Supposedly sustainable investment funds make a staggering list of promises, including higher returns, lower risk, combatting climate change and even supporting diversity. And many believe them: investments in ESG (environmental, social and governance) funds are on track to pass £34 trillion by the end of 2022, nearly double their £18.4 trillion in 2016.
But sustainable investing has also attracted strong criticism. Former BlackRock sustainable investing chief Tariq Fancy labelled ESG a “dangerous placebo”, and the Wall Street Journal has published a week-long series of rebuttals to the trend, with their opening piece entitled “Why the Sustainable Investment Craze is Flawed.”
Whatever side you’re on, you have incentives to make your claims extreme. Asset managers promising that their ESG funds will save the world see new business flooding in, and are heralded as saviours of capitalism. Critics have similarly become famous by ordaining themselves as whistleblowers who’ve uncovered a financial scandal.
If you’re a first-time investor trying to decide where to put your money, it can be hard to know who to believe. So if we strip back the hyperbole and examine the evidence, is sustainable investing worth the hype? To answer that, we’ll consider the three objectives that investors have when buying ESG funds.
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Does sustainable investment make more money?
The first objective is, unsurprisingly, financial. By investing in sustainable companies, you’ll increase your returns, and by shunning unsustainable ones, you’ll reduce risk. Industries like electric cars are the future of transport, while dumping fossil fuel companies means you’re immune to a carbon tax.
There’s evidence that certain dimensions of ESG pay off. One of my studies finds that companies with high employee satisfaction, a “social” dimension, deliver shareholder returns that beat their peers by 2.3%-3.8% per year over a 28-year period. Other research finds higher returns for companies with superior governance and those that link CEO pay to performance.
But ESG is plagued by confirmation bias. Since we want to believe that ethical companies perform better, we latch onto studies that assert this, even if the evidence isn’t that strong.
This highlights how the financial case for sustainability hinges on which ESG dimensions you consider. Every day, attention-grabbing articles insist that “investing in ESG pays off”. But to argue about whether ESG helps or hinders returns is as fruitless as asking whether food is good or bad for you – it depends on the food.
Does sustainable investment change company behaviour?
The second objective is the fund’s impact on company behaviour. Divestment campaigns aim to encourage shareholders to sell the stock of certain companies and deter new investors from buying it. By divesting (say) fossil fuel companies, the argument goes, we deprive them of capital and stop them creating more pollution.
But investor boycotts don’t starve a company of funds, because you can only sell if someone else buys. They’re very different from customer boycotts, which do strip a company of revenue.
Perhaps divestment doesn’t pull the plug on a company immediately, but doesn’t it make it harder for it to sell shares in the future? Not necessarily. “Brown” companies like fossil fuels and tobacco aren’t raising much capital to begin with – they’re in yesterday’s industries with few growth opportunities. And evidence suggests that the cost of raising capital has little effect on company expansion.
The stock price might matter for many other reasons than the cost of capital. Even if a company isn’t raising capital, a low price worsens the CEO’s reputation and demotivates employees. But if so, my research suggests that the best strategy is actually tilting (leaning away from a “brown” sector but still being willing to own companies leading on ESG in that sector), not exclusion (shunning that industry outright).
If a fossil fuel company knows it will be divested whatever it does, there’s no incentive for it to develop clean energy. But if its shares will be bought if it’s leading its sector in sustainability, this motivates it to clean up its act by investing more heavily in cutting emissions.
Many accuse ESG funds with stakes in brown industries of hypocrisy, and praise those that won’t touch a troubled sector like oil, but the reality is far more nuanced. And owning brown companies is the only way to hold them to account. The investment firm Engine No. 1 famously got three climate-friendly directors appointed to Exxon’s board because it held shares in the company.
Claiming you’re a true sustainable investor because you only invest in green companies is arguably like a doctor crowing that all her patients are healthy – when it’s a doctor’s job to treat the sick.
Is sustainable investment the right thing to do?
The final motive is moral: you believe it’s morally right to invest in certain companies. For example, even if diverse firms don’t perform better, it’s reasonable to invest in them as an expression of your values.
But identifying “moral” companies is difficult, because many key dimensions of morality are difficult to observe. A company could put minorities on its board to check the diversity box, but do nothing to create an inclusive culture.
So is sustainable investing worth the hype? It does have the potential to improve performance, but only if you focus on particular dimensions. It can change company behaviour, but through tilting and engagement rather than exclusion. ESG is neither the panacea that advocates allege, nor the scandal that detractors declare. But shades of grey get lost in the shadows if we only look for black and white.
Alex Edmans does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.