What is ESG? Once we get beyond the “environmental, sustainable, governance” tag line, what is the methodology used to rank companies? Who does this work? Who are their clients who pay for that research?
Favors of ESG
There are currently 3 “flavors” of ESG investing, exclusionary, impact, and thematic. Exclusionary investing is plainly that, excluding capital allocation to companies that do not meet certain criteria because they are not environmentally friendly, don’t offer equal opportunities, or have terrible corporate governance in legal practices or company culture. For example, the 8 billion dollar legal judgement in 2011 against Chevron for Ecuadorian human rights violations related to the pollution of a part of the rainforest that harmed many of the local inhabitants might knock out Chevron from being an investable company via ESG exclusionary screens. Since then, Chevron has publicly said that litigation forever would be cheaper than actually paying the judgement, and has made good on their word to litigate and is doing so to this day. An exclusionary ESG strategy would seek to deny any financial dealings with Chevron on the basis of all 3 ESG factors.
Impact Investing focuses on creating tangible physical change in the world through the deployment of capital. This can range from investing in early round start up funding for a clean energy tech company, or a company promoting social change via free coding education for people in lower income neighborhoods, municipal bonds to address storm water drainage, or even KIVA micro loans to female entrepreneurs in a developing nation.
Thematic Investing may choose a single theme or a general theme for investment guidance. A single theme might be the elimination of childhood cancer, so one would find all the companies doing research into childhood cancer and try to invest in those companies. Or clean tech / renewable energy might be one’s theme of choice investing into electric vehicles, renewable energy companies, and maybe even excluding oil drilling companies. Another flavor within this can be Cathy Wood’s ARK funds, each of which have a theme / narrative about what the future will look like, and deploys capital into those companies that fit their version of the future.
This is the current narrative, one that doesn’t need to exist but that’s the “research” product being sold at the moment.
Each flavor of ESG screening can run into issues. For example, an exclusionary screen may omit a company like Next Era Energy, the largest producer of wind & solar energy. However, they do still dabble with fossil fuels. Some exclusionary screens put Next Era Energy in the same category as Exxon Mobile, who’s ethos is “we drill for oil, we ain’t changing”.
An impact investor might love the work that Johnson & Johnson does through their company, through the Robert Woods Johnson Foundation, etc… however, Johnson & Johnson was fined 4.7 billion for selling baby powder with carcinogenic asbestos. They continue to sell that product elsewhere in the world, but not in the USA & Canada.
Thematic investors might love the thought of decentralized finance and electric vehicles, space exploration and an amazing sci-fi future. But decentralized finance requires “mining” which requires a TON of energy usage with uses a lot of fossil fuels. Space exploration will probably involve a lot of work done by Lockheed Martin, Raytheon, and other defense contractors. And electric vehicles/batteries need many rare earth minerals that must be extracted from the earth via heavy mining operations.
How to ESG Invest?
The field is still new, and a response to the Great Financial Recession, subsequent money creation that came from that, and the deployment of that capital into fracking. There’s more to it than that, but for the sake of a nice bite sized story, that’s a good one. I think it comes down to the “G” more than anything… the corporate governance. The cynics would say that companies & the financial system is currently co-opting “ESG” investing. Like the saying goes, what starts out as a movement, turns into a business, which becomes a racket. The “G” is the most telling part of it. The process of movements, turning into businesses, then into rackets requires one thing in particular… regulatory capture. The revolving door of regulators, who become lawyers, representing the companies that ESG is trying to address… is all about the “G”.
There are several “ratings agencies” out there who’s primary clients are financial firms. Sustainalytics was one of the first, and are now owned by Morningstar. MSCI is in the game, and their biggest customer is Black Rock Financial. Bloomberg is well… Bloomberg. Thompson Reuters, etc… all the usual players are in the “ESG” rating system. There are over 100 organizations that provide ESG ratings. It’s safe to say, that we are firmly in the “cause has become a business” stage.
The challenge now is to not allow everything to become so co-opted; that everyone just invests in a nice name with some nice ratings… but has terrible governance with excellent PR teams. That’s really everyone’s job… you can fool some of the people some of the time, but you can’t fool all of the people all the time. I’m hoping that’s true.