction of the speakers reminded of the London subway mantra: “see it, say it, sorted”.
Nothing could be further from the truth. Market participants continue to hold to the 50-year old paradigm that has informed investment behaviors and attitudes. ESG has done nothing to change that logic. Modern portfolio theory (MPT) and the Capital Asset Pricing Model (CAPM) that held primacy when I was studying for the CFA charter thirty years ago still dominate the investment management industry. The 20% COVID-19 market correction in the first quarter of 2020 followed the Great Recession market correction between October 2007 and March 2009 – when the S&P500 lost 50% of its value. There were some parallels between these two “corrections”: namely, there was nowhere to hide. Correlations between sectors, asset classes all moved to one – the only safe haven was cash. How many times do we have to experience a market correction with no safe haven to realize that we might need to revisit our investment theory?
If market participants are singularly focused on maximizing their risk adjusted financial returns, how has, or will, ESG investing save the people and the planet? How will “doing less harm” restore the climate, regenerate the ecology and repair the social fabric – let alone protect your wealth in the next correction?
Jay Clayton (head of the Securities and Exchange Commission) was quoted recently in the Financial Times: SEC Chief Warns of Risks Tied to ESG Ratings
Mr. Clayton stated in the article: “I have not seen circumstances where combining an analysis of E, S and G together, across a broad range of companies, for example with a ‘rating’ or ‘score’, particularly a single rating or score, would facilitate meaningful investment analysis that was not significantly over-inclusive and imprecise,”
A few days later the Financial Times ran another ESG themed article detailing the success of ESG funds through the first quarter market volatility – where ESG funds generated marginally better returns than the broad market - ESG Passes the COVID Test. The article quoted Larry Fink, the head of BlackRock, Inc. from his annual letter extolling the benefits of ESG investments:
Mr. Fink quoted in the article: “…conviction is that sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors…”
The planet and society are in deep crisis. ESG investing is very popular and getting a lot of attention. At TILT, we think that both Mr. Clayton and Mr. Fink are correct. The practice of creating an ESG score in the current investment paradigm supports a very imprecise way to manage money. ESG factors may well mitigate overall portfolio risk, and they will NOT regenerate the social and environmental deficits that are threatening our existence.
ESG scores are predicated on narrow inputs within an enterprise’s operations, the raw data behind the scores is obscured by high levels of subjective opinion and analysis. Wall Street firms and the intermediaries that provide ESG scores all work to discern “better” ratings to enable investment managers to deliver the “best” risk adjusted financial returns. Are asset owners capable of defining and measuring their own non-financial goals, or do they need experts who work at ESG rating firms to define their purpose for them? Do asset owners care about an enterprise’s inputs (e.g., the way employees are treated) or are they interested in outputs - how an enterprise’s products and services impact people’s lives? Or both?
How does a company that produces, sells and profits from products that create egregious health outcomes amongst consumers, that treats its employees well and that has an “A” rating from the Climate Disclosure Project earn a strong ESG rating? Perhaps it’s because the ratings are based on inputs not outputs. Perhaps it’s because asset owners only care about investment profit and “E.” Mr. Clayton is correct, the various ESG scores tell a very incomplete and inchoate story about a company – especially if you are buying the shares to regenerate the social and environmental capitals that are in deficit.
While the data supports Mr. Fink’s argument that ESG investing reduces risk – investors need to think about more than risk mitigation. If you are someone who seeks to regenerate the various non-financial capitals that have been depleted – you are someone who wants to go beyond ESG investing, and we’d like to know what you’re thinking about!
“I like the people who worked to produce the Citi conference today. I think that they care about the health and wellbeing of people and planet. I also think that their thinking is “stuck” in a fifty-year-old paradigm that has outlived its usefulness. COVID and peace officers murdering Black people in the US has exposed the work that we all need to do, and ESG investing is not going to accomplish that work.”