Investment Outlook: Fourth Quarter 2021 - Environmental, Social, Governance, and Rational Thinking?
Environmental, social, and governance characteristics are increasingly used as criteria when professional investors diligence new opportunities. The three factors are collectively referred to as “ESG,” and it is in vogue for money managers to market their investment products as “conforming” to ESG tenets. In 2021, ESG was very in vogue – as of November 30th, $649 billion has been invested into ESG-focused funds, representing 43% of equity fund inflows. ESG-focused funds now represent about 10% of all managed equity assets in the world.
I have puzzled over the notable shift in how investors allocate assets for years now. One of the most perplexing components of ESG thematic investing is how no one can agree exactly what ESG means. There are over 150 ESG frameworks providing, “ESG Scores,” attempting to express the qualitative as quantitative. There is no common language – companies will score differently depending on the rules of the chosen framework. This can theoretically allow funds to “greenwash” by picking a framework that confirms their existing holdings as now reflective of “ESG” compliant. Additionally, once a fund commits to using ESG criteria, irrational investing behaviors may arise, as the fund must maintain certain ESG ratings.
The core theory of ESG thematic investing is that focusing on these three categories does beneficial things for the world while realizing high returns along the way. The most important development in ESG funds was when they defeated the mentality that there was a trade-off between high returns and high ESG scores. However, instances keep coming to light of a disconnect between that perception and reality.
The best example of irrational behavior I have found to date was highlighted in Bloomberg writer Matt Levine’s excellent “Money Stuff” column. A group of bankers and private equity funds teamed up to create a product called “Coal to Zero.” This fund planned to buy coal mines and gradually shut them down. Burning coal accounts for 46% of global CO2 emissions, so reducing the amount of coal available has a measurable impact. Obviously, a fund hoping for financial returns cannot buy coal mines without mining some of the coal. The plan was to mine only the high-efficiency thermal coal, leaving the remaining ~75% of low-energy coal in the ground. Thermal coal demand is high and likely to increase going forward. As a result, mining thermal coal is the main profit driver for coal mines, while the remaining 75% has a far lower margin while emitting far more CO2.
The “Coal to Zero” product would produce positive returns on investment while making a tangible positive impact on global carbon emissions. The alternative was to let owners who did not care about ESG extract 100% of the coal from the ground, creating marginally higher profits but exponentially higher emissions. For an ESG fund manager, this sounds like a home run, right? Apparently not. The “Coal to Zero” project was completely shut down this year, as ESG funds were not willing to show ownership of a coal mine on their financials.
This outcome is indicative of what ESG investing is still lacking. Without a universal measure of the impact of ESG criteria, situations like the Coal to Zero fund will continue to happen. Both objectives of ESG were missed: investors lost out on returns, and more coal will be mined without concern for emissions. Considering that 10% of global assets under management are now invested under ESG guidelines, I believe now more than ever investors need a consistent ruler with which to measure these funds. Ideally, a universal set of guidelines would be outcome-driven and discourage decisions made based on aesthetics, as was clearly the case with the Coal to Zero fund.