It wasn’t long ago that every other investor I talked to wanted to know how to take the environmental, social and governance characteristics of companies into account in their portfolio. ESG investment products that exclude stocks with the worst ESG characteristics enjoyed years of interest, and dollars, on the premise of “doing well by doing good.”
But cracks are beginning to show. Morningstar data for U.S. fund flows show that the fourth quarter of 2023 was the fifth consecutive where the appetite for sustainable funds was weaker than for conventional funds. Globally, the quarter was the first since tracking began in 2018 that sustainable funds saw net outflows.
Alongside waning investor interest, new research suggests that ESG investing may not be doing as much good as had been hoped. The theory behind the practice is that divesting from the least sustainable companies will increase their cost of capital, pushing them to be greener.
Evidence on the ability of ESG investing to affect firms’ costs of capital is mixed, but if it is successful in achieving this objective, the result may be, counterintuitively, counterproductive.
In the 2023 paper, Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms, the authors show empirically that reducing the cost of capital for “green” firms (firms with positive environmental impact) leads to, at best, small improvements in their environmental impact, while increasing the cost of capital for “brown” firms (firms with negative environmental impact) makes their environmental impact even worse.
This means that if sustainable investing successfully shifts capital away from brown firms and toward green firms, it may be making brown firms browner without making green firms greener. The reason is simple when you think about it.
Take an insurance company as an example. It may rank well on sustainability metrics, but it can’t really get much greener. On the other hand, when a brown firm like a heavy construction materials supplier is backed into a corner by an increased cost of capital, it might lean further into its existing high-pollution operations, or it may even cut corners on pollution mitigation.
Rather than avoiding brown firms altogether, research suggests that tilting – holding brown firms which have taken corrective action – may be more effective at reducing externalities.
Aside from the (potentially counterproductive) “doing good” argument, another attribute in favour of ESG investing is that it acts as a hedge against adverse news about the climate and environment. There is evidence from the period spanning 2012 to 2020 that green stocks have performed well when concerns about the climate have increased.
This information is useful if you want to hedge that specific risk, or if you know that climate concerns will increase further in the future. But any asset that hedges a major risk must have lower expected returns. Investing in companies that are recognized by the market as good hedges against ESG risks is likely to decrease, rather than increase, investor returns.
ESG investing seems like a good idea, but its usefulness depends on your objectives. The ability of ESG divestment to have real impact on how companies behave through the cost of capital channel is somewhere between limited and counterproductive. Tilting toward brown firms that are moving in the right direction may be more impactful.
“Doing good” aside, owning greener assets might provide a hedge against increasing climate and environmental concerns, but this comes at the cost of lower expected returns.
Many ESG-minded investors just want to carry the ESG banner, which is fine, but as BlackRock’s former chief investment officer for sustainable investing, Tariq Fancy, has explained, this could be like selling wheatgrass to a cancer patient. There is limited evidence to support its efficacy, and it might detract attention from more effective activities.
Hedging ESG risks and feeling good about your portfolio are valid reasons to consider the ESG characteristics of the companies that you own. When it comes to making the world a better place, I don’t have the solution, but ESG investing probably isn’t it.
Benjamin Felix is a portfolio manager and head of research at PWL Capital. He co-hosts the Rational Reminder podcast and has a YouTube channel. He is a CFP® professional and a CFA® charterholder.