Why the sustainable investing craze is flawed

ESG funds, as they are known, promise to invest in companies with better environmental, social and governance characteristics, to save the planet, to improve the conditions of workers or, in the case of the US Vegan Climate ETF, To prevent the animals from being eaten.

Money has poured into ESG funds as noisy lobby groups push pension funds, university endowments and some central banks to move their investments. The UN-backed Principles for Responsible Investment say that the signatories have $121 trillion in assets under management; Even assuming a lot of double-counting, that’s most of the world’s managed money.

Over the next few weeks, Streetwise will detect an explosion of ESG investments and I think it’s mostly a waste of time – but not completely. Understanding the inevitable trade-offs, I’ll also offer some solutions and discuss how to use your money.

ESG supporters can point to what looks like successes: their pressure has encouraged many companies to sell dirty power plants, mines and, in the case of Anglo-Australian miner BHP, its oil business. It has also forced a board change at Exxon Mobil.

Sadly, selling assets or shares does nothing to save the planet just because someone else bought them. As much as oil and coal are dug and burned under separate ownership as before. And there are so many people buying assets, because never before in history has there been so much private capital operating without the public reporting requirements brought on by the stock markets.

Rich people who want to make the world green can buy and close dirty businesses even when they are profitable. However, so far this has not happened in any significant way. Wall Street fund managers’ pitch is just the opposite – that green investors can change the world and make more money, not less.

“a lot [clients] “Only get excited when they’re comfortable they’re not sacrificing returns,” says Valentijn van Nieuwenhuizen, chief investment officer at NN IP, the fund manager being bought by Goldman Sachs.

If fossil fuels are being released into the ground instead of being extracted and sold, then someone has to suffer somewhere. ESG investors expect the loss to be passed on to others. The problem is that the less eco-minded investors who buy those stocks, oil wells or power plants aren’t going to own them until they stop being profitable.

It makes sense for an investor or company to sell fossil fuels quickly if they think a retreat from coal and oil is inevitable—indeed, it was the pitch of the activist who took on Exxon—but it Investing is only according to a political prediction, not a way to fight climate change.

Some of the biggest sources of fossil fuels are immune to shareholder pressure anyway. Most of the world’s oil is pumped by government-controlled companies led by Saudi Arabia and Russia. Exxon may be forced to change its approach, but the global supply of oil is still determined by OPEC, as President Biden demonstrated an appeal to the cartel to pump more to keep fuel prices down Is.

ESG supporters have three big arguments, which sound reasonable, but have major flaws.

First, if companies treat the environment, workers, suppliers and customers better, it will be better for the business. This can work where companies have missed something to boost profits, such as adding solar panels to a sunny roof or creating better employee retention programs. Early ESG workers plucked the low-hanging fruit here, but management has become painfully aware of changing customer and employee expectations, so the opportunity ahead is slim.

Adding costs to reduce a company’s carbon footprint or paying employees more should only help the stock price if it increases revenue or reduces other costs, such as greater loyalty from carbon-conscious consumers. create, reduce employee turnover or improve relations with regulators.

Otherwise profits can only be maintained by passing in higher prices through higher costs, and—unless the firm has monopoly power—eventually customers who don’t care will go elsewhere. The alternative is to reduce profits, but ESG investors are almost universally against it.

The second ESG point is that by abandoning the shares or bonds of the dirty companies, and embracing the clean companies, it will direct capital out of the bad things and toward the good ones. Ultimately, the bond market should be less attractive to expanding filthy companies than a lower stock price or higher borrowing cost, and vice versa for clean companies.

In practice, there has been a very weak link between the cost of capital and overall corporate investment for at least a few decades. Small changes in the cost of capital are less important than the risk and return estimates of a new project.

That doesn’t mean there’s no link. With extremely expensive stocks, Tesla has repeatedly taken advantage of its ability to issue new stock to invest in factories and research. Higher prices earlier this year for clean-energy stocks could encourage similar corporate investments. The flip side, of course, is that buying wildly more shares isn’t a good way to make money, as clean-energy stocks show losses of a third or more from this year’s peaks. A change in the cost of capital may just help save the planet, but once the short-term change in valuation is over, it will lead to poor performance.

A third claim by some ESG investors is that they are just trying to make money, and this includes companies that are taking invaluable risks to the environment, workers or customers. Since they call themselves “sustainable” or use “ESG integration,” funds that do so look like the rest of the ESG industry. The selection principles of the most popular ESG indexes, for example, from MSCI, involve identifying only those risks that are financially significant.

I would say, sure. If you think that the government is going to increase fuel tax, then do not buy the manufacturers of gas-gujjars. If you think that the government will impose further restrictions on coal plants, then coal production will be an even less attractive investment.

Equally, if you think customers will be willing to pay more for brands that cut their carbon use, then by all means bet on your shares. Just don’t fool yourself that you are making a huge difference in the world with your investment decisions. Red blooded capitalists chase these profits as much as any green investor. There is no need to persuade the capitalists to exercise discretion; They’ll do what you want if you make it profitable through customer demands or government intervention (or, if we’re lucky, new technology).

ESG investing works in a similar way. Shareholders can motivate companies to stop lobbying governments in favor of fossil fuels. Certainly it can help inspire customers and governments to do the things that will really make a difference.

My big concern about ESG investing is that it distracts everyone from the work that really needs to be done. Rather than trying in vain to direct the flow of money to the right causes, it is easier and more effective to tax or regulate the things we as a society believe are bad and subsidize those things. We give what we think is good. The wonder of capitalism is that money will flow by itself.