State of ESG: A boutique firm’s critique

In researching the state of ESG (market trading instruments), there are two articles that most inspired this post: The Secret Diary of a ‘Sustainable Investor’ by Tariq Fancy and The ESG Movement: The “Goodness” Gravy Train Rolls On! by Professor Aswath Damodaran.

Both are long-form reads and well worth your time.

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Almost all investment conferences and webinars these days have an ESG angle.

Those of us who are skeptical about the signal vs noise ratio – that ESG rhetoric is miles ahead of action – are justified in our suspicion.

Talk is cheap. Action is costly.

A bottom line is that Alphalytics cannot, with integrity, offer ESG-labelled products that deliver on both profit and purpose.

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Macro view: What did COP 26 achieve?

Source: The Economist, COP26 update

At the macro level, the new Nationally Determined Contributions (NDCs) for 2030 presented in the run-up to the COP26 summit (Nov 2021) narrowed the gap by a mere 4bn tonnes. Pledges at the summit on methane, coal, electric vehicles and forestry shaved off roughly 2bn tonnes more.

Far from hitting the target emissions gap in 2030 for 1.5 degree Celsius, it is a minor victory that COP26 achieved a pledged reduction of an additional 6bn tonnes.

Micro view: Profit vs Purpose

At the individual investor level, most investors seek an ESG product because that is the right thing to do – it feels good to align profit and purpose.

In the realm of market-trading financial instruments, the intersection of profit and purpose is what sells: Investors are told that investing in ESG products means that they can have their cake (purpose) and eat it too (profit).

In actuality, it is very complicated to untangle the two:

“Trying to figure out whether a company’s good environmental and social deeds actually translates into financial profits is a bit like trying to figure out how much purpose and profits truly overlap, which is a bit like trying to figure out if a morning coffee is healthy or not: the more work you do, the more confused you end up.” -Tariq Fancy

In the game of market-trading instruments where returns are competitive, Alphalytics has yet to be convinced of the simplistic sales pitch that ESG profit overlaps with ESG purpose.

Here are three reasons why:

#1 Follow the money

To a product specialist or a relationship manager, ESG is low-hanging fruit: An easy sales wrapper to seal the deal for FOMO investors seeking to invest with purpose.

A key to selling any financial product is to keep it simple: Show due diligence by way of a proprietary 100-point ESG checklist, slap an ESG label on it, and watch the product fly off the shelf.

Because there is always money to be made from telling people what they want to hear.

To a portfolio manager, ESG data is simply another data set. In the first place, they are inherently incentivized to perform. If there is alpha to be captured, if ESG information was truly useful, they would use it without being asked.

Ask yourself: Is the ESG sales pitch coming from the portfolio manager or the marketing/product department? How much does your relationship manager truly know about what goes into the instrument? How is each party in the product creation and sales distribution chain incentivized?

#2 Follow the business focus

Follow the core business focus: Understand a business’ fiduciary duty. Know the rules of the game.

“The weakest evidence in ESG’s favor is on profitability and cash flows, since almost every study that purports to find positive correlation between profitability and ESG scores trips up on the causality question, i.e., are “good” companies more profitable or are companies that are more profitable able to take the actions that make them look good?” -Professor Aswath Damodaran

Be wary of companies with 50-page long ESG annual reports. Be wary of incumbents whose mission, for the past 30 years, has been to maximise profit but is now touting its transformative, bottoms-up ESG street cred. Be wary of Top 10 “Best ESG Company” rankings.

At best, the jury is still out on whether good companies are better for the bottom line.

From Alphalytics’ experience, the companies that are truly doing good are doing so quietly and under the radar without chest thumping. Perhaps those are the companies that deserve your attention and funding.

#3 There is no such thing as an objective ESG score

Finally, adding to the general sense of confusion is the widely varying measurements of ESG performance.

“Often, everything ranging from levels of greenhouse gas emissions to supply chain labor standards and the diversity of the board of directors is mashed into a single “ESG score” for a company, which serves as a quick and convenient measure of corporate virtue.” -Tariq Fancy

Be wary of the companies with deep pockets to participate in the ESG scoring game. As articulated by the WSJ, whether Tesla or Exxon Mobil is more sustainable “depends on whom you ask.”

Be prepared to roll up your sleeves to do your homework in order to align your purpose with off-the-shelf financial instruments.

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Change is coming. To bet against ESG is to be on the wrong side of history.

The gathering momentum towards ESG is commendable, necessary, and inevitable. And it has never been more important to be armed with knowledge about what constitutes ESG.

As an individual investor, it is not just about checking the boxes to drive an EV, buy an ESG-friendly ETF, and divesting from fossil fuels.

Alignment of profit with purpose is the collective hard work of education, financial support for a long-term just transition, changing country-level and cross-border regulations, and backing an international carbon tax.

We need to continually attempt to – the best we know how – approach ESG investing with integrity, accountability, and humility.

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