Will ESG Finally Grow Up?
ESG is a huge, gross gravy train for fund managers, consultants, and marzipan layer technocrats of various flavors. The whole thing is rotten. If you work in the space, your choices are to be a useless idiot trolling in the trenches for what you think is a good cause, be a feckless knave in it just for the money, or find something else to do. Robert Armstrong in the Financial Times
ESG – approaching investment decisions through a lens of environmental, social, and governance concerns – has exploded in popularity in recent years, and like any suddenly-popular trend it has experienced its fair share of growing pains. The quote above might be somewhat exaggerated, but it broadly assesses the unfortunate state of play in the ESG industry.
(A “useful idiot,” by the way, is what Lenin called naïve people in the West who supported what the Communists were doing in the early Soviet Union. Dorothy Parker, for example, a Stalinist until her death, was a “useful idiot.”)
Of course, all ESG investors shouldn’t be tarred with the same brush. Many of these investors are thoughtful about what they’re doing, recognize the hard decisions they must make, don’t overestimate the impact of ESG decisionmaking, and don’t use their ESG approach as an excuse to run around virtue-signaling.
But far too many ESG investors – mainly institutional players – have brought to ESG investing all the thoughtfulness and maturity of a Greta Thunberg. These investors have been living in a Cloud Cuckoo Land where the simple act of not buying an oil company stock will change the world, where ESG portfolios will obviously outperform non-ESG portfolios, and where anyone who doesn’t invest using ESG is a common thug.
Very few investors could have foreseen the Russian invasion of Ukraine, but only asleep-at-the-switch ESG investors got clobbered. That’s because ESG portfolios were positioned – if you blindly followed ESG rating firms’ recommendations – for a naïve world where nothing really bad (except climate change) could happen.
If the ESG rating services were really concerned about social and governance issues, how in the world could those services have recommended a bunch of Russian companies like Lukoil, Yandex, and Sberbank? Yet all these companies were ranked in the top quartile for ESG by Sustainalytics, a widely-used ESG rating firm.
BlackRock’s emerging markets ESG fund – based on JP Morgan’s ESG index – got clobbered after the Ukraine invasion because it was over-exposed to Russia. Why? Because JP Morgan excluded roughly 20% of the world’s countries for failing to meet minimum ESG scores – including India. When a democratic society is excluded in favor of a dangerous kleptocracy, something is decidedly wrong with ESG thinking.
Properly managed, ESG can play a very useful role in encouraging good behavior by companies. Instead, it’s become a kind of game in which companies make modest adjustments to their activities that vault them into the top ESG rankings and many ESG investors then blindly buy them.
Among the companies ESG investors mostly won’t own are so-called “defense stocks,” typically defined to mean a company that derives more than 5% of its revenue from defense activities. This was another aspect of the Cloud Cuckoo Land of ESG investing. Did it occur to these investors that national defense is what keeps democracies alive, that it is only a strong military that allows ESG investors to indulge their ethical preferences rather than being told what to do by some tyrant named Putin or Xi or Kim?
Amusingly, post-Ukraine, some ESG funds are slapping themselves upside the head and saying, “What in the world were we thinking?” Consider Skandinaviska Enskilda Banken AB in Sweden, which only a year earlier had proudly announced it would not own defense stocks. Now that Russian armies are much closer to the Swedish border, the bank abjectly admitted it was reversing its position.
If there is a sense in which people who wouldn’t soil their hands with defense or energy stocks turned out to be little more than Putin’s handmaidens, how should ESG evolve to be more of a grown-up player?
First, parachute down from Cloud Cuckoo Land. Just because some investors want to make the world a better place, not just make money, that doesn’t mean they have to be airheads. No one – not just ESG investors – is happy with a world where strong militaries are essential to national survival. But that’s the world we live in, and that’s the world ESG investors live in. Don’t shill for the sociopaths.
Second, recognize that, whether we like it or not, fossil fuels are utterly essential not just to keep people warm and factories humming, but to keep free nations free. Certainly we want to move toward a world where the human impact on climate change is much more modest. But if we move too quickly we cause “greenflation,” a too-rapid rise in the cost of energy. That rise directly harms billions of poorer people around the globe and it also undercuts political support for green policies.
Third, understand that just because we fervently believe in certain environmental, social, governance and cultural issues, that doesn’t mean everyone else does, or that people who disagree with us are idiots or criminals. Try a little humility for a change.
Fourth, leave virtue-signaling to Hollywood nitwits. No one is impressed that you won’t own an oil stock.
Fifth, do your own homework. If ESG is so important, that means it’s too important to leave to the likes of ESG-rankers like Sustainalytics, MSCI, or Yahoo! Finance.
Sixth, now and then, think like an investor. Don’t follow the ESG herd all the time; don’t imagine that green stocks can grow to the sky; recognize that companies are gaming you; notice that as more and more capital flows into ESG funds the value of green stocks is being artificially inflated, harming your future returns.
Finally, recognize that the ESG Industrial Complex is harmful to your money and your ethics. Like everyone else in the financial industry, too many ESG-industry players are only interested in moving money from your pocket to theirs.
ESG is in fact a wonderful addition to the investment world and, properly handled, it could quite possibly make the world a better place. But the many problems with ESG, and with certain kinds of ESG investors, dramatically undercut its potential.
Next up: A Coat of Varnish, Part 7
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