Is it game over for ESG?
By Ian Nolan, founding partner of Circularity Capital
That would seem to be the allegation made by some commentators and politicians, notably in the USA. Indeed, some of the biggest names in asset management, including BlackRock, are facing legal challenges as to whether their espoused commitment to ESG principles is in breach of their fiduciary duties to maximize investment returns.
One common response to this challenge, albeit a somewhat defensive one, is to argue that applying an ESG screen to investment opportunities is just good risk management practice. Even the most focused and financial returns-driven investor doesn’t want to find themselves holding a stranded fossil fuel asset or one whose value is diminished by fines or reputational damage from environmental, human rights, or behavioral lapses.
However, even tested against this low bar, current ESG claims are open to very considerable challenge. Some of the most notable cases of corporate fraud and reckless bankruptcy seemed to have come (FTX recently, Lehman Brothers, and Enron previously) from companies that had carefully cultivated their top-tier ESG ratings. As a minimum, this shows that the current ESG system can certainly be gamed by cynical participants.
Further fuelling the fire, the various rating agencies, unlike credit rating agencies, give very different scores to the same company. Should Tesla’s ESG ranking really be (because of Musk’s foibles) lower than that of Exxon Mobil? Maybe that’s an easy one, but when looking at Tesla how should we think about the enormous benefit of having forced a whole industry onto an electrification path, against the environmental and labor standards issues of rare earth metal extraction in less developed countries?
There most obvious challenge to the current rating systems is that ‘ESG’ is a broad concept covering three very different topics, and that there is no conceivable ‘unit of account’ which would allow us to aggregate the scores in these very different categories.
In a world where everything has a monetary value, we can add two different categories together. An apple costs 25p and an orange 20p – the combination is worth 45p. But if we can’t ascribe a monetary value to the degree of compliance with Board composition rules then how can we aggregate a score on this metric with another non-monetary category such as equality of pay across genders? Scores are by necessity qualitative, and there is no single answer as to the relative weights which should be ascribed to them. In a world of non-monetary measures, we can’t say much more than that an apple and an orange together constitute two pieces of fruit.
More importantly still, whilst the ‘S’ and the ‘G’ categories do seem to be capable of being subject to some degree of their own (non-comparable) qualitative evaluation, the same could certainly not be said of the ‘E’ in ESG. The qualitative evaluation of ‘S’ and ‘G’ largely focuses on inputs, rather than outputs. That approach makes little sense in relation to understanding the environmental footprint of a business, where it is certainly output that we need to measure.
It is therefore easy to argue that a whole ESG edifice has been at best hugely oversold, or at worst built on the shakiest of foundations, testimony mainly to the asset management world’s short attention span and cynical opportunism. That would certainly seem to be the conclusion of Stuart Kirk, infamously ousted as Head of Responsible Investment at HSBC Asset Management (“The banking approach to next zero is just claptrap” FT November 11th, 2022.)
So where do we go from here? Notwithstanding its many flaws and its attraction as a target to anti-woke culture warriors, ESG isn’t going to go away. Indeed, the $1.2tn Norwegian sovereign wealth fund recently sent a warning shot to the world’s so-called ESG laggards (FT, January 19th, 2023).
We should, however, recognize that what we can get from a conventional ESG approach is much more limited than is claimed by many of its more cynical proponents. What’s more, if we want to think harder and differently about the challenge, maybe we should go back to the beginning and see if we can build back up from the first principles.
The foundational issue, surely, is whether the fiduciary duties of investment managers and company directors should extend beyond financial returns and give consideration to externalized costs or benefits. Milton Friedman is often quoted in this regard – “the one and only social responsibility of businesses is…to increase its profits.” Others reference Adam Smith and his concept of ‘the invisible hand’.
But how many of those advocates know that Adam Smith also wrote in their earlier work – “The Theory of Moral Sentiments”? Taken together, the two books offer an integration of economics and morals, developing a philosophy that would harness the force of self-love without being dominated by it. In more modern economic terms, the theoretical case for a laissez-faire, market solution derives from an economic model which assumes complete markets and doesn’t deal with the market failure of externalized costs. If polluting the atmosphere with CO2 is to private advantage, its profits privatized and its costs socialized, then of course we will have too much pollution.
It seems therefore to be entirely legitimate for businesses to tell the government that it needs to level the playing field, by taxing the externalities – a carbon tax. Government shouldn’t try to excuse itself from responsibility by blaming businesses for the problem and implying that better ESG behavior would be sufficient to solve it. No doubt – given the right incentives – the creative genius and naked self-interest of market participants could find the most cost-effective solutions to climate change. Certainly, the oddly-named Inflation Reduction Act in the USA seems likely to incentivize a major shift towards a more environmentally sustainable economy.
But business can do much better than being a passive bystander, awaiting the government to lead the way.
At Circularity Capital, we believe that the right place for businesses to start is by properly understanding their own environmental footprint and then focusing on those actions which reduce it whilst simultaneously increasing their financial profits.
Our experience has shown us that properly evaluating a company’s environmental footprint is a complex and painstaking exercise. It is often helpful to undertake a lifecycle cost analysis (LCA), but use of this tool requires numerous assumptions to be made. Objectivity and data gathering are necessary to ensure that the inputs to the model are justified.
The good news is that, once the exercise has been well done, you have a robust understanding and articulation of a company’s environmental footprint, which can be validated to prove its provenance.
We invest in companies whose environmental footprints are “better” than their competitors, who are often operating wasteful ‘take-make-dispose’ linear economy business models. But the real magic happens where the environmental advantage is accompanied by advantages on cost and quality, such that the company’s proposition is faster and cheaper, as well as better – in an environmental sense.
We find this combination in the business models that underpin a circular economy. These offer faster, cheaper, better solutions and will allow us to de-couple economic growth from both ever-increasing natural resource consumption, as well as natural capital degradation.
Properly understanding the business models that can deliver those twin objectives isn’t straightforward, and the effort to do so couldn’t be more different from the approach of sub-contracting judgment to an external agency’s unexplained ‘black box’ model of ESG evaluation.
Companies with authentically lower material resource intensity than those in the wasteful take-make-dispose linear economy have both a cost advantage and a superior customer proposition, leading to faster growth. Both of these are likely to be recognized and monetized in financial markets through a ‘sustainability premium’ added to the earnings multiple used in their valuation.
By digging deep into the ‘E’ in ESG, investors can therefore deliver premium financial returns and contribute to a healthier planet in a combination of which Adam Smith would surely be proud.
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