Unpacking the Paradox of ESG Investing

Published: 2023-09-22 00:00:00

Arbitrage Blog Image

Environmental, Social, and Governance investing, often abbreviated as ESG, was first introduced in a 2004 report commissioned by the UN. Since its inception, ESG investing has become both a trending and controversial element of the financial world. Despite the debates surrounding it, ESG investing originates from a vital and well-intentioned place in today's era. Under the ESG framework, companies are assessed using three main criteria:

Environmental - This examines a company's emission contributions that might affect climate change or its efforts in combating it.

Social - This pertains to how businesses interact with their employees and customers.

Governance - This delves into the company's leadership approach and its value to shareholders.

These considerations seem sound, but what are the actual implications of this investment approach?

For starters, companies might divert from their core mission of delivering excellent products to optimize their ESG appeal instead. Take Exxon Mobil for instance. They rank among the largest oil producers in the United States and score high as an ESG investment. Exxon Mobil shifted its focus away from oil production because of the adverse impact on its ESG rating. However, this has caused oil prices to soar, prompting the U.S. Government to access its strategic oil reserves. Ironically, while Exxon Mobil can boost its ESG ratings by outperforming competitors in ESG metrics, its overall carbon footprint might argue against its high ranking.

Another challenge with ESG investing is its subjective nature. Unlike value investing, which involves analyzing stocks for undervalued companies via financial statements, ESG scores are based on varying fund criteria and differing interpretations. This has sometimes resulted in unexpected rankings, like Tesla's exclusion from some ESG funds while Exxon Mobil remains in the top tier. This discrepancy prompted Elon Musk, Tesla's CEO, to label ESG as a "scam." ESG has become so political that Larry Fink, Founder & CEO of BlackRock, the largest money management firm in the world, has decided to stop using the word. Fink was quoted as saying, "I don't use the word ESG anymore, because it's been entirely weaponized... by the far left and weaponized by the far right," This is in his best interest as ESG management fees are 3x-4x higher than similar non-ESG investment vehicles.

Moreover, the efficacy of ESG in affecting genuine corporate change and delivering shareholder value remains debatable. Despite ESG funds managing an impressive $2.7 trillion by the end of 2021, studies by Columbia University and the London School of Economics found that companies in ESG portfolios often underperformed in compliance with labor and environmental regulations. Additionally, these entities yielded lower financial returns and posed higher investment risks.

In sum, the tangible achievements of ESG investing are primarily twofold: enhancing the profit margins of fund managers and initiating dialogue on ESG-centric investing. The former might be viewed cynically, while the latter is undeniably crucial. Moving forward, the focus should be on genuinely transformative companies. Maybe Tesla will get us fully electrified? Mayne Nvidia powers a company that discovers an effective means to conduct carbon sequestration? The journey ahead is uncertain, but prioritizing genuine ESG-driven companies is paramount.

This is not investment advice. Study: https://hbr.org/2022/03/an-inconvenient-truth-about-esg-investing

Like this article? Share it with a friend!