Innovators such as the Tesla CEO create more excitement for investors than government exhortations to do the right thing.
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ESG: Everything Sounds Good — But Is It?
Earth Week is over, but the residue of excitement over environmental, social and governance investing remains. ESG funds have been among the biggest winners to date from the pandemic, and the Biden administration’s announcement that it wants to cut greenhouse gas emissions in half by 2030 is seen to add fresh impetus.
The money flowing into ESG ETFs has been impressive, while a survey of big institutions and fund selectors for Natixis SA shows a sharp increase in the numbers claiming to use ESG criteria when they allocate capital:
But how confident should we be? Surveys like this will always be vulnerable to the risk that respondents are just saying what they think they should. And when it comes to investing, there is a huge issue with definition. E, S and G are all somewhat ambiguous — particularly the G. There are ever more anxious attempts to draw up precise standards, which are vital for the creation of passive ESG funds.
This raises many issues. The ratings being used for ESG indexes are almost comically varied. In governance, in particular, there is almost no agreement between the main companies currently offering ESG ratings. The correlation between their choice of companies that score well on governance is almost zero, meaning that one rater’s opinion is of no guidance at all in guessing what another’s will be. I featured the following graphic, produced by the British academics Elroy Dimson, Paul Marsh and Mike Staunton for last year’s Credit Suisse Global Investment Returns Yearbook, in a Points of Return last year, and it remains relevant. It shows the degree of correlation between ratings from FTSE Russell, MSCI and Sustainalytics, all companies that offer ESG ratings for use in indexing:
All of this suggests that it is dangerous to attempt to use passive investing to encourage good behavior just yet. Companies are unclear as to exactly what they are being asked to do and how they are to be judged. Further, they will be tempted to “game” the evidently flawed metrics. Such issues also call into question how much government policy should incorporate climate risks. If the data are this unclear, for example, is there really a good case for monetary policy to include climate goals? As monetary policy is decided by people with expertise in monetary economics, and not necessarily climate science, they would be particularly vulnerable to relying on unreliable metrics.
Beyond that, there are broader questions about how to motivate a battle against global warming. Traditional economics suggests that we deal with a negative externality (like pollution) by making it expensive. That leads to emissions permits, carbon taxes, environmental fines and so on. But if we try to channel insights from behavioral psychology, questions arise. Carbon taxes are like being told to eat your greens by an over-powerful government. With social distrust at high levels, and many in the U.S. disbelieving the notion of man-made global warming, this isn’t the way to reach ambitious targets.
It might make better sense to shower rewards on those who can come up with technology and products to deal with the problem. The remarkable fame of Elon Musk of Tesla Inc., who next month will host Saturday Night Live, or Cathie Wood of Ark Investment Management, shows that couching climate goals in positive rather than negative terms has a future. People get excited by them, and they don’t invoke ESG criteria, or a sense that they are somehow good for you, to generate excitement.
Musk and Wood may turn out not to have all the best answers. Capital might yet get showered on others who do. As ever in markets, there is a risk of overshooting. That may well have happened already. But given the seriousness of the problem, it’s a risk worth taking.
Rewards for the Well-Meaning
“We’re not so naive that we believe that things will be solved by countries and companies making vague, distant insufficient targets,” said Greta Thunberg, the teenage activist and multiple Nobel Peace Prize nominee, to Congress last week. But it appears that the same cannot be said of equity investors, who are prepared to hand out a lofty valuation on the basis of good intentions alone — at least when it comes to climate change.
Some number-crunching from Savita Subramanian of BofA Securities Inc. shows that ESG is having a big effect on valuations: All investors need to see is a lofty target or ambition, rather than actual success in reducing emissions. Companies with below-median carbon emissions trade at significantly higher multiples of book value, it is true — although companies that make no disclosure trade at slightly lower multiples than those that admit to bad ones. How companies present these numbers is important:
However, in the sectors that account for the bulk of emissions (utilities, energy and industrials), an ambitious carbon-neutral target will earn a sharply higher price-earnings ratio. This isn’t true of other sectors. So companies can do a lot to boost their share price, and reduce the cost of equity capital, by announcing a lofty long-term goal. This appears to impress the stock market, even if it doesn’t impress Greta Thunberg:
Subramanian’s research also revealed an unwitting short-termism. Technology companies are popular with ESG funds, for obvious reasons. They tend not to have large factories, and have very liberal social attitudes. The problem is that while they indeed have low “Scope 1” emissions (direct from sources owned or controlled by the company), their Scope 3 emissions aren’t much lower than those of auto manufacturers. This category refers to the broader range of emissions caused by the company, such as from business travel or leased assets, or from use of its products. As large tech companies also tend to have a relatively low headcount and to back the “gig economy,” there is an argument (covered here) that ESG investors’ enthusiasm for tech unintentionally furthers trends such as inequality and underemployment:
Does ESG Spell Trouble for China?
Two of the biggest trends in global finance could be about to come into conflict. ESG investment is all the rage, while China’s growth continues to fascinate the world. But China is notorious both for environmental pollution (as any visitor to Beijing in winter can attest), and governance issues. The government maintains direct control over many companies, even if it invites others to contribute capital, while it has shown enthusiasm recently to interfere with the biggest private companies.
So do these trends conflict? This was the center of a fascinating debate held on the ERIC research network last week. The argument from Stewart Paterson of Capital Dialectics was very much that China could find itself a victim of ESG methodologies. It is a massively coal-intensive economy. This is from Paterson’s presentation, and shows that China’s appetite for coal is now almost equal to the rest of the world .
He points out:
- Even adjusting for purchasing power parity, China’s GDP is three times as carbon-intensive as the EU and twice the U.S. and world average.
- 57% of China’s energy comes from coal.
- The China Electricity Council is pushing for a 30% expansion of coal capacity by 2030.
On such a basis, it would seem that any fund making some pretense of following ESG criteria would by default exclude China. That has knock-on geopolitical effects, as the country could do with foreign capital.
Andy Rothman of Matthews Asia, a long-time bull on China, offered a more positive perspective. China’s entire economic plan revolves around moving to a model that is far less carbon-intensive, focused on consumption and services rather than construction and manufacturing. Primary industries, such as agriculture and forestry, account for a tiny share of the economy, but what is most important is the declining share of secondary industry — mining, manufacturing, utilities and construction. Tertiary industries such as real estate, finance and retailing now account for more than half of Chinese GDP, and the leadership’s desire is for the share to keep growing:
Beyond the environment, investors in China must contend with the possibility of governmental interference. There has been an escalating attempt to rein in Big Tech in recent months, led by the adventures of Jack Ma at Alibaba Group Holding Ltd. What should we make of this?
For Rothman, it should be viewed as part of the complicated and evolving relationship between the Communist leadership and capitalism, as it has held on to power by steadily allowing more of a role for the private sector. “The Communist Party leadership understands that the reason it’s remained in power much longer than any other authoritarian regime is that it’s changed in terms of economics and personal freedom. All the wealth creation is coming from privately owned entrepreneurial companies.”
Looking at the experience of the Soviet Union and Russia, Rothman says the lesson China has taken is that it was a mistake to let the wealthy interfere in politics. “So the message is ‘feel free to get rich, but don’t feel that getting rich and famous allows you to interject yourselves into politics’.” That doesn’t mean, for Rothman, that the Chinese leadership will do anything to limit the power of private capital.
For Paterson, however, the “commanding heights” of the economy remain dominated by the state. “The party is increasingly moving away from judging its success on economic criteria because it’s much harder to reach those criteria. The emphasis is now on national rejuvenation, or exceptionalism, and redistribution. That to my mind doesn’t seem to be a very good environment in which to manage capital.”
Finally, should Americans or Europeans invest in China at all, given that it is an opponent, or even an enemy? There is an interesting call from the Biden administration to come on this. In May last year, the Trump administration told the Federal Retirement Thrift Investment Board, which manages pension money for federal employees including many veterans, that it shouldn’t change its benchmark for non-U.S. stocks from the MSCI EAFE (covering the rest of the developed world) to the MSCI All Countries Excluding U.S. (which includes emerging markets), because this would involve investing in China.
The membership of the five-member investment board was about to turn over as several members reached the end of their term, so it decided to defer a final decision on whether to use the new benchmark. Three Trump nominees were never confirmed. In February, Biden confirmed that their nominations had been withdrawn. So the commission, which now includes several acting members, carries on until they can be replaced and the issue can be addressed again.
If China becomes subject to some government-sponsored disinvestment push, akin to the campaign against Apartheid-era South Africa, that will force a lot of institutions into difficult decisions. With ESG growing stronger all the time, it’s easy to imagine that the criteria could be seen to have expanded to exclude China.
After a strange Oscar night, it was good to see that My Octopus Teacher was named best documentary; it’s on Netflix and was plugged in this space a few months ago.
Having seen none of the best-picture nominees, I cannot comment. But it’s interesting to look at how wrong the academy usually manages to be. A list of the acknowledged great films includes few that won, and plenty that weren’t even nominated. There’s Citizen Kane, of course. Time can discern that Goodfellas is a better movie than Dances With Wolves, or that both Pulp Fiction and The Shawshank Redemption are superior to Forrest Gump. Vertigo won nothing and was nominated only for sound and picture editing in the year that Gigi swept nine awards. Vertigo has lasted longer.
The only time I’ve seen all the best-picture nominees before the awards ceremony was in 1997, when The English Patient won. Trainspotting and Kenneth Branagh’s Hamlet both failed to get nominated that year, and have left a much greater impression on my memory. Of the others, Fargo has probably fared best in critical memory (Frances McDormand won that year as well). Shine, about the pianist David Helfgott, has been forgotten. So, less fairly, has the lovely Mike Leigh movie Secrets & Lies. The one perceived as a makeweight at the time which I think has lasted better than any of them was Jerry Maguire, which introduced Renee Zellweger and brought a supporting role Oscar for Cuba Gooding Jr. Too mainstream to win, it introduced at least two enduring phrases, “Show me the money” and “You had me at hello” to the culture. Thoughts welcome. Have a good week.
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