Tuesday 20 December 2022

ESG, a good idea gone bad

Some years ago we praised the assessment of Environmental, Social and Governance (ESG) factors to evaluate potential investments. Now we unfortunately must say, forget it, don't do it. Whether you are looking to ESG to apply your morals or values, or you simply want to find investments that outperform in the long run, ESG has become a waste of time and money.

Problem #1 ESG Scores are inconsistent, contradictory and opaque and therefore useless to the investor

Brian Tayan has saved us a lot of time compiling the details of ESG's sorry condition in a lengthy well-documented review article at the Harvard Law School Forum on Corporate Governance titled ESG Ratings: A Compass without Direction. A key comment in the review highlights a critical problem:

"Studies find low correlations across ESG ratings providers. [professional ratings companies like MSCI, FTSE, S&P, Sustainalytics, Refinitiv] This is perhaps surprising if ESG ratings are supposed to measure the same construct." 

They don't come up with the same evaluation result at all, so whose is one to believe? Which ESG fund is best amongst the many with non-overlapping holdings? It's impossible to tell. Diving into the details of the hundreds of data points each ESG evaluator collects would be daunting in itself. It is impossible in practice given the opaqueness of the assessment criteria along with the considerable dose of judgement calls by analysts looking at the exact same facts and figures. Even professional investors like big pension funds cannot figure out what the ESG scores mean. Do you think we individuals have the faintest hope of doing so?

An indication that ESG has become a fad that the investment industry is exploiting to "skin the rubes" is that the marketing of many ESG funds to the public emphasizes making the world a better place (i.e. the moral virtue argument) while the rating scheme actually aims to gauge the risk the world poses to the company (i.e. the maximize investment performance approach). Worse yet, Tayan cites research that "... companies in ESG portfolios (those with high Sustainalytics ratings) have worse records for compliance with labor and environmental laws relative to companies in non-ESG portfolios during the same period." High ESG can thus mean the exact opposite of what many morally-driven investors seek! Yiles!

More research is cited indicating a doubtful link between ESG and investment performance: "They conclude that “the financial performance of ESG investing has on average been indistinguishable from conventional investing.”

Bottom line, individual investors are best off in low-expense broad-market funds. There's little point to ESG funds. The top ESG scoring companies are all in the broad market funds anyway.

Problem #2 Mandated ESG scoring and reporting replaces markets with government coercion towards political and social objectives

An example is already here. The Canadian federal government announced in its spring 2022 Budget that banks, insurance companies and pension funds will be obliged to report "climate-related risks and exposures" after 2024. And not only about themselves but about their clients too. The climate crusade against fossil fuels is being institutionalised by force. The extension from reporting to mandatory financing restrictions on oil, gas and coal is merely a next step already being pursued. Banks are being forced to abandon lending at a profit as their primary driver to a different one imposed by force by political agents. ESG has become dominated by the single factor of climate. That's not healthy or sensible.

An excellent summary of the debasement of ESG is Why Business Should Dispense with ESG by Samuel Gregg on 4 Dec 2022 at the American Institute for Economic Research. The key knock Gregg levies against the new and useless strain of ESG is Stakeholder Theory, which maintains "... that the purpose of business goes far beyond profit and maximizing shareholder value". ESG is thus no longer "... the practice of businesses prudentially assessing their surrounding economic, political, and social environment to identify those constituencies (“stakeholders”) with whom any company must work if it is to realize profit."

Hilariously, Tayan reports a study that found more ESG disclosure does not improve consistency of scores, it widens the divergence due to the subjective nature of evaluations. 

Whatever value ESG had for investors to be able to invest as they see fit has rapidly been usurped and corrupted.