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When BlackRock chair and CEO Larry Fink sent his annual letter to CEOs and clients in January, he used the opportunity to effectively put the entire investing universe on notice. He said the giant asset management firm, with US$9-trillion invested mainly in index funds, would be getting very serious about climate change. The issue would be “a defining feature” in companies’ long-term prospects, as Fink put it. “I believe we are on the edge of a fundamental reshaping of finance.”

His pronouncement came only a few months after Brookfield Asset Management revealed its hiring of former central banker Mark Carney to spearhead the $575-billion firm’s environmental, social and governance (ESG) strategy and merely days before General Motors disclosed it would end the production of gas-powered vehicles as of 2035.

The timing of these companies’ pivots seems right. A climate change denier recently departed from the White House, and the pandemic has disrupted supply chains, exposed unsafe working conditions and threatened to turn office buildings into stranded assets. But these high-profile developments also shine an extra bright beam on the old question of whether it pays to invest ethically. It is (still) not clear what kind of bounce ESG investing delivers, even as it becomes an increasingly crowded space.

In the past four years, investment funds that use ESG principles expanded from a third of the global market to two-thirds, says Sean Cleary, BMO professor of finance at Queen’s University’s Smith School of Business and the executive director of the Institute for Sustainable Finance. ESG, he adds, “has been gaining traction.”

Several organizations, including Bloomberg and Morgan Stanley (with its MSCI Index), now rank companies based on ESG criteria, ranging from environmental policies to good governance strategies.

After the 2008 credit meltdown, capital markets scholars showed that companies with higher ESG ratings outperformed their peers. As University of Waterloo professor of accounting and finance Elizabeth Demers notes, that performance could relate to those companies taking a prudent approach to risk management in volatile conditions.

However, the COVID-19 pandemic—which had nothing to do with obscure financial instruments or overheated markets—ignited a global economic crisis that posed a different sort of stress test for ESG stocks and funds, one that has drawn the critical scrutiny of analysts who follow this kind of investing.

University of Calgary finance professor Yrjö Koskinen and three collaborators recently published research showing that the stocks of U.S. firms with high ES rankings (the researchers excluded governance) dropped less dramatically during the precipitous March 2020 market plunge than markets overall. The result held even when Koskinen and his colleagues focused on specific industries or firms with certain financial management policies, such as keeping cash reserves on hand.

In a 2018 study, Koskinen’s group also found that investments in corporate social responsibility initiatives tended to “decrease systemic risk” and increase firm value, especially for companies that offer specialized products.

That’s the good news, from an ESG perspective. The less promising finding is that these same firms rebounded less vigorously than the markets overall as equities climbed back in the second quarter of 2020. Drawing the conclusion that high ES scores are always better from a valuation perspective, Koskinen adds, “is way too optimistic.”

Demers’s research muddies the ESG waters even further. An August 2020 New York University Stern School of Business paper she co-authored found that high ESG scores didn’t “immunize” stocks during the market crash. “We conclude that celebrations of ESG as an important resilience factor in times of crisis are, at best, premature,” the report stated.

Besides these seemingly contradictory results, Koskinen and Demers agree that the relationship between high ESG rankings and valuations or returns is complex—not quite causal, but not immaterial, either. “There are a lot of other things going on in the world,” Demers says.

For example, both point to research showing that investors who seek out stocks or funds with high ESG scores tend to be more loyal and less likely to unload their holdings in volatile markets. Some of that loyalty, moreover, is imposed by large institutional funds that have woven ESG principles into their investment strategies.

Koskinen says there was also evidence during the spring pandemic market free fall that some fund companies were actively buying shares in highly ranked ES companies. The rationale, presumably, was that these firms may be better positioned to withstand the economic shocks created by the pandemic.

Good PR is also a factor. With more and more investors looking for funds with some kind of sustainability or social burnish, issuers have a more traditional financial motive to depict themselves as being on the side of the angels—as, in fact, do the various ranking outfits, whose business it is to measure goodness. MSCI, Demers points out, “has a commercial interest” in promoting these kinds of indices.

Demers further notes that the immutable laws of supply and demand seem to be at work here. The “massive” appetite for shares in companies with high ESG rankings far outstrips supply, which means increased valuations may be an artifact of this imbalance. “It’s not because ESG is driving value per se,” she says. “It’s because there’s excess investor demand for ESG-oriented firms or indices.” In the medium term, however, those imbalances may level out, at which point companies or fund families touting these kinds of performance metrics won’t stand out quite as obviously.

It’s also interesting to observe which of the letters in this now ubiquitous acronym are generating the most traction these days. Professor Cleary points out that many companies, especially larger ones, started adopting good governance practices about 15 years ago. He adds that the devastating impact COVID-19 has had on many workplaces has also brought the S issues to the forefront.

But both Demers and Koskinen say the E is the marker that is attracting the most attention from both executives and investors who are thinking about future crises.

The motivation isn’t just the deluge of scientific evidence about climate change, plus the daunting material risks facing, for example, property insurance companies. “It’s fundamentally a long-term reality that with changes in the climate and regulation, firms are going to have to change their behaviour or they’ll have to completely abandon their businesses,” says Demers. Adds Koskinen: “When Fink writes these letters, everyone pays attention.”

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