This is why critique of ESG investing does not wash
Assuming that social good and financial interests will only converge in the future is wrong
Over the past few years environmental, social and governance (ESG) investing has grown exponentially. The worldwide value of ESG-driven assets has almost doubled over four years, and more than tripled over eight years to hit $40.5-trillion in 2020.
Driving that growth has been the belief among investors that ESG investments provide a win-win scenario, in which they can help save the planet while netting positive returns. To a large extent that has held true. It was found in a 2020 study that 60% of sustainable funds outperformed the market over 10 years.
Some nevertheless believe the win-win scenario offered by ESG is a fallacy. The Financial Times’s US editor, Robert Armstrong, argues that “win-win arguments promoting both bigger profits and better social returns are illogical”. Just how valid is this counterargument? And should it affect the decision-making of anyone wanting to take an ESG-led approach to investing?
According to Armstrong, the illogic of the win-win argument can be explained by it resting on the following fallacies:
- The time horizon over which individual investors operate doesn’t match that at which social good and financial interests must converge. Nor, he argues, is this convergence within the scope of any corporation’s planning horizon.
- A “wicked or ‘anti-ESG’ portfolio perfectly well might offer the best available return”. Even as ESG portfolios become more de rigueur, Armstrong suggests, an “anti-ESG” portfolio might provide better value because the assets in it can be bought cheaper.
The problem with the logic behind the first fallacy is that it assumes the point at which social good and financial interests must converge is in the future. But it’s not. Despite considerable reductions in local and international travel due to Covid-19, 2020 was still the hottest year in history. It was found in a 2020 report by Greenpeace Southeast Asia and the Centre for Research on Energy & Clean Air that globally, air pollution has a $2.9-trillion economic cost, equating to 3.3% of the world’s GDP. How much more money should be left on the table before social good and financial interests converge?
The trouble with the second argument is that it ignores the societal pressure and consumer shifts that could force companies that are “anti-ESG” to change their policies, or even pressure them out of existence. Certain “anti-ESG” companies could thrive and outperform in this scenario, but as a whole the risk could warrant the discount.
None of that is to say every ESG-focused company is guaranteed to succeed. Even with all the right policies in place, a company can still make products that don’t resonate with changing consumer wants and needs. It is therefore imperative that investors choose funds with experience and a strong record regarding backing fundamentally strong ESG companies. They should also steer clear of relying completely on ESG funds that invest in listed companies.
Private equity funds are, for example, often capable of identifying companies that have a potentially strong proposition and are more focused on taking a hands-on approach to their success. Without the vagaries of the stock market to deal with, they can take a long-term approach that benefits the companies in the portfolio and investors.
The growth of ESG over the past few years is therefore not a sign of misguided investors taken in by a fallacy. Nor is it, as some have suggested, the early signs of a bubble. The most investor-friendly companies will be the ones that lead the way regarding ESG.
That’s not because they’re simply giving the investors what they want. It’s because, fundamentally, ESG principles are what makes a good company. By serving the environment, looking after the social good and exercising good governance, they’re setting themselves up for long-term success (as long as they’re also producing products consumers genuinely want).
Sceptics who think the ESG win-win scenario is a fallacy would do well to remember that.
• Mabuto is partner at Spear Capital.
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