Promises and fallacies of ESG investing

For the second quarterly gathering of 2022, Lacey Heubel, Head of Responsible Investment at Dimensional, spoke to the group on ESG investing (investing subject to environmental, social and governance factors).

ESG investing offers four promises to investors:

  1. Higher returns
  2. Reduced risks
  3. Values alignment and
  4. Real-world impact

Lacey considered each of these in turn and considered the extent to which it fulfils them.

The difficulty when comparing returns starts with a lack of consensus around the definitions of ESG investing, which are not necessarily objective.  Much of the available search also covers only limited timeframes.  Two meta studies (research which looks at multiple other studies) looked at both company performance and investor performance.  The first found some correlation between company performance and ESG credentials but there was not necessarily a causal relationship.  With regard to investor returns, the second study found no correlation between these and ESG characteristics.  It is likely that market prices already reflect forward-looking expectations for a company and therefore these already take account of its ESG characteristics.  This makes the effect difficult to predict reliably and the effect of overweighting on the basis of ESG characteristics tends to overweight a portfolio towards growth stocks

With regard to risks, these can be considered as both unsystematic and systematic.  For the former, it is possible to use ESG ratings as an individual company level, although these measure its resilience to long-term ESG risks rather than providing a value judgement as to whether a company is ‘good’ or ‘bad’.  For example, one of the highest rated was British American Tobacco.  The difficulty with using ratings is that they are subjective and there is a wide range of ratings between different providers.  This compares with credit rating for example, a field in which the various ratings agencies are more consistent.

As to systematic risks, climate risk models produce very variable predictions even though all expect a detrimental change.  By way of illustration, a 6°C rise in temperatures is anticipated to reduce GDP by 5-40%.  However, with 256 considerations going into the 12 United Nations sustainable development goals, a more focused approach may be necessary.

When it comes to values alignment, Dimensional is informed by the responses of its clients to regular surveys and also by research.  Accordingly, its focus is on reducing exposure to greenhouse gas emissions.

In terms of the impact on the real world, it is difficult to assess the extent of the linkage between investor’s actions and that impact.  For example, an impact which saves companies’ costs while also providing some ESG benefit is likely to be something which the company would have done anyway.  Businesses also have multiple sources of capital so are not dependent on ESG-influenced investors for it.  Indeed, if ESG investing reduces businesses’ cost of capital, it will inevitably reduce the future expected returns from those businesses.  There is also the risk that if public companies divest from activities which have a high environmental impact, these activities might move to the private equity sector; this would therefore have no impact on the environment and would reduce the extent to which such activities are subject to future scrutiny.

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