Environmental, Social, and Governance (ESG) investing has evolved from a niche strategy to a fundamental aspect of many modern portfolios. ESG refers to the evaluation of a company’s environmental, social and governance practices, which investors believe can lead to sustainable and responsible growth. From what was once a nice differentiator, it has become increasingly crucial for businesses to integrate ESG considerations into their operations to remain relevant and maintain stakeholder trust. However, the question remains -investors must ask themselves what success in an ESG strategy really means.
The rationale for ESG investing is two-fold. First, by supporting companies with robust social impact initiatives, investors can direct capital away from those that neglect their responsibilities. Not only can investors feel good about not profiting off questionable practices, but this also encourages firms to focus on their ESG metrics if they wish to attract investor attention and raise cheaper capital in the future.
Second, investors believe that firms with sustainable practises are more resilient and better equipped to navigate the risks and challenges of years to come, ultimately leading to better financial performance. A meta-analysis from the NYU Stern Center for Sustainable Business suggests that a business strategy focussed on ESG issues is often linked to higher Return on Equity, Sharpe Ratios, and Alphas among portfolios and firms. The study attributes this relationship to the idea that a focus on ESG metrics is quite often synonymous with high-quality management teams.
While this outperformance may have been the case in the past, in recent times this relationship seems to have broken down. In fact, since the invasion of Ukraine and the subsequent global energy supply crisis, investments in energy have outperformed their ESG-friendly counterparts. This indicates that the suggested relationship is beholden to a shift in the global macroeconomic environment, at least in the short term.
Furthermore, other research suggests that when adjusting for sector exposures and the different risks a firm faces, the observed higher financial performance is actually attributable to factors other than ESG initiatives. Put differently, it is not the fact that firms are ESG focused that explains improved financial metrics, but rather the fact that ESG firms are quite often technology and asset-light companies on a high growth trajectory. From an environmental perspective, these are the firms that had minimal emissions in the first place.
In this sense, we must redefine what success actually means, away from purely rewarding firms that would have favourable ESG metrics anyway. Ask yourself, would you rather see a 100% reduction in emissions from a firm whose operations hardly involve any emissions at all, or even just a 1% reduction in emissions from one of the world’s largest emitters?
Kelly Shue and Samuel Hartzmark argue in their recent paper that not only is the latter far more important, but that ESG investing can even be counterproductive. Empirical evidence suggests that an ESG strategy that raises the cost of capital for high-emitting firms can push them into financial distress, leading them to pursue short-term ‘browner’ projects to keep business running. In fact, it is actually these very firms that have the largest scope for change and could benefit the most from an injection of capital, provided it is directed to the right projects.
So how should investors make sure that dirty firms have access to the capital they need to make a change while ensuring that they don’t get away with business as usual? The answer is clear: instead of ‘punishing’ firms with poor ESG initiatives, sustainable investors should meaningfully engage with the firms of which they are shareholders.
However small, ownership grants the opportunity to influence decision-making at the board level. From a retail investor’s perspective, this could be as simple as just voting at the annual general meeting (AGM), something that is possible by mail. To take it a step further, one could even attend an AGM to ask questions and voice an opinion.
Undoubtedly though, the greatest impact comes when investors small and large come together to make their demands known. A prime example of this is the siege of Australia’s largest greenhouse gas emitter AGL. Led by software billionaire Mike Cannon-Brookes, investors managed to influence the election of four key board members with the aim of accelerating a shift out of coal power and towards renewable energy. This unprecedented stirring of Australia’s energy pot would not have been possible if Cannon-Brookes held a traditional ESG portfolio – one in which AGL would never hold a place.
ESG investing has made significant strides in promoting corporate responsibility and sustainable practices. Undoubtedly, this is something investors value and will continue to demand in the future. However, instead of solely seeking the feel-good factor of owning ESG-friendly companies, investors need to actively engage with their portfolio of firms, using ownership to push for more substantial changes. Quite often, this may involve an ownership stake in a firm with poor ESG metrics. In this sense, what we consider an impactful ESG portfolio needs to be redefined. Instead of seeing ‘success’ as a portfolio consisting solely of responsible firms, many of which would have favourable ESG metrics by default, investors should be mindful where the largest scope for change actually is. By adopting a more comprehensive approach, investors can foster genuine social and environmental impact, paving the way for a more responsible future.
The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.
