Preface

In last month’s Absolute Return Letter, I concluded that, although we do not yet have enough data to draw any definitive conclusions, the “E” in ESG appears to have affected equity returns more than the “S” and the “G”. This month, I will look at a different aspect of ESG investing; I will assess whether the fact that more than $20 trillion of institutional assets is now tied up in various ESG products (source: PwC) has actually changed anything, or it has just become a buzzword to make investors feel better about themselves. Has the world improved as a result of ESG investing, or is it just a fad?

Why does ESG investing exist?

Last August, in Havard Business Review, Kenneth Pucker and Andrew King wrote a now famous paper called “ESG Investing Isn’t Designed to Save the Planet”. When I first read those words, I was admittedly taken back. If that wasn’t the intention, what was? Allow me to quote from Harvard Business Review:

“Most people assume that ESG Investing is designed to reward companies that are helping the planet. In fact, ESG ratings which underlie ESG fund selection are based on “single materiality” — the impact of the changing world on a company P&L, not the reverse. Asset management firms have been happy to let the confusion go uncorrected — ESG funds are highly popular and come with higher management fees. The danger with ESG investing is that it might convince policy makers that the market can solve major societal challenges such as climate change — when in fact only government intervention can help the planet avoid a climate catastrophe.”

There you have it. ESG ratings were not created to save the planet but to assess how a changing world affects the P&L of the companies being rated. This confusion has proven very convenient when marketing ESG products. Asset management firms have been able to charge higher fees, as many investors mistakenly believe the purpose is to save the planet and are willing to pay a premium for that. Take for example Blackrock’s approach to ESG investing (and I quote Havard Business Review again).

“When BlackRock launched its U.S. Carbon Readiness Transition fund in April of 2021, the exchange-traded fund raised $1.25 billion in one day — a record. Among other things, the fund promised “broad exposure to large and mid-capitalization U.S. companies tilting toward those that BlackRock believes are better positioned to benefit from the transition to a low carbon economy.” That sounds good, but there is no mention of driving the transition and the fund holdings seem remarkably standard: Exxon, Chevron, and Conoco Phillips are among the fund’s top 100 holdings.”

What does it all mean?

As a result, everybody is confused. Private investors certainly are. So are many institutional investors. Even portfolio managers don’t always understand the true objective of the ESG ratings system, which is the foundation of ESG investing.

I am not the first to raise this point. The word is spreading quite fast now. Take for example this article from Bloomberg: “[ESG] ratings don’t measure a company’s impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders.”

The most entertaining one I have come across more recently is this one which argues that ESG investing is actually bad for human rights. Overall, I think it is fair to say that ESG investing is facing stronger and stronger headwinds; however, arguments continue to fly in all directions, and it is hard not to get confused. Having said that, let me try and sum up where I stand.

Even if one accepts the argument that ESG investing was never created in a noble attempt to save the planet, it has still had a positive impact on some companies’ behaviour, I believe. Why? Because listed companies need to be on constructive terms with investors to attract their attention, and many (but not all) CEOs have concluded that an easy way to warm the hearts of investors is to pay attention to the “E”, the “S” and the “G”.

One of the noticeable exceptions to this stance is the one taken by Darren Woods, CEO of Exxon Mobil, who has been on a multi-year tirade against the green lobby. He is arguing that:

(i) fossil fuels will be needed for many years to come to meet rising energy demand;

(ii) the world is not on a path to Net Zero by 2050, as most people are unwilling to pay for cleaner alternatives.

(See the story here.)

Although the green lobby is up in arms about Darren Woods, Wall Street love him and have rewarded Exxon’s stock (XOM) with some solid performance. As you can see in Exhibit 1 below, after struggling to keep pace with S&P 500 in 2019-20, the stock has since closed much of the gap that opened up in those years, with 2022 being a particularly strong year for XOM.

Conclusion

Meanwhile, I am struggling to come up with a half-decent argument why Darren Woods is wrong – why he should pay Specsavers a visit next time he is in London. He is right. Fossil fuels will not be completely phased out for many, many years, and Net Zero is not going to happen by 2050, unless governments change gear and begin to take the problem seriously instead of just paying lip service.

Having said that, when I believe ESG investing has actually had some positive impact on the planet, it is because most CEOs are not like Darren Woods. Many have realised that taking the issue seriously has had a significant, and positive, impact on the relationship with many of their large, institutional investors.

When I still believe the impact has been quite modest, it is because far too many countries do not (yet) take it seriously enough and because the problem cannot be fixed just by reducing emissions. We are already pregnant, so to speak.

On this last point, two issues stand out:

(i) The ongoing climate change is a function of cumulative emissions since the early days of the industrial revolution – not a function of present emissions – and cumulative emissions won’t drop just because present emissions do;

(ii) Humans are not the only guilty part; according to my source, ‘only’ 60-70% of the rise in the temperature can be attributed to human behaviour, meaning that the temperature would still be rising, had humans continued to live as they did prior to the industrial revolution.

Having said that, considering how much time has already been spent on the topic, and how many new rules and regulations have been introduced in recent years, it is outright embarrassing that CO2 emissions reached a new all-time high in 2023 (Exhibit 2).

Niels C. Jensen

1 May 2024‍