Yes Freakonomics, E.S.G. Investors Are Actually Helping the Environment, and so are Activists and Impact Investors.
This article is a response to the podcast: https://freakonomics.com/podcast/are-e-s-g-investors-actually-helping-the-environment/. The views and opinions expressed in this article are my own.
Freakonomics opens its podcast with an interview of Professor Kelly Shue of Yale, who has completed some interesting research into the subject of ESG investing.
ESG — it’s not one thing.
Let’s begin where I am in complete alignment with the podcast. As Professor Shue states, “It’s always been strange that “E”, “S”, and “G” are bundled together.” I wrote a piece on exactly this point here on Medium in 2021 called “ESG — it’s not one thing.” In summary, companies can perform anywhere from excellent to atrocious on matters of the environment, social responsibilities, or governance, nearly independently. The dot-plot of company performance on E, S and G would look like a Rorschach test, as few companies outperform on all three measures.
Freakonomics and I agree — completely — that trying to rate companies across three substantially diverse measures, amalgamated into a single metric of their “ESG-ishness” is a fool’s errand. One need look no further than the inclusion of companies with some of the worst environmental records in history in popular ESG indices (e.g., Exxon Mobil within the S&P ESG 500). Supposedly those firms are included because of their better performance on Social and/or Governance attributes, although that’s debatable. That of course begs the question, is a company that employs child labor (i.e., poor “S”) but installs solar panels (i.e., good “E”) better than a company that cuts down forests (i.e., poor “E”) but has 50% women on its board (i.e., good “G”)? How is anyone making such a determination? Do two apples equal one orange?
Again, Professor Shue and I completely agree that amalgamating these three diverse aspects of good-corporate health, “E”, “S”, and “G”, is erroneous. It tells stakeholders worse than nothing, it is misleading. Each aspect must be assessed independently, reported transparently, and the decision to invest or not made personally by the investor or their representative.
The big point.
In general, Professor Shue makes a valid point based on her research: ESG investing is not achieving the maximum effect it could, given the $35 trillion of shareholder power it has to exert.
The general thesis of an ESG investor is to sway capital market flows from underperforming companies to outperforming companies with an objective of “Raising the cost of capital” for the underperformers (as Professor Shue calls them, the “brown companies”). ESG’s main tool is typically trading shares on the open market — buying green company shares and selling brown company shares. Professor Shue is absolutely correct about this thesis, and the results as she states are precisely what was hoped for by the ESG investors: brown firms find capital more expensive relative to green firms. We all seem to agree that ESG is doing what it was intended to do.
So why then is Freakonomics concluding that ESG is failing?
First, let’s review what they mean by failing: that ESG investors are not helping the environment. Shue makes this assertion based on the theory that distressed companies may take value destroying actions. If brown firms are pushed into insolvency by ESG investors, because their cost of capital rises relative to green firms, then in those moments of distress they will do things like “cut some corners on compliance efforts or pollution-abatement efforts”. Distressed companies become hyper short-term focused and because of the scale of their brown activities, any increase in brown actions will be significant.
While I think that conclusion in theory could be true, in practice it’s not really what the world sees happening. We see coal companies being replaced by renewable power companies. We don’t see coal companies becoming more brown as they shutter their doors — perhaps because they are already doing one of the worst things we know to harm the environment: burning coal. Could they pollute more by burning worse coal — no, they burn the coal they have — or pollute more by dumping their coal ash in worse ways — no, that’s a surefire way to get put out of business even faster by the EPA — or by burning more coal — no, their product is suffering rapidly falling demand, so there are no buyers.
What about other fossil fuel companies, could they become more brown in distress? The evidence in the podcast suggests that Exxon (a very brown firm) is actually trying to become more green. In fact most of the large oil and gas companies now have renewables arms as their response to the distress of fossil fuels. There is no evidence given in the podcast about this increased brownness in distress, just the thought that it could happen, through the notion of compliance and pollution-abatement.
While corporate finance theory agrees with Professor Shue that companies in distress can do irresponsible things, the theory typically points to this irresponsibleness in the form of taking high risks. Distressed firms could take bets on new technologies, new business lines, new geographies, mergers and acquisitions, and other high risks in the hope of turning the tide of distress. Again, what we see is large oil and gas companies taking bets on new renewables segments. Cutting compliance and pollution-abatement costs would seem minor efforts for a firm in true distress.
Moreover, I think the flaw in this argument — that by pushing brown firms into distress, ESG investors are hurting the environment — centers on the inevitable lifecycle of a fossil fuel company. As fossil fuels are a finite resource, these firms (or at least their brown activities) are going out of business — absolutely. It is not a question of “if”, only “when”. If brown firms are going to do more brown things (e.g., dump their coal ash) as they near insolvency, then whether ESG investors push them there or not, the irresponsible actions of their poor managers are not going to change. What will change is the elimination of all the carbon emissions foregone because ESG investors pushed them out of those brown businesses more quickly.
The podcast then remarks, “brown firms exist in a lot of sectors that are actually crucial to a well-functioning society”. The point being that pushing brown firms into insolvency could backfire on ESG investors, leaving society without crucial services.
Leaving aside what corporate finance theory says about diversification (i.e., that it hates it) or about voluntarily paying for externalities because your stakeholders are pressuring you (i.e., that it hates it too), there is an important practical aspect to this concern. In practice no firm (brown or green) that is providing crucial services to society is going to go out of business (quickly or slowly) unless and until there is a viable alternative. The objective of ESG is not to revolutionize sectors in this way, but to evolve them. The method of increasing cost of capital is not driving a brown sector out of business over night, but rather over decades, and only to the extent that greener options can take their place (making efficient use of a lower cost of capital). What we see in the real world is the outcome of ESG efforts being to evolve the world towards those ESG objectives, reflecting the stickiness of crucial corporate sectors in the face of ESG efforts.
So, apologies Freakonomics, but if ESG investors end up evolving brown firms out of business more quickly, they have helped the environment…substantially, but maybe not enough as Professor Shue concludes: shouldn’t $35 trillion of shareholder power be able to do more? Our planet is still heating-up!
If not ESG, then what.
Two alternative forms of investing are mentioned in the podcast as having more luck in bringing about change: Activist investing and Impact investing. While the podcast does not differentiate the three forms of investing it discusses, they are fundamentally three distinct approaches.
I already discussed ESG investing as a form of trading shares, with the goal of influencing the cost of capital. This form of investing is very popular because it does have the desired effect, as Professor Shue confirms, and it does so in a very diversified manner, attuned to investor needs for risk-return tradeoffs. That is to say, the reason there is $35 trillion of ESG investing is because it has attracted a lot of stable money from places like pension funds, mutual funds, and personal savings. Money that people want back some day, with an appropriate return, to live their lives.
The focus of ESG funds is to manage a pool of investments, not unlike traditional asset managers do. They are analyzing performance metrics, as well as ESG measurements. Their skillsets are used to manage financial performance of funds among the subset of ESG investments that have been selected. For the most part, they are not seeking to engage with Management of their portfolio companies to influence change — although voting of shares for resolutions has become more popular — but rather invest in companies that already meet their mandate. This process is referred to as screening — selecting companies that either exhibit attributes desired (positive screens) or excluding companies that exhibit attributes undesired (negative screens). Once through the screen, the fund is operating very similarly to any other asset manager.
Activist investing by contrast, is an approach of highly concentrated share purchasing. The Activist is intending to persuade change in the target firm, typically with some notion of that change improving share value, among possibly other objectives. Professor Shue suggests that Activism is better than ESG because “it might be helpful [to ESG objectives] to engage with their [target] management”, the way that Activists do.
Engine №1 is cited as a successful Activist story for its $35 million investment in Exxon, and engagement with Exxon’s Management team. $35 million represented nearly 10% of Engine №1’s funds under management — a large, concentrated stake needed to instigate action at Exxon. In fairness the jury is still out on how much effect Engine №1 had on greening the target (n.b. Exxon continues to announce substantial new brown spending including a $13 billion project in Guyana). Nevertheless, Engine №1 did successfully get the attention of Management and a form of agreement to seek green improvements, leveraging their $35 million (a mere fraction of one percent of shares outstanding in the target).
Why don’t ESG funds just “act more activist” with the level of holdings they have? That thinking does a disservice to the efforts of Engine №1. The reason they can take a stand against Exxon is in large part because their staff focus intently on Exxon, creating a viable strategy specific to Exxon, to seek the changes they desire in Exxon. Engine №1 made their shareholding very clear to Exxon as part of their strategy. ESG investors by contrast, typically own shares in a company unbeknownst to that company. ESG funds simply don’t have the same resources to try and “act more activist” with pools of holdings perhaps 10–50 times as large as Engine №1.
Regardless of that fact, there are actually examples of ESG funds taking a more activist approach. ESG funds, for example, were instrumental in getting Dick’s Sporting Goods to remove assault weapons from its stores. But stories like that are always going to be the exception in ESG because most of that $35 trillion sits inside large funds that just don’t have the resources and skills available to dedicate to activist investing.
That brings us to the third investment approach of Impact investing. Professor Shue rightly suggests that Impact investing is “quite promising”. Full disclosure, I am the CFO of one of the oldest and largest Impact Investing firms in the world. While I agree with her characterization of the promise of Impact investing, I disagree that it is “niche, risky and specialized products”.
Impact investing, like Activist investing, is different from ESG investing. Impact investing’s key characteristics are:
1. Investments are made into companies, not between investors. The funds invested by impact investors get spent by operating companies on activities that generate impact directly. For example, an Impact investment in a renewable energy company might pay for the acquisition and installation of new solar panels.
2. Impact (the outcome of producing benefits to human beings and the planet, in the groups most in need of those benefits, beyond the recipient of the investment) is the objective of impact investing — not a side result. It is still an investment with a risk-adjusted return proposition, but made with the intent of producing the impact.
3. The impact, not just the financial outcome, is measured. Reporting on the plethora of impact outcomes contrasts with the notion of rating ESG features into a single metric/rating.
Impact investments can be in any financial form — debt through equity, highly structured or standard. Each investment meets the risk-return spectrum in the same way that any other investment does — they are not inherently “risky”. Junk bond investing may be risky. A senior loan to a well-capitalized, asset backed company, with an impressive credit profile is not particularly risky.
The ability to negotiate a financial instrument privately to precisely meet the needs of recipients is what substantially differentiates Impact investing from ESG or Activism. That’s not “specialized”, it’s the flexibility of private markets — be they private credit or private equity. It is true that the skills required to operate in private markets are different than those needed in public markets, but then both are actually specialized.
Perhaps the $1 trillion impact investing space (a number cited by the Global Impact Investing Network) is “niche” compared to the $35 trillion ESG space, but that’s still a pretty big niche.
The future.
Professor Shue and I share the goal of seeing the $35 trillion in ESG investments being used more effectively to help the environment.
I don’t think the answer is for ESG investors to reverse the courses of their funds and start buying brown securities, as the podcast concludes. ESG investors are helping the environment now by being the force of evolution for many sectors of the economy to turn green.
The future, however, could focus more intently on the promise of Activism and Impact investing. Activists can work with Management teams at brown and green companies to help direct action, while Impact investors can be a major force for funding the changes we want to see in the world.
The future of the entire Socially Responsible Investing space could lean more to Activism and Impact — it’s up to the individual investors to make that change by voting with their wallets.
