The paradox of ESG investing

ESG definition:

• Environment. What kind of impact does a company have on the environment? 
• Social. How does the company improve its social impact?
• Governance. How does the company’s board and management drive positive change? 

John Cochrane has a good post on how it effects change:

The point of ESG investing is to lower the stock price and raise the cost of capital of disfavored industries, and therefore slow down their investment.

If it works, it raises the cost of capital to non-ESG firms, which lowers the Net Present Value (NPV) of their investments (because they have higher discount rates). As a consequence, non-ESG firms get very picky, and invest only in projects with higher rates of return. 

On the other side of the coin, NPV investing lowers the cost of capital to ESG firms, which raises the NPV of their investments (because they have lower discount rates). As a consequence, ESG firms get less picky and invest in more projects with lower rates of return. 

The paradox: "if you don't lose money on ESG investing [relative to non-ESG investing], ESG investing doesn't work. Take your pick." 

========ANTICIPATING BLOWBACK=========

from those who cite studies showing that ESG firms do better on average than non-ESG firms.

If this were the case, I would guess that the causality runs in the opposite direction, i.e., from successful firms who invest in ESG projects because they can afford it.  Cynically, this could be a form of virtue signaling to attract consumers who identify with ESG causes.  

As the Financial Times warns:

investors should be more discriminating in how they assess corporate capabilities rather than swallowing hook, line and sinker evaluations from investment houses desperately inflating their so-called ESG portfolios to meet the huge surge in investor demand.

What happens if we cannot measure ESG?

 Barrons:  Tesla (electric cars, batteries) was just added to the S&P ESG Index, albeit with a lower ESG score than Phillip Morris, a US Tobacco manufacturer. From Free Beacon:

ESG ratings are supposed to guide investors, and their money, toward ethical enterprises. But Big Tobacco has lapped Tesla in the ESG ratings race more than once: Sustainalytics, a widely used ESG ratings tool, gives Tesla a worse score than Altria, one of the largest tobacco producers in the world. And the London Stock Exchange gives British American Tobacco an ESG score of 94—the third highest of any company on the exchange's top share index—while Tesla earns a middling 65.

Here's why:

How could cigarettes, which kill over eight million people each year, be deemed a more ethical investment than electric cars? It may have something to do with the tobacco industry's embrace of corporate progressivism.

Companies like Altria have gone out of their way to emphasize the diversity of their corporate boards and the breadth of their social justice initiatives, from funding minority businesses to promoting transgender women in sports. But Tesla, whose executives are overwhelmingly white men, has resisted that bandwagon, going so far as to fire its top LGBT diversity officer last year.

If we cannot measure ESG, we cannot align the incentives of those companies that follow ESG with the investors who want to invest in them.  

Political fund dilemma

The Economist has a nice summary of the contradictions of ESG investing:

There are plenty of problems with the esg movement. Working out if assets are esg-compliant is complex, and prone to bias, mismeasurement and public-relations peacocking. Proponents of feel-good investing want to have their cake and eat it, insisting that the focus on stakeholders is actually better for shareholders, too.

But it also correctly identifies the problems with anti-ESG inveting:

At the moment, taking a position against esg is much more expensive than going with the crowd. This is particularly true when it comes to anti-esg laws, which are more preoccupied with bashing esg-promoting firms than with prioritising shareholder returns and cutting costs for taxpayers.

BOTTOM LINE: letting politics interfere with inveting criteria is going to cost you.

Potential Workers Use ESG as an Employer Screen

A new multiple author study looks at how workers sort into, or out of "good" firms, that is, firms with environmental, social, and governance (ESG) practices. From their abstract:

We conduct a field experiment in partnership with the largest job plat-form in Brazil to study how environmental, social, and governance (ESG) practices of firms affect talent allocation. We find both an average job-seeker’s preference for ESG and a large degree of heterogeneity across socioeconomic groups, with the strongest preference displayed by highly educated, white, and politically liberal individuals. We combine our experimental estimates with administrative matched employer-employee microdata and estimate an equilibrium model of the labor market. Counterfactual analyses suggest ESG practices increase total economic output and worker welfare, while increasing the wage gap between skilled and unskilled workers.

Limiting your investment portfolio to only ESG projects should lower returns. However, this could easily be overcome if better workers have a preference for ESG employers.

Can ESG investing stop climate change without sacrificing returns?

 The WSJ gives us a clear answer:  NO.  

Although this is a gross simplification of the argument, ESG investing to save the environment means buying fossil reserves and leaving them in the ground where they lose all their market value.  

The ESG paradox: "if you don't lose money on ESG investing [relative to non-ESG investing], ESG investing doesn't work. Take your pick." 

Is ESG investing illegal? In TX it is.

Breaking:

...US District Judge Reed O’Connor found that the airline breached its fiduciary duty ... by prioritizing ESG considerations over the financial interests of participants.  ... The court criticized American Airlines for allowing its asset manager, BlackRock, to advance goals unrelated to maximizing returns for plan participants.

“ERISA does not permit a fiduciary to pursue a non-pecuniary interest no matter how noble it might view the aim,” O’Connor said, according to separate reporting by Bloomberg Law. He went on to maintain that ESG investments “often underperform traditional investments by approximately 10%

See related posts:

• The paradox of ESG investing.
• Can ESG investing stop climate change without sacrificing returns?
• Is ESG investing illegal?

Tractor Supply Ditches DEI, ESG After Online Attacks

• We will review and consider revising our current DEI goals while still ensuring a respectful environment. [Diversity, Equity, Inclusion]

• Withdraw our data on emissions and focus on our land and water conservation efforts. [ESG=Environmental, Social, Governance]

Stories: Bloomberg, Zerohedge

See also:

• The paradox of ESG investing
• What happens if we cannot measure ESG?
• How Saudi Aramco, world's largest oil company, became "green."

Does it matter that ESG goals are hard to measure?

From Steve Hayward:

If businessmen do have a social responsibility other than making maximum profits for stockholders, how are they to know what it is? Can self-selected private individuals [management] decide what the social interest is?

In other words, if managers can pick their own vague performance metrics, expect them to shirk or follow objectives of their own choosing.  One would think that management consultants would recognize this, but look at PwC:

...PricewaterhouseCoopers published a “sustainability survey” of 140 major U.S. corporations, arguing that “companies that fail to become sustainable–that ignore the risks associated with ethics, governance and the ‘triple bottom line’ of economic, environmental and social issues–are courting disaster.” The triple bottom line, PwC concluded, “will increasingly be regarded as an important measure of value.”

To be fair, PwC's Guide to Key Performance Indicators, seems to recommend clear performance metrics: 

Key performance indicators (KPIs), both financial and non-financial, are an important component of the information needed to explain a company’s progress towards its stated goals,

... in addition to "management accountability," and "corporate transparency." But pursuing ESG, with the conflicting "triple bottom line" makes it harder to hold managers accountable. Claiming to be Green is easy.  Doing it is much harder.  And no one wants to talk about the tradeoffs which, as Hayward notes, may be substantial:

Despite its flexible criteria, the DJSI (Dow Jones ESG Index) lagged the Dow Jones Industrial Average significantly. Over the last decade it has achieved an annual return of 5.2 percent, while the DJIA has returned 15 percent per year, and the S&P 500 14.8 percent.

And don't you violate your Fiduciary duty if you follow ESG goals at the expense of profit? 

Here are past blog posts on performance measurement. 

BOTTOM LINE: If you cannot measure it, you cannot control it.

How Saudi Aramco, world's largest oil company, became "Green"

Irony is my favorite kind of humor!  From Bloomberg:

The unlikely tie-up between Aramco and ESG began with the creation of two subsidiaries — the Aramco Oil Pipelines Company and the Aramco Gas Pipelines Company. Aramco sold 49% of the shares in each unit to consortiums led by EIG Global Energy Partners LLC and BlackRock Inc., respectively. These investors used bridge loans from banks to fund those transactions.

In order to generate cash to repay the bank loans, the EIG and BlackRock consortiums created two special purpose vehicles: EIG Pearl Holdings and GreenSaif Pipelines Bidco, both registered at the same Luxembourg address. These SPVs then sold bonds, which, since they had no direct links to the fossil-fuel industry, ended up getting an above-average score in a widely-used JPMorgan Chase & Co. sustainability screening based on third-party ESG scores.

From there, the bonds made their way into JPMorgan’s ESG indexes, which are cumulatively tracked by about $40 billion of assets under management. Investors in the SPV bonds include funds managed by UBS Group AG, Legal & General Investment Management and the investment arm of HSBC Holdings Plc.”

BOTTOM LINE: if you cannot measure it (ESG), you cannot control it.

Noisy ESG metrics lead to moral hazard and adverse selection

 

Noisy performance metrics lead to moral hazard (firms shirk on ESG efforts), and adverse selection (ESG investors more likely to invest in firms who are not ESG). 

 Link: AEA 

Incentive alignment in Benefits Corporations

Begun in Maryland in 2012, thirty states now have Public Benefits Corporations (B-corp's) (wikipedia, seeking alpha, quora) 

• For-profit companies that can be publicly traded, but which follow other goals, like ESG. 
• B-corp managers get legal protection from shareholder suits based on low profitability, as they can claim they are pursuing ESG goals.

Chapter one identifies their fatal flaw: not only is ESG hard to measure, but it also conflicts with the pursuit of profit.  This is similar to the problems created by balanced scorecards.

Without good performance metrics,  it is hard for shareholders to tell if B-corp managers are doing a good job, so managers will pursue their own goals at shareholder expense.

Related:  ESG blog posts

How much do I give up to invest in ESG funds?

The retired Chief Economist of NASDAQ and Chief Risk Officer of U. Chicago's endowment has the answer:

...The neutral portfolio’s cumulative return (334%) outgained the market (230%); the results were substantially more compelling using equal-weighted returns as an alternative method.

...

One interesting result is the point at which performance notably begins deviating—2017-18, around the time companies (and perhaps their profits and returns) began feeling pressure from the power and influence of supposedly passive asset managers such as BlackRock, State Street and Vanguard, as those behemoths’ push into ESG intensified.

This is a "compensating differential" from Chapter 9, albeit a negative one. In other words, you pay to invest in ESG funds. See related posts

Is ESG investing illegal?

FROM WSJ: 

 ...BlackRock’s environmental, social and governance investment policies appear to involve “rampant violations” of the sole interest rule, [...which] requires investment fiduciaries to act to maximize financial returns, not to promote social or political objectives. 

 See related posts:

• The paradox of ESG investing
• Can ESG investing stop climate change without sacrificing returns?

ESG investing is a "normal good," i.e., demand falls when income falls

 WSJ:

When an economic shock causes our incomes to shrink, we become more risk-averse. And, in the authors’ words, we start to view the emotional or nonfinancial appeal of ESG investing as “costly” and “unsustainable” if it means forfeiting returns.

Is ESG investing illegal?

For fund managers, it may violate their fiduciary responsibility (to maximize returns) to their shareholders.   Apparently, the legal risk is too big for JP Morgan, State Street, and BlackRock:  

Asset managers have been walking a fine legal line. GOP Attorneys General in 2022 warned that they might be violating their fiduciary obligations and antitrust laws. House Judiciary Committee Chairman Jim Jordan in December subpoenaed BlackRock and State Street Global Advisors for documents and communications related to their involvement in “collusive” agreements.

The climate alliance’s new rules would compound the legal and political jeopardy. In its withdrawal announcement, State Street said its rules “are not consistent with our independent approach to proxy voting and portfolio company engagement.” BlackRock said the rules “would raise legal considerations.”

Big is Green, Procompetitive, and Saves Lives: The Economics of Route Consolidation

28 Jun 2023

Luke M. Froeb

Vanderbilt University - Owen Graduate School of Management

Mark Lane

TensorX

Ed Powell

TensorX

Mikhael Shor

University of Connecticut Department of Economics

Steven Tschantz

Vanderbilt University - Department of Mathematics

Date Written: June 23, 2023

Abstract

[When a firm like Amazon consolidates routes, e.g., by convincing groups of stores to use Amazon’s fulfillment services instead of independent alternatives], the reduction in delivery miles results in lower costs, less pollution, and fewer accidents, injuries, and deaths.

Keywords: Travelling Salesman Problem, Vehicle Routing Problem, Economic Tradeoffs, ESG, merger effects, merger efficiencies

Suggested Citation:

Froeb, Luke M. and Lane, Mark and Powell, Ed and Shor, Mikhael and Tschantz, Steven T., Big is Green, Procompetitive, and Saves Lives: The Economics of Route Consolidation (June 23, 2023). Available at SSRN: https://ssrn.com/abstract=4489828 or http://dx.doi.org/10.2139/ssrn.4489828