5 minute read
AN INCONVENIENT TRUTH ABOUT ESG INVESTING
The principles of environmental, social and governance factor investing (ESG), or “socially responsible investing”, have been around for over 200 years. It is, however, only in the last decade or so that ESG investing has really gained traction, with its popularity amplified by the Covid-19 pandemic. By September 2020, impact investing index funds had swelled to US$250 billion in the US and more than a trillion US dollars globally, with both figures having risen markedly since the start of the pandemic.
While it is applied in a variety of formats, ESG investing essentially entails making investment decisions which not only prioritise potential financial returns but environmental and societal benefits as well, while adhering to high governance standards. The argument for ESG investing is that by investing in firms that are socially responsible, the investor is less exposed to political and regulatory risk. This in turn should lead to lower volatility of cash flows and higher profitability in the long run, which allows for greater strategic independence.
On paper then, ESG investing sounds very promising. Investment returns under this framework not only consist of financial gains but societal benefits as well. But it does have some noteworthy drawbacks, too. The problem with this style of investing starts with the fact that there is no universally agreed upon definition of what ‘goodness’ is or what it entails. Secondly, and perhaps more importantly, there is no standardised or quantifiable method to measure it.
Traditional corporate finance theory states that the duty of a public company is to maximise shareholder value. While it is not always obvious what a company should do to maximise shareholder value, it is almost always obvious when it has succeeded in doing so – the share price goes up. That is not the case with ESG. Shareholders and other stakeholders, such as governments, employees, customers and society will undoubtedly have different, and often opposing or contradictory views about what is good for the environment, society and governance. Maximising shareholder value does not tell a company’s management team what to do, but it does hold them accountable for doing (or not doing) it. “Doing good for society” can be ambiguous when short and long-term goals are potentially at odds. For instance, is it good for a developing market country to drill more oil whichsupports the domestic population through subsidised fuel prices and increased mining royalty and tax revenue for socially responsible spending by the government – or to drill less oil to keep emissions down?
These types of debates have been brought up by several African leaders lately, and with good reason. As recently as May this year, Angolan president João Lourenço stated that he believes his country has a right to benefit from its natural resources and pointed out that western nations are responsible for the vast majority of carbon emissions. He added that the shift towards a lowcarbon economy should be “gradual and responsible”.
Several other African countries, including Namibia, are expected to start producing oil and gas within the next decade, which is why this debate is particularly relevant right now. The majority of developed countries have benefited enormously from fossil fuels over the past 200 years while they industrialised. Burning fossil fuels enabled an era of strong growth for these countries, resulting in drastic improvements in productivity, income, wealth and living standards. A heavier weighting to the environmental aspect of ESG could deny developing countries the opportunity to similarly benefit and address the social and developmental issues that they are contending with today. Allocations towards ESG may inadvertently divert funds from companies and initiatives in developing markets, where implementing ESG is costly, towards companies in developed markets with strong balance sheets established during times when investment criteria were more concerned with profitability.
A 2019 study of ESG scores found that these scores were influenced by company size and location, with larger companies receiving higher ESG rankings than smaller ones, and companies operating in developed markets scoring higher than their emerging market counterparts. It is, of course, possible that larger companies are better corporate citizens than smaller ones because they are often able to better allocate resources to secondary goals such as ESG, but it is also just as probable that these larger companies have the resources to play the ESG scoring game better. A quick scan through the constituents of ESG indices reveals as much, with companies such as Exxon Mobil and Chevron, two of the largest oil producers in the world, among the largest constituents of these indices.
The lack of a consistent framework seems to have resulted in a healthy dose of cognitive dissonance with regards to ESG investment. Is it possible that a lack of a robust framework around ESG investing is resulting in passive ESG investments and ESG index trackers acting as a barrier to entry for smaller companies and those in developing markets precisely because such entities lack the scale and balance sheet strength necessary to implement du jour ESG principles?
There is little denying that the world should be moving towards a more sustainable way growing global population. At the same time the need to uplift human lives and livelihoods in poorer regions is equally undeniable. It follows that if ESG investing is to honestly set out to achieve a broad spectrum of “goodness” it is likely in need of a revamp. A revamp where small entities and entities in developing economies are not excluded from global capital markets.
Side note: There are various domestic and regional entities doing great work in allocating capital towards ESG efforts in Southern Africa. However, these entities are often limited to domestic capital markets due to the reasons mentioned above.
Danie van Wyk - Head: Research
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