Should we Stop Talking About ESG’s Financial Performance?

    Stockholm (NordSIP) – Between taxonomies, principles, hubs, alliances and partnership, the jargon permeating sustainable finance and the abundance of new ideas can often obscure relatively straightforward questions we should be asking ourselves about sustainable investments.

    Last week, two articles came to my attention that conspired to raise a question I believe we all should consider: Should we stop talking about the performance of sustainable investments?

    Contradicting Arguments

    In an article published last week, we reviewed the recent research by Lubos Pastor of the University of Chicago, Robert F. Stambaugh and Lucian A. Taylor of the University of Pennsylvania, highlighted by the UN PRI. The paper reviewed the arguments often used to promote ESG and found that investors should expect to find lower returns from green assets. These results, the authors noted, stand in direct opposition to the general understanding that sustainable investment will lead to better performance in the long term.

    That pro-sustainability argument is not difficult to make. Intuitively, well-governed companies, investing in a fossil-free future that is inclusive of labour force and considerate of the communities and environments where its operations are based should succeed in a world experiencing climate change and increasing social and environmental awareness. However, proving the point appears difficult.

    Clearly, the Pastor, Stambaugh and Taylor study highlighted by the PRI is not aligned with this view. As I mentioned in that article, this is not news for anyone following developments in sustainable fixed income markets. I cite an old but incisive observation by Peter Lööw, Head of Responsible Investment at Alecta, a Swedish pension provider, where he notes that the strong demand for sustainable products has created a “greenium”. “The problem is that we are seeing very significant demand for green bonds in the Nordics, which pushes the limit on the pricing of those bonds. This is causing us to opt-out of some opportunities these days because they are just too expensive,” Lööw said. “We don’t have the mandate to pay that extra premium – the greenium,” he adds.

    The intuition of the benefits of sustainable investments is very clear. But if we are to follow the science – and we have to follow the science – then we cannot simply continue to speak of sustainable investments as though ESG factors are an unambiguously positive contribution to financial performance. The evidence just does not wholeheartedly endorse this view.

    Equilibrium Pricing or Temporary Market Dynamics?

    One way to tackle the issue and reconcile the two opposing views is to consider the possibility that the present greenium is a temporary problem caused by the extreme popularity of sustainable investments.

    We know that the growth in supply of sustainable investment projects does not match the exponentially rising demand from investors. Every single article about projects tackling or strategies mapping onto the UN Sustainable Development Goals (SDGs) has to acknowledge the gigantic US$2.5 trillion funding gap faced by this agenda.

    According to that view, the greenium is nothing more than a reflection of the imbalance between supply and demand of sustainable projects. Once the supply of sustainable projects increases, market dynamics will facilitate a decrease in their price and eliminate the greenium, this line of argument would suggest. Should the market dynamics turn on its head, the greenium could even be replaced by a green discount.

    In this case, the problem with the argument that ESG factors can generate attractive returns is that that state of affairs will only materialise when all factors are internalised and supply increases: in the long-run equilibrium, which we have not yet reached. Faith and patience should then be the order of the day.

    What is ESG Investing?

    Notwithstanding the validity of the aforementioned argument, it strikes me that there is another, more fundamental problem with claims regarding the performance effects of sustainable investments.

    To understand the issue though it seems appropriate to acknowledge the distinction highlighted in a Financial Times opinion piece by ex-HSBC Asset Management’s Global Head of Responsible Investing, Stuart Kirk. In it, Kirk highlights the importance of distinguishing between input ESG investing and output ESG investing.

    Input ESG investing focuses on the integration of ESG consideration into the ESG process. This has now become a relatively standard practice for all asset managers who apply filters and consider the broad range of ESG factors in their decision to invest in a specific security or company. Output ESG investing, however, focuses on finding companies with the right ESG profile.

    ESG ratings are an easy shortcut to the pursuit of output ESG investments. As is the case with many strategies, asset managers can simply take a set of corporates listed on some pre-established investment benchmark and rank the companies by ESG rating. By re-weighting the components of the benchmark according to their ESG rating, it becomes possible to create an appealing ESG version of an existing investment benchmark, which now elevates its members according to their ESG performance.

    Subjectivity and Measurement Problems

    The problem however, is that sustainable is not an objective adjective. It is a well-known fact among ESG investing specialists that ESG ratings are considerably less correlated than well-established credit ratings. This, in effect, means that the people in charge of deciding who is sustainable and who is not sustainable cannot agree with one another.

    A 2020 study by Berg, Koebel and Rigobon, from MIT and the University of Zurich, Aggregate Confusion: The Divergence of ESG Ratings, illustrates this problem quite well. Not only are ratings not particularly well correlated, but there’s also a lot of variance in their correlation.

    Kevin Prall CFA, of Global consultancy EY offers another perspective on the same problem by comparing the ESG ratings of Sustainalytics and S&P.

    Confronted with this reality, Prall is forced to recognise that “while ESG has become central to the capital allocation process for investors and corporations alike, the disparities between today’s ESG ratings limit their usefulness in extracting meaningful insights about a company’s financial resiliency and long-term value. The path forward should focus on the fundamental analysis of ESG value drivers and reconciling rating methodologies.”

    But ESG ratings are by necessity subjective. There is no objective universal way to rank the importance and weight the contributions of environmental, social and governance considerations into the value of a firm. It is even possible that factors within these dimensions could be wholeheartedly orthogonal to one another.

    On the one hand, some companies will be more controversial than others. This is the case for the companies considered in Figure 2 of Berg, Koebel and Rigobon 2020. On the other hand, the manner in which each factor is prioritised will often be as much a reflection of the focus of the investors and the rating agencies as those of the firm in question.

    Is there any point in talking about the financial performance of ESG Investments?

    If we can’t agree on how sustainable a company is, how can we speak of the effect of sustainability on a company’s financial performance? It is not entirely clear to me that we can or should actually want to do this. This seems to be the unpleasant implication of the subjectivity of ESG assessments.

    However, this observation does not have to negate the relevance of ESG investing. As a matter of fact, it supports the often-heard point that good sustainable asset managers do not blindly follow ESG ratings and external opinions. Instead, those views are considered as one of several inputs informing the investment process.

    Whether focusing on input or output ESG investing, investors should take ownership of their decisions rather than delegating their decisions to specialists and worrying about the performance of others.

    Image courtesy of Alexas_Fotos
    Filipe Albuquerque
    Filipe Albuquerque
    Filipe is an economist with 8 years of experience in macroeconomic and financial analysis for the Economist Intelligence Unit, the UN World Institute for Development Economic Research, the Stockholm School of Economics and the School of Oriental and African Studies. Filipe holds a MSc in European Political Economy from the LSE and a MSc in Economics from the University of London, where he currently is a PhD candidate.
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