Sustainability, climate change, and social justice have been growing issues over the last several years. Consumers and investors have been shifting towards more socially responsible choices. It would be nice if our investments made the world a better place.
The obvious way to invest responsibly is to exclude companies that rank poorly on environmental, social, and governance (ESG) criteria and optionally shift those investment dollars to companies that exemplify the causes you care about. This is commonly referred to as ESG investing.
With assets surpassing $35 trillion in 2020, ESG is a big business, but is it good for your portfolio or for the earth?
In this USA Today op-ed, BlackRock’s former Chief Investment Officer for Sustainable Investing states:
Sadly, that's all it is, a hopeful idea. In truth, sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community.
ESG costs investors
You may think that investing in high-quality, sustainable firms should be good for your bottom line, but both investing theory and empirical evidence suggest otherwise. Here's why.
Investor tastes make ESG stocks expensive and dirty stocks cheap.
The paper Disagreement, Tastes, and Asset Prices proposes that, if enough people share the same taste, desirable stocks will be more expensive than undesirable stocks. Tastes could be any attribute that makes one group of stocks more popular than another. For example: disruptive technology vs. incumbent technology or sustainable companies vs. offensive companies.
Expensive stocks have lower expected returns.
Long-term expected returns are largely influenced by the price paid by investors, favoring cheap stocks over expensive ones. ESG stocks should have lower expected returns than their dirty counterparts because of taste-driven price differences.
In their study called The Contributions of Betas versus Characteristics to the ESG Premium, Ciciretti, Dalo, and Dam find that companies with higher ESG scores have lower expected returns to the tune of over 1.5% per year per standard deviation in ESG scores. Another study, A Sustainable Capital Asset Pricing Model (S-CAPM): Evidence from Environmental Integration and Sin Stock Exclusion, finds an average exclusion effect of 2.79%.
Berle, He, and Ødegaard found that the dirty companies excluded by Norway's ESG strategy had superior performance of about 5%. This story from 2017 estimates Norway's portfolio underperformed by 1.1% over 11 years.
While the theory of investing points to lower expected returns for green funds, reality can be very different in the short term. The 2021 study, Dynamic ESG Equilibrium, found that recent shifts in tastes for ESG investing caused a large gap between expected returns and realized returns in favor of ESG stocks.
Green companies might shield investors from climate risk. That reduces expected returns and is a bet against the climate.
In Sustainable Investing in Equilibrium, Pastor, Stambaugh, and Taylor discuss the theory that green companies may shield investors from certain types of climate-related risk. When researchers say "climate risk," they're referring to financial impacts on your portfolio if the climate were to take a sudden, unexpected turn for the worse.
Ironically, ESG investors are betting against the climate because green firms could prosper in the face of sudden climate shocks. That's what it means to reduce "climate risk."
Green companies may be better at mitigating climate risk because a sudden shock to the climate can:
Induce governments to impose stricter limits on polluters
Increase sales of green products and services
Further affect investor tastes in favor of ESG
Reducing risk often comes at the cost of reducing expected returns. In a previous blog post, we wrote that investors get paid to take on financial risks. Investors should carefully assess what risks are appropriate to them because an attempt to eliminate all risk would make investment returns unnecessarily low.
ESG funds are less reliable and charge higher fees.
Having fewer positions in a portfolio increases day-to-day risk and dispersion of outcomes, making it harder to plan for future needs. The more opinionated an ESG portfolio is, the fewer the positions and the the less reliable it becomes.
The demand for ESG also drives up the fees that investors pay to fund managers. SPDR S&P SmallCap 600 ESG ETF and iShares ESG Aware MSCI USA ETF charge 0.15% and 0.12% respectively. That's 4x to 5x more expensive than 0.03% for the Vanguard Total Stock Market ETF. Funds that provide more specialized ESG exposure will charge even more.
ESG funds might not reflect your values
The lower expected returns and reliability of outcomes of ESG investing could be ok if your portfolio actually reflects your values. Investing theory predicts that the high prices of ESG stocks should help the world by encouraging green firms to do more projects. On the flip side, the low prices of dirty stocks would encourage dirty firms to partake in fewer projects--albeit only the most efficient and profitable projects.
Research from Columbia University and London School of Economics shows that companies in ESG funds had worse outcomes than non-ESG firms. The ESG firms, on average, had significantly more labor and environmental violations, paid more in fines for those violations, and produced more carbon emissions in total and per unit of revenue. They found that ESG scores, used to determine which firms ESG funds pick, are correlated with the quantity of voluntary ESG disclosures from a firm, not with the firm's ESG performance. Moreover, they show how firms in ESG funds tend to be better at governance rather than environmental or social issues.
Looking inside ESG funds is important to understand whether it reflects your values. Would you be surprised to learn that one of the top ESG funds, iShares ESG Aware MSCI USA ETF, includes exposure to fossil fuels through Chevron, Exxon, and others? Or that SPDR S&P SmallCap 600 ESG ETF holds CoreCivic and GEO Group, companies that own private prisons?
In Aggregate Confusion: The Divergence of ESG Ratings, Berg, Kölbel, and Rigobon find significant disagreement among ESG ratings. (Correlation is only 0.54.) ESG ratings diverge primarily due to disagreement in how to measure ESG--including the underlying data--and second by disagreement in the definition of ESG.
The researchers also found evidence of the halo effect, a common human bias, among ESG ratings. Their data shows that when a ratings agency would give a company a high score for one criteria, that the same agency would score the company highly in several other criteria.
Dodging social responsibility
This scathing article by The Intercept points out that strong financial incentives created by ESG and inconsistencies in ratings methodology could make it easy for companies to manipulate their ratings through superficial improvements. We've seen that firms more easily improve their governance scores over their environmental or social scores. They can also raise their overall ESG scores through voluntary disclosure of carbon emissions, even if those emissions are high.
A potentially more concerning method of ESG ratings engineering is to spin-off or sell assets, which drag ESG scores down, to 3rd parties, such as private equity, who have little accountability and no regard for ESG ratings.
Finally, ESG investing itself moves dirty companies from the portfolios of people who are concerned about social responsibility into the portfolios of investors whose motivation might be more about making money than improving society.
Is there a better way?
Could we invest with purpose and resolve the problems of lower portfolio performance and subjective ESG ratings at the same time? Instead of incentivizing firms to greenwash their marketing narratives, can we hold them accountable for their actions? We believe we can. It's called Impact Investing, and that's the topic of a future post.
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