The European Union wants to force the financial sector into more sustainable finance / investment decisions. My post uses state of the art asset pricing theory by Pedersen et al (2019). I show that ESG regulation will reduce the performance of ESG regulated investors at the expense of unregulated investors (hedge funds). It is safe to call this a regulatory failure.
ESG and Asset Pricing: Model Description
The referenced asset pricing model hosts three types of investors. The relative occurrence of these investors will determine equilibrium prices and the positioning in risk / return space for each investor.
Type U investor. This investor is unaware of any link (positive or negative) between ESG criteria and future returns. Consequently, he does not employ ESG characteristics in his investment process. Type U investors subsidize active ESG managers (they trade with investors who know the predictive characteristic of an ESG feature, while they don’t). Type U will neither offer ESG products nor superior information based on ESG signals. It is difficult to see how this investor will survive in the long run, but he is useful when we look at regulation. [The cynic in me believes type U has been introduced by above authors to appease more dogmatic academic peers and to make the case for active ESG Investments.]
Type A investor. Type A investor is fully aware of the predictive content of ESG signals. Thanks to the existence of type U investors, predictability is not fully exploited (i.e. not fully reflected in prices) yet. Note that Type A does not care about ESG in the sense that ESG activists do. He will happily invest into stocks that employ children in cobalt mines and he will increase his investments in this company further if this company has good governance. If type U investors disappear, the predictive component of ESG also disappears and there is no relation between ESG characteristics any more.
Type M investor. Type M investor is dogmatic. Apart from risk and return he wants ESG exposure and is willing to sacrifice returns to reflect his own value judgements. In other words, he is extending ESG exposure to characteristics that start to become negatively correlated with future returns.
Equilibrium
Short term. What does the capital market’s equilibrium look like and what does it mean for risk adjusted performance for these investor types? Type A investor will always hold the best (maximum Sharpe-ratio) portfolio. As long as type U investors are around, he will benefit from predictive ESG signals, i.e. type U investors subsidize type A investors. Type M investors will create better performance than type U investors (as they also hold ESG stocks and some of them are positively linked to future returns), but never as good as type A investors.
Long term. Type U investors will dissappear (no regulation needed) as they neither offer better performance nor ESG compatible products. In this case the predictive power of ESG stops. The ESG signal is fully exploited. This is the situation described by in a recent paper by Luo/Balvers (2017). Type A investors will now still perform better than ESG investors (but really they become indistinguishable from type U investors as predictability faded away). ESG investors (type M) on the other hand simply become constrained Investors who do not want to hold part of the asset universe (non ESG stocks). In order to induce other investors (type A) to hold these stocks they need to offer them a premium. We arrive at two fund separation. The efficient frontier portfolio lies on the convex combination of ESG and non ESG portfolio. The market portfolio (average investor) plots below the efficient frontier dependent on the percentage occurrence of ESG investors. The more ESG investors are around, the higher will be the premium for non ESG investors. Please note that arguments about systematic risks are beside the point, i.e. they are already subsumed within our model. Systematic risk is priced because a large group of investors (not just you and me) are exposed to them. To the degree some stocks are less exposed to, for example, climate risk, investors will receive lower returns, while non-ESG investors get compensated for these risks, i.e. type M investors will receive lower returns as they hold proportionally more ESG stocks than the maximum Sharpe-ratio portfolio.
Impact of Regulation
What does the Regulator want? He clearly wants to reduce the amount of type U investors. As argued above it is unclear whether they can survive in equilibrium anyway. What about type A investors? They are rational textbook investors. Sustainability is an application of Irving Fisher’s net present value rule. Everything that affects future cash flows (including brand) is part of company analysis. Why? Out of self interest and profit motive. Type A is a truly fiduciary investor. He is likely to strongly weight G (governance) criteria, but to a lesser extent E (enviromental) and S (social) criteria.
Regulation targeting type U investors. To the degree the regulator is a superb ESG investor (joke!) he can correct the mistakes by type U investors and make them type A investors. In reality, type U more likely remains a type U investor or becomes a (forced) type M investor.
Regulation targeting type A investors. These investors know much better what they are doing than the regulator. Regulation is likely to hurt them if they are forced to overinvest into ESG, i.e. now they need to hold ESG stocks just because they are ESG without respect to future returns. This opens the door for hedge funds (unregulated investors) to exploit the system and create better performance on the back of regulated investors. Given that client regulation restricts access to hedge funds dependent on investors’ wealth, the system gets rigged further. Hedge fund investors will benefit at the expense of everyone else. What’s next? Attacking hedge fund managers because they are too rich? Special income taxes? Hajek has seen this all coming.
Regulating type M investors. It is tempting to think that type M investors are least affected by regulation. However, if type U investors disappear so does the premium they earn from (accidentially) holding stocks that have ESG characteristics positively related to future returns (all stocks are now correctly priced).
Summary
Within the above asset pricing model I show that forcing investors to extend investments into stocks with ESG characteristics that are negatively correlated with future returns (for everything else we don’t need regulation, as this is in the investor’s own interest), will reduce the performance of ESG regulated investors at the expense of unregulated investors. Regulation will force investors to hold portfolios that are well dominated in risk-return space. This is another version of regulatory failure, not market failure. Dogmatic ESG investing might bring spiritual benefits for those who want to impose their own personal embargo on the world, but must (!) hurt their returns in equilibrium (in expectation and in the long run). Needless to say that environmental threats are real, however, they need to be adressed by creating markets (e.g. for CO2 usage), rather than by indirect regulation. But this is stuff for another post.
Post Scriptum
Type A investors (e.g. Blackrock) are themselves under attack to pay more attention to E and S criteria from aggressive lobby groups. At some point they might have to give in to these pressures for their own interest (not necessarily clients’ interest). This creates a new governance problem for those firms. Do their investment products still offer best advice or do they balance rational investment decisions versus public perception? Environmental problems (which we undeniably face) are best adressed by incentivising corporations to use ressources optimally (CO2 tax beginning at the origin of the value chain). Forcing investors to overinvest into ESG will be answered by corporate greenwashing. We will end up with an array of regulation that only benefits lawyers, consultants and civil servants, i.e. those we need to pay off from revenues created by free enterprises.