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ESG investing is not just about the E

ESG is doomed. Like Smart beta, ESG investing as a mass-market phenomenon is ultimately doomed. These are not my words. They were written by David Stevenson in his daily blog, The Adventurous Investor, in November.

Why does he think that ESG is doomed? First, David thinks that the acronym ESG “covers far too many bases for any meaningful fund investment allocation policy”. This in turn increases the risk of greenwashing. In addition, different ESG metrics often conflict with each other. David quoted a “hypothetical example” of a technology firm that has low carbon footprint but pays the CEO an obscene amount (readers probably can immediately think of a well-known company run by a certain eccentric billionaire …).

Secondly, apart from excluding offending companies, will fund managers realistically have time to engage these “brown companies” and get them more ESG focused? And lastly, David thinks that whilst some managers agree that ESG may not be long term factors (like small cap, value etc.), ESG products are still being marketed with likely outperformance as a side effect of companies that follow ESG principles. David concludes that we are falling into a trap of ESG becoming a strategy that “acts as an expression of groupthink”.

The hype (allow me to use this word for now) in ESG in recent years has been driven a lot by the awareness of climate change, global warming and the need to address environmental issues. If you don’t pay attention to the environment, you are not a responsible citizen of the planet. Similarly, investors should prioritise allocation of capital to businesses that care about the environment. Therefore, it is not surprising that we have seen a lot of investments linked to start-ups in renewable energy, even if some involve technologies and claims on sustainability that are opaque or even slightly mythical.

Companies also make a lot of effort to demonstrate that they are working towards net carbon zero and making their business model more sustainable. But as many analysts and commentators have been pointing out, the demonstration involves making the right statements (or noises), publishing numbers that get the companies high ESG score by rating agencies, but little on realistic and observable action plans – especially if they conflict with other important business and strategic objectives.

Sometimes I think ESG is like a three-legged stool, with each attribute representing one leg. You need all the three legs to be balanced to make sure the stool doesn’t fall over. But as the E factor attracts easy attention and prominence, the investment industry is at risk of over-focusing on E but ignoring S and G in their ESG investment process and product development. The three-legged stool has a very long E leg, making it difficult to stand on its own and ultimately likely to fall.

Therefore, it is good to see David mentioning a way forward that resonated with me – focus on S, or social aspects, in ESG investing. David quoted research from the Otto Beishem School of Management in Germany which showed that the “social elements of ESG may be a more important contributor to corporate valuations”.

Logically, if a company cares about our society, it will put in effort to minimise the negative impact of its business activities to the environment. Why? Because damaging the environment harms people. The harm may not become apparent immediately, but a company that focuses on the S aspect of ESG should think beyond the current generation in the society. Equally, a company that cares about society will emphasise governance. Only a company that is governed well can deliver good for society.

Or, using my favourite words from Professor Alex Edmans of London Business School, companies who want to genuinely do good will inevitably put more emphasis on the social factor. And if the research from Otto Beishem showed that the S factor improves company valuation, perhaps ESG investment is not doomed. It is time for investors, managers and product providers to start balancing the three-legged ESG stool with better focus on the S factor.

James Chu CFA

Head of Investment Solutions

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