What’s The Future Of ESG Investing?

ESG investing is here to stay in one form or another. It’s already evolving into a dominant force in Europe as Price Waterhouse Consulting claims that 60% of mutual fund assets there will be ESG related by 2025. On the eve one of the most consequential elections in American history, it is worth speculating the future of ESG investing in the United States. Depending on the outcome, I foresee the following possibilities under three broad categories: (a) Public policy; (b) Disclosure issues; and (c) ESG investing in general:


Climate deal: Should Joe Biden win the presidency and the Democrats take the Senate, the new administration will push for some kind of carbon tax deal, a cut on carbon emissions or at the very least, mandatory disclosure of carbon emissions. European firms routinely disclose such data. It’s hard to determine whether carbon emissions are correlated with future stock returns partly because ratios of scope 1 and 2 emissions divided by revenue are highly clustered by industries. Predictably, energy has high emissions per unit of revenue and energy stocks have not done well of late. Technology on the other hand has low emissions per unit of revenue and technology stocks have been on a tear. However, there is some evidence linking emissions per unit of revenue to higher operating efficiency. 

The actual price per unit of carbon charged will matter a lot. For example, Sweden charges $119 per ton of carbon relative to $49 in France, $22 in the U.K. but only $0.08 in Poland. Meanwhile the U.K. charges a carbon tax for electricity plants and manufacturing locations for large businesses and that too for emissions, is in excess of the allowance given to such businesses. Given the complexity involved and the room of bureaucratic and lobbyist’s wrangling, I do not foresee a carbon tax in the U.S. for at least the next four years especially given the need to dig out of the COVID related economic fallout.

Green investments: A Biden administration is likely to push for green investments, either via explicit green linked fiscal stimulus, subsidies and/or via regulation. Hence, electric cars, pollution abatement, bio fuels, energy storage and the like are likely to do well. Scrutiny related to whether green investments actually employ the funds raised for stated purposes and whether such investments lead to measurable better environmental outcomes will increase. The current evidence for a link between the issuance of green bonds and subsequent reduction in emissions is weak at best and the track record of federally directed green stimulus is also not flattering.


E&S reporting will improve not G: There is much to like about the recently released Davos scorecard of ESG metrics. Assuming that some version of this scorecard is mandated in a Biden presidency, a fundamental analyst will have access to new information on E & labor related S to assess a firm’s productive efficiency: (e.g., freshwater/land use, air pollution and nature loss measures), workforce efficacy (e.g., labor costs, training provided, diversity inclusion) and capital allocation (e.g., ESG links to capital allocation). This is because barely 15% of U.S. firms currently tell us what their wage and compensation costs are. Hence, any improved disclosure of labor costs is welcome. Current disclosures on the efficacy of capital allocation could also use improvement. Firms rarely tell us whether they go back and check if the projections underlying an acquisition or major capex investments are reconciled with their actual performance. 

I expect to see less progress on S related to the quality of the firm’s citizenship or on G. My worry with the Davos metrics is that they are heavy on E and S but weak on checks related to managerial power. We will continue to rely on alternate data sources of G and S that we use now (i.e. CEO pay ratio, CEO pay for performance data from proxy statements, lobbying expense, value of federal subsidies, contracts, grants, aid, board composition, shareholder proxy proposals, federal enforcement records, litigation history, unionization). Although in the past I’ve called investors to make the request, I do not expect to see a firm’s tax return anytime soon.

Non-comparability of metrics will continue to be a problem: I have spent some time looking at the E&S metrics in Europe. Despite the legislation and social pressure in Europe, these disclosures are barely comparable across firms in the same industry.  For instance, SAP in Germany provides perhaps the most quantitative ESG reports I have seen covering metrics such as women in management, employee engagement index, business health culture index, leadership trust index, net promoter score of the firm from the customer’s perspective, net GHG emissions, total energy consumption and data center electricity usage. Most of these data are absent in other large German firms or such disclosures are not comparable. For instance, SAP claims an employee engagement of 93% in 2019 while Siemens reports that the average approval among employees for aspects of innovation, diversity, openness and leadership was 70%. So, I ask, did SAP consider the same aspects in its employee engagement survey? That’s impossible to answer. But the solution for now is to rely on primary sources of data such as federal filings as opposed to potentially biased self-reported metrics.


Harder questions on virtue signaling: As the honeymoon phase of ESG investing ends, harder questions will be asked regarding firms attempts to cloak themselves in virtue to score PR points. Firms and funds will have to, sooner or later, provide evidence related to the key question in this area: can we improve outcomes for stakeholders without destroying shareholder value?  

Easing up on ERISA restrictions on ESG: If a Biden administration takes over, the restrictions imposed on ESG investments through ERISA compliant pension funds should ease. That should reinstate and expand the market for ESG investing.

Compliance costs will increase: What one regulatory hand giveth, the other taketh away. While ERISA restrictions might ease, more reporting and compliance will likely kick in. The EU has proposed its Sustainability Finance Disclosure Regulation (SFDR), which, among other things, requires asset managers to disclose how they have integrated sustainability at the portfolio level! I am not sure how much value such reporting will add, if it does come to pass.

Will ESG investing unravel? The ESG industry has by and large gotten away with avoiding the alpha question because of the stock market boom in technology stocks. The typical ESG mutual fund has at least 20% of its assets in technology stocks, which have experienced bumper returns. Tech also happens to have greater ESG ratings. If the tech bubble bursts, as we get out of the COVID pandemic and/or the new administration becomes more aggressive with anti-trust enforcement, where will the alpha for ESG come from?

Or, the other threat comes from inflation and hence higher interest rates. The permissive deficit policies of central banks on both sides of the Atlantic have arguably encouraged a speculative bubble in ESG investing. 

An ETF that screens out rent seeking and crony capitalism:  Fair minded investors on both the left and the right of the political center would agree that crony capitalism and managerial rent seeking are problems afflicting our politics and corporate America. If these investors are serious about putting their money where their mouth is, will they buy an ETF that screens out crony capitalists and rent seekers?  I am happy to launch such a fund. Any takers?

In sum, expect larger markets for ESG investments, more disclosure regulation, non-comparability of such disclosures, greater scrutiny related to what the investor is actually getting for her money and hopefully a winnowing of the wheat from the chaff. Interesting times lie ahead for the world of ESG investing.

This article originally appeared on Forbes.


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