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Why ESG Investing Has Been Such a Letdown


Sloane Ortel

Founder and Chief Investment Officer of Ethical Capital.

Environmental, Social, and Governance (ESG) investing has gotten a lot of attention in recent years, as the promise of aligning portfolios with ethical values gained mainstream recognition.

But it’s long past time to wonder whether it deserves all the hype.

Despite the promises of real-world impact, glossy brochures with pictures of solar panels on them, and a substantial weight of evidence indicating that these data can help mitigate financial risk if properly applied, the truth is that ESG investing often fails to deliver on its promises.

To help our clients, their friends, and the broader world make sense of this, we decided to explore some of the limitations of ESG data and discuss why it falls short of what individual investors tend to expect from it.

The Illusion Created By ESG Ratings

One of the troubling aspects of ESG investing is the high ratings given to extractive businesses that are known for their negative impact on the environment and society.

Take Nestle, for example, a company that is almost synonymous with corporate greed to many of our clients and readers. Surprisingly, many ESG rating firms rate Nestle near-perfect, raising serious questions for me and many others about the validity and reliability of these ratings.

That doesn’t mean the whole practice is worthless. Investment professionals are supposed to act with independence and objectivity for good reason: there are countless examples throughout history of rating agencies failing to properly perform their duties. One of the most notable is extremely recent: the “great recession” of 2008-9 was in part precipitated by rating agencies issuing inflated assessments of low-quality mortgage assets.

In reality, any investor worth entrusting your hard-earned dollars to ought to understand that it’s unrealistic to wholly outsource investment decisionmaking to some scoring rubric or process.

The Inherent Limitations of ESG Data… and all Data for that Matter.

Investment decision-making is fundamentally about making do with incomplete information.

Even if we were able to use these data to create accurate assessments of corporate alignment with social good, other data gaps would inevitably emerge in a thorough analysis.

At a certain level, there are just natural limits to what can be known.

Here’s a somewhat personal example: I’m a transgender woman. And even though we pick the management teams and companies that we invest in with extremely carefully, I still assume that at least one (and likely more) of the super-sustainable companies in our portfolio is led by someone who believes I shouldn’t be allowed to use an indoor bathroom.

That’s largely why ESG data is geared towards anticipating and avoiding certain risks rather than driving impact or justice: financial risk is plain easier to estimate.

Think about it: If a company depletes water sources near its production facility that it relies on to create its product, it naturally follows that the firm will either pay punitive fees to source the stuff or experience a production slowdown. Both of these circumstances would result in foreseeable declines in revenue that a forward-looking investment strategy might well be able to profit from.

Disaggregating Vague “Build a Better World” Value Propositions In ESG

In a recent webinar, I shared a stylized hierarchy of value propositions for sustainable investing with the assembled group. If you’d like to access that full discussion just click the image below. But give it a gander in any case, because I want to tell you a few things about it.

A stylized heirarchy of "better world" value propositions showing impact at the top of the pyramid,

At a high level, the premise of this chart is that the vague idea of “aligning with a more sustainable future” can be broken up into four parts:

  • Managing externalities. This is the most basic reason that ESG (and the associated data) are important. Having access to information about the composition of a company’s workforce, the carbon intensity of its operations, and the long-term planning processes it uses to prepare for a range of possible futures helps us know that their operations are not creating negative consequences for surrounding communities. Crucially, this can also help us gain confidence that the company is insulated from negative surprises, which goes a long way towards mitigating risk.
  • Aligning with growth trends. Any version of “building a better world” includes building new tools, technologies, and infrastructure. And whether we’re talking about safe housing for seniors, scaling renewable energy generation, or building better software for teachers, paying careful attention to what the world needs is a big help when designing investment portfolios. As analysts, we’re able to work backwards from what’s needed, identify large growth opportunities, and then ensure we own companies that are well-placed to meet those needs.
  • Avoiding stranded assets. As climate change unfolds and humanity reacts to it, substantial disruptions in financial markets are all but certain to emerge. These will never be entirely avoidable, but they are somewhat forseeable. Take the case of fossil fuels, which will hopefully be substantially less widely used sometime in the next couple of decades. The financial think tank Carbon Tracker estimates that $1 trillion of oil and gas assets are at serious risk of becoming worthless as a result.
  • Driving real-world impact. This is what most people think of when “sustainable investing” comes up. It’s difficult to deliver and even more difficult to quantify, which has left many people with false understandings of what’s possible. With that said, all of the strategies we manage seek to avoid preventable harm to living things while also contributing to positive real-world outcomes. With that said, we do our best to learn from the industry’s past mistakes when discussing this with our clients, and will always seek to underpromise and over-deliver.

Each of these four components of “building a better world” is worth thinking about in isolation, but as a practical matter it’s worth remembering that we pursue them is all at once. There is a substantial difference between driving positive change in the real world and protecting your hard-earned dollars, but we pursue them all at the same time as part of an integrated process.

Reasonable Expectations: The Key to Satisfaction

We focus on making sure that our clients have reasonable expectations about what to expect from the funds they entrust to us. That work is not just about the sustainability characteristics of the portfolios we design for them, but also:

  • Helping current and prospective clients reach evidence-based understandings of what returns they should expect from their portfolios.
  • Holding regular webinars dedicated to answering any question on the minds of our clients and broader community.
  • Taking a disciplined approach to growth, which includes ensuring that our support resources are sophisticated enough to serve as a real-time resource for client issues.

At a high level, the attention we’ve paid to all of the holistic considerations above is meant to help you understand whether it makes sense to involve this firm in your life for the long-term. We think of ourselves as your purpose-built partner for long term investing, and would love the chance to demonstrate what that means.

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