Is 'ESG' Investing Just Another Politically Correct Term For Seeking Funds?

Environmental Social and Governance (ESG) investing has emerged as a major investing theme all over the world in recent years.

The value of global assets invested in ESG hit the $40 trillion mark in 2020. ESG funds claim to invest in companies that follow environmental, social and governance standards.

The argument provided is that being “responsible and good” can help companies increase their value. ESG investing allows investors to exclusively invest in companies that are not harming the environment, local communities, employees and other stakeholders, while simultaneously generating superior returns.

In a nutshell, ESG promises the ideal of compassionate capitalism while generating high returns — which almost sounds too good to be true.

Does ESG increase Business Value?

Let’s analyse the first claim — that following high environmental, social, and governance standards can allow companies to increase their value at a higher pace than companies that do not follow these standards.

The claim might not be completely false — some companies which have a higher ESG score do raise capital at a lower rate. Research has so far proved to be inconclusive for a generic conclusion.

Some companies might even be gaming the system to appear more ESG compliant. For instance, according to investor Chamath Palihapitiya, some companies might be using ESG as a marketing gimmick to raise funds at a lower cost.

Further, Tariq Fancy, the former chief investment officer for sustainable investing at BlackRock, put forward the opinion that the corporation’s main focus is on creating wealth for shareholders and that it will only pursue ESG compliance if it is good for shareholders.

Most company managements are focused on furthering their own careers and agendas, and antagonising shareholders is probably not the best thing to do.

Fund managers who run sustainable funds face the same challenges. If the funds do not create value, the assets under management will fall, resulting in lower fees.

Therefore, to depend on a fund manager to invest responsibly while simultaneously generating returns might not achieve either.

If a former proponent of sustainable investing is sceptical about the claim of ESG increasing a company’s value, it does call into question the merits of the arguments.

Subjective Evaluations

Another problem is the subjective nature of evaluating ESG scores. Several firms have begun offering ESG scores for companies. These firms use subjective criteria to evaluate companies on various measures and attribute an ESG score.

There is no truly objective way to measure the “goodness” of a company. The weightage given to various factors is subjective. Companies might also tweak operations and reporting, solely to fit in with the ESG criteria.

For instance, Amazon brings buyers and sellers together and sells millions of goods each day.

It brings happiness, convenience and absolute ease to the life of most customers and sellers alike. It is a great business from an investor’s point of view, with network effects, scalable tech platforms and multiple product offerings.

It has already been a great wealth creator with good cash flows and a negative working capital cycle.

Amazon’s one-day shipping product, Prime, has received flak for polluting the environment much more than regular shipping.

Its warehouses, trucks, last-mile delivery vehicles, aeroplanes and data centres generate large amounts of carbon dioxide.

Further, it has been criticised for low pay, labour law violations, unsafe work centres, and layoffs, among other issues.

Putting a score on each factor objectively is certainly not possible.

An Excuse to Charge Higher Fees

Investment companies are always on the lookout to create new products to entice investors and charge higher fees. In the current socio-political climate, where the Left’s narrative dominates the mainstream discourse, the grandiose ideas of socially-responsible and environmentally-conscious corporations have been used to promote ESG products.

In recent years, the words like inclusive, sustainable, and diverse, among others, have only been used by businesses to maintain their “woke” image and attract more customers. Sustainable investing funds seem to be cut from the same cloth.

These funds serve as an excuse for fund managers to extract higher fees from investors. Several Indian ESG funds are a miniature version of the index with investments in mainstream large-cap companies, and yet they charge almost five times the fees of an index fund.

Their investments also include vehicle manufacturers, cement companies and other old-economy companies.

ESG investing’s ability to generate superior returns over the long term remains to be seen. Higher returns are generated when an investor’s assessment of a situation differs from the market’s assessment.

It is unlikely that an ESG score, which is publicly available data, can confer an investing edge to investors. While some ESG funds have outperformed the indices during the pandemic, it is quite possibly due to their heavy exposure to technology stocks and exclusion of the energy sector.

In the past, some studies have indicated that ESG investing has underperformed the index. While debates about investor returns continue, the trend continues generating handsome management fees for fund managers.