You have to impose sanctions on producers (investment management firms) and consumers (private and institutional clients) alike! Be prepared for more regulation and more intrusion on your freedom to invest. Don’t worry: it’s for a good cause. But, is it?
Empirical Evidence
For a libertarian like me, there is nothing to object if investors voluntarily depart from maximizing the returns from their investments and instead choose to support companies that fulfill criteria beyond maximizing shareholder value. Everybody is entitled to his own personal embargo on the world. However, he (and the regulator) needs to be aware that this comes at a cost: expected performance. Limiting your choice set MUST lead to worse results. Period. If your constraints (ESG score) are not binding, i.e. if every greedy, capitalist, profit maximizing investor would hold the same portfolio (because it’s just rational investing), well, then you don’t need ESG!
Now, some of my readers might object that empirical studies exist showing that ESG tilted portfolios outperform a broad investment universe (their benchmarks). These studies typically suffer from three problems, each of them big enough to render them mostly meaningless:
Interpretation of outperformance. The use of ESG criteria is not limited to ESG investors. In particular, quantitative investors have long been aware that good governance is positively correlated with future returns and all corporate finance textbooks will talk in length about the negative impact of agency costs (for firms with bad governance).
Lack of Control Variables. We can not judge the merits of outperformance without performance attribution, i.e. we need to know where outperformance comes from. Avoiding energy stocks might be driven by a decarbonization filter but it will be largely driven by movements in oil prices. If oil prices fall in a recession it is difficult to claim the related outperformance as the intended consequence from ESG investing. Similarily, it is well known that ESG scores are high for quality stocks, low volatililty firms, technology stocks and large stocks. If these traditional factors (well established for about 70 years, i.e. ahead of the ESG hype) perform well over a period of time, this will also lift ESG portfolios and is not due to the concept of ESG investing.
Lack of Theory. Avoiding stocks with high carbon footprints satisfies climate activists, but it should be clear that these stocks command a positive risk premium (higher expected return) in capital markets equilibrium. More on this in the next section. Mixing rewarded and unrewarded characteristics is unlikely to yield an efficient portfolio.
Recent Research
I just came back from a research conference in London organized by Imperial College and Unigestion. Two papers offered new and interesting insights.
Carbon risk. The first paper by Bolton and Kacperczyk found that stocks with high carbon footprints (polluters) outperform stocks with low footprints (non-polluters). The study carefully used control variables and can rely on sound economic intuition. Carbon intensive firms face the risk of regulatory retaliation and technological change (probably faster and smarter than the regulator).
Market efficiency. ESG criteria (and investors following them) are dogmatic. This paper found that firms with low valuations AND low ESG scores (applies to many value stocks) are likely not to be touched by ESG investors. To the degree arbitrage is limited, those prices might not be corrected as swiftly as we would expect, if the ESG crowd becomes large. The likely benefits will accrue to hedge funds. Well done…
Conclusion
Does altruism truely exist or don’t we always have a rational motive for what appears to be selfless behaviour. Habermas defined solidarity as the things we do for others out of pure self interest, if we can expect others to have the ability and willingness to return our favour. How does this extend to ESG? Does it exist? The rational part surely does and each and every investor would be mistaken to ignore it. Market pressure will ensure this. The pursuit of self interests does not need regulatory help. Everything else is likely to be an illusion with costly regulatory consequences.