The trouble and contradictions with ESG investing

Can ESG investing live up to its promise?

Lesson summary

Hi there everyone, I’m Jeff and this is Plain English lesson number 510. JR is the producer and he has uploaded the full lesson content to PlainEnglish.com/510.

Coming up today: a continuation of Thursday’s lesson about ESG investing. Last week, you learned what it was and why people are drawn to the concept of investing in companies that “do good” in addition to doing well by earning profit. But if ESG sounds too good, to neat, to be true…well, I think it is. And today we’ll talk about some of the difficulties and contradictions in ESG investing. In the second half of the lesson, I’ll tell you what it means to welcome someone with open arms. And we have a quote of the week. Let’s dive in.

The trouble with ESG investing

Last week, we talked about ESG investing, the idea that stock investors can direct their funds to companies that respect goals over and above shareholder value, goals like protecting the environment, respecting employees, and practicing strong corporate governance.

“ESG” stands for “environmental, social, and governance.” It’s an idea that companies should be measured on more than just profits. ESG investing has grown in popularity in recent years . What was once a niche interest for a small sliver of the investing world is now big business. But as it has grown in popularity, some problems have emerged.

We’ll put them into three categories. The first problem is confusion around the purpose of ESG investing. The second problem relates to conflict among the three components, E, S, and G. And the third problem is that a large ESG investing industry has sprung up , made huge fees, and possibly has not made any difference at all.

Let’s go in order. What is the purpose of paying attention to environmental, social, and governance matters when investing? We can summarize the confusion two words: divest or engage? Some people would tell you it’s so that you can direct your investment to companies that do good, while depriving other companies of the capital they need to grow. These investors favor divesting, moving money away from companies that do not score well on ESG metrics.

But there’s a problem with that. If I, for example, decide not to invest in, say , a tobacco company, that’s great for me. My conscience is clean. But someone else is right behind me, willing to invest in that same company. Did my protest make any difference in the world? Some people would argue that my divestment made no difference at all, and it might have even made that other investor a better return.

So some people say the idea should be different, and these ESG investors are in favor of engaging. They say that ESG investors should invest in all companies, even the bad ones. But they should use their influence as shareholders to affect the company’s behavior. If enough shareholders care about ESG issues, then they can vote together to replace members of the Board of Directors or otherwise affect the company’s actions. These investors who favor engagement think that they can improve companies’ actions by using their influence as shareholders, as owners.

Think of a tobacco company again. As a shareholder, I could, theoretically, exercise my influence to encourage the company to act responsibly in its marketing to teenagers and to look for ways to transition away from selling a harmful product. But that would require me to hold shares in a “bad” company, selling a “bad” product, and there’s no guarantee I would succeed in my influence campaign, even when combined with many other shareholders.

And that makes the “divest” ESG investors uncomfortable. It’s not an enviable choice: either stage a protest that has a small impact, if any, or invest in an ESG-bad company and risk not achieving any ESG goals even from the inside.

But what is a “good” ESG company or a “bad” ESG company? Some research organizations try to answer the question by producing scorecards on a company’s respect for common environmental, social, and governance goals. But the E, S, and G objectives often contradict each other.

Here’s an example. One environmental goal is to reduce the overall carbon emissions in the world. One social goal is to not buy minerals from countries with corrupt governments that abuse the citizens living near mines. So imagine a maker of electric car batteries. The product will help the world transition away from fossil fuels. But to make the batteries, the company has to buy from some unsavory countries in Africa and Asia, lining the pockets of corrupt governments. Is this an ESG-good or ESG-bad company?

This kind of internal contradiction was on display when Tesla, an electric car maker, was kicked out of an ESG index while ExxonMobil, an oil producer, was welcomed with open arms . Tesla, they said, was good for the environment, but didn’t do enough to protect racial minorities in the company. ExxonMobil drills for oil, but has impeccable governance.

Another problem with ESG investing is its effectiveness. Individual investors, even very rich ones, own just a small portion of public companies. And individual investors don’t have the time or expertise to weigh all the ESG considerations in their investing decisions. And even if they did, they don’t have the time or the money to try to influence, by themselves, public companies. So instead, they buy into ESG mutual funds or ESG index funds, and the fund managers do the hard work for them.

And indeed the ESG fund managers do try to exert influence for good. They vote in shareholder ballots in favor of ESG priorities and do sometimes vote to replace Board members. But for that hard work, the fund managers charge hefty fees. The ESG investing industry is booming, with many of the big investment managers hawking ESG index funds and ESG mutual funds. They have discovered that retail investors care a lot about ESG issues and trust them, the fund managers, to do all the hard work. Every index fund and mutual fund comes with a fee, and investment managers have discovered they can charge much higher fees for ESG funds.

You can see where this is going. A lot of investment managers have created funds with heavy ESG branding and these funds are, in practice, not a whole lot different than a non-ESG fund. The SEC, America’s securities regulator, has started to notice. In one example, the SEC sued BNY Mellon for creating an “ESG” fund and then proceeding to invest in individual stocks without always even taking ESG metrics into consideration.

Fund managers have discovered that they can create a new fund, sprinkle the words ESG and sustainable all over their marketing materials, attract a lot of capital, charge high fees, and not even do much extra work. And recent academic studies have suggested that top ESG funds not only make a lower return than non-ESG funds, but that they’re also not terribly effective at improving companies’ ESG track records. It’s almost like the worst of both worlds.

Is all hope lost?

A lot of these problems have come to light here in 2022. Is all hope lost for the investor that wants to do good? I would argue that all hope is not lost, but the term ESG has some real problems. Ultimately, I think investors should stop thinking about E, S, and G factors together, since they often don’t make sense when considered as a single group.

I also think a lot of investors want to take the easy way out. The world is full of hard choices; buying an ESG fund sounds like a simple answer to the hard realities of the world—but it’s not. And the investment managers hawking expensive and ineffective ESG funds aren’t helping, either.