Is ESG investing a placebo?

If you are interested in 'socially conscious' investing and haven't heard of Tariq Fancy, that changes now. Mr Fancy, a Canadian social entrepreneur was, for 21 months, the Chief Investment Officer of sustainable investing at BlackRock.

Founded and helmed by Larry Fink, BlackRock is the world's largest asset manager, with over $9 trillion of assets under management. That makes for a significant clout in the boardrooms of large companies around the world. So, when Mr Fink's letter to CEOs in 2017-18 spoke about a "sense of purpose," and was followed up a year later with "a company's ability to manage environmental, social, and governance matters demonstrates the leadership and good governance that is so essential to sustainable growth, which is why we are increasingly integrating these issues into our investment process," the Davos crowd sat up and took notice.

In January 2018, Tariq Fancy joined BlackRock with a mandate to help integrate ESG (environmental, social and governance) factors into the investing process for all of BlackRocks' funds, including managing those that were raised under the ESG umbrella. He quit in September 2019. Earlier, in 2021, he wrote a set of columns in three parts which can be accessed at https://bit.ly/3huYJzJ, where he states in the preamble that the essay "shares how my thinking evolved from evangelizing "sustainable investing" for the world's largest investment firm to decrying it as a dangerous placebo that harms the public interest". What caused this change of heart and is the accusation justifiable?

Does ESG investment increase returns?
A key pitch for marketing ESG funds is the claim that investing in these businesses generates better risk-adjusted returns, since ESG-compliant companies offer lower risks in the future. Tariq makes the point that this is not factually provable. Investment managers, he suggests, are like professional basketball players, whose incentives are based on points on the board, i.e., returns generated. If higher returns were indeed generated by investing in ESG-compliant companies, these managers would, without any need to be persuaded, have invested in these stocks. If at all there are better returns, these are not happening in the time frame that is material to the clients of these investment managers, forcing the need for a marketing spin. This is indeed a hard argument to refute.

The effectiveness of ESG-compliant funds
A key argument forwarded in favour of ESG funds is that these make the cost of equity higher for businesses that are low on the ESG score. Low stock prices lower the ability to raise funds on the 'cheap', raising the barrier for such businesses to expand. Fancy's counter argument here is this doesn't help enough.

Arguing that for every secondary-market sale, there is a buyer, he suggests that lower stock prices in the secondary market do not stop bad business. While venture funds focused on providing capital to companies that develop products and technologies to reduce carbon emission, for example, do provide environmental benefits, secondary-market funds that sell stocks of fossil-fuel companies do not really lower the pollution generated. They just provide an opportunity to purchase shares at a depressed price for those whom they sell to. Importantly, for such venture funds to make a dent in climate change, the quantum needs to be many multiples of what it currently is.

ESG is an ineffective measure
Though Tariq does not raise this issue, ESG as a measure is flawed in design.

ESG metrics that are tracked by MSCI and various other companies are derived out of a weighted average of marks assigned for each - environmental, social and governance factors. It is entirely possible that a poor rating in carbon production is offset by a great rating on governance. Importantly, some rating companies use relative ranking for companies operating in the same industry. A cement company producing a lot of CO₂ can be rated high on the ESG scale if it is better than its peers.

Climate change has to be perhaps the most important and long-ranging effect that socially conscious investors need to worry about. While it is possible to reduce waste and improve recycling at a local level, climate change requires concerted global action. To conflate metrics combining parameters that are orthogonal dilutes the impact that such investing could potentially produce.

ESG as a placebo
Climate change needs immediate and concerted action. Historically, resource-pricing has not factored in a long-range impact to the environment, making climate change a good example of market failure. To assume that markets will help correct this failure is like doing the same thing while expecting a different outcome. Only direct action from governments in the form of taxes for polluters and incentives for non-polluting alternatives can create the framework where climate change can be addressed.

Fancy's point is that getting investors to put money into ESG funds doesn't actually stop the production of CO₂, for example. At best, it serves as salve to the conscience of investors who think that they have done their bit to help the environment. Cynically, fund houses that sell such products know that they are neither able to positively affect the environment nor better investor returns. They simply use this as an opportunity to sell more expensive funds to investors.

In all this, the pressure on governments to take direct action in the form of raising taxes reduces, benefitting polluters who can claim to have become 'carbon neutral' by setting off their current and continuing pollution with some hypothetical 'savings' from future projects, which would potentially have increased CO₂ production if not for these investments. And without this direct action, attempting to roll-back on climate change or even stop at the current levels will likely remain an unattainable goal.

Not everyone will agree with all of what Fancy writes but we shouldn't lose sight of the fact that climate change is happening and the more we delay direct action, the less likelihood that we will stop its ill effects. Waiting for financial markets to find a solution may not be in the best interests of mankind.