In recent years, sustainable investment funds, boasting a plethora of promises from higher returns to combatting climate change, have witnessed exponential growth. The allure of Environmental, Social, and Governance (ESG) funds has attracted investors worldwide, with investments on track to surpass a staggering £34 trillion by the end of 2022, nearly doubling the £18.4 trillion figure recorded in 2016.
However, amidst the rising popularity of sustainable investing, critics have emerged, challenging the efficacy of ESG funds. Tariq Fancy, the former BlackRock sustainable investing chief, went as far as labelling ESG a “dangerous placebo.” The Wall Street Journal, too, voiced skepticism through a week-long series titled “Why the Sustainable Investment Craze is Flawed.”
When faced with such polarizing views, it becomes difficult for first-time investors to discern the truth amidst the hyperbole. To get to the heart of the matter, we must carefully examine the evidence and the three primary objectives that investors aim to achieve with ESG funds.
Financial Returns
Undeniably, the first objective of investors is to seek financial gains. The argument is that investing in sustainable companies can lead to higher returns, while shunning unsustainable ones can reduce risk. For instance, industries like electric cars are seen as the future of transport, whereas divesting from fossil fuel companies can provide protection against carbon taxes.
Research does indicate that certain ESG dimensions can yield positive results. Studies have found that companies with high employee satisfaction, falling under the “social” dimension, have outperformed their peers by 2.3% to 3.8% annually over a 28-year period. Additionally, firms with superior governance and those linking CEO pay to performance have also shown higher returns.
Nonetheless, the financial case for sustainability is tainted by confirmation bias. People tend to grasp onto studies that support the notion that ethical companies perform better, even when the evidence may not be robust enough to establish a clear link.
The bottom line is that the financial benefits of sustainability depend on which ESG dimensions are considered. Assertions that “investing in ESG pays off” are akin to debating whether all foods are universally healthy or unhealthy – the impact varies based on the specific factors at play.
Impact on Company Behavior
The second objective is to assess how ESG funds influence company behavior. Divestment campaigns aim to dissuade shareholders from holding stocks of certain companies and discourage new investors from acquiring them. The argument is that divesting from, say, fossil fuel companies would deprive them of capital and curb their environmental impact.
However, divestment differs from customer boycotts, as selling shares requires someone else to buy them. Therefore, it may not necessarily starve a company of funds. Moreover, “brown” companies, such as fossil fuels and tobacco, often belong to declining industries with limited growth prospects and may not heavily rely on capital raising.
Evidence suggests that the cost of raising capital has little bearing on a company’s expansion. Instead, factors like stock prices can impact a company for various reasons unrelated to capital costs. Interestingly, research indicates that a strategy of tilting (leaning towards ESG-leading companies within a sector while not outright excluding the “brown” sector) might be more effective than complete exclusion.
Owning shares in companies associated with polluting industries may enable investors to hold them accountable and influence their sustainability efforts. Engine No. 1, a notable investment firm, famously secured the appointment of three climate-friendly directors to Exxon’s board by holding shares in the company.
Moral Obligations
The final motive behind sustainable investing is the moral responsibility to invest in companies that align with one’s values. For example, even if diverse firms do not necessarily perform better, some investors may still choose to invest in them as an expression of their principles.
However, identifying “moral” companies can be challenging, as critical dimensions of morality may not be readily observable. A company might superficially demonstrate diversity on its board but lack a truly inclusive culture.
In conclusion, the hype surrounding sustainable investing must be viewed through a nuanced lens. It offers potential for improved performance, but this depends on specific ESG dimensions. Impact on company behavior can be achieved through tilting and engagement rather than outright exclusion. Ultimately, ESG is neither a miraculous cure nor a financial scandal; rather, it exists within the realm of gray areas, lost amidst the search for definitive answers in a world that often appears black and white.
