20 Apr 2019
ESG Investing Skepticism
Note: I want to credit Cliff Asness and the folks over at Diligent Dollar for many of the ideas in this post.
I’ve been reading about Environmental, Social and Corporate Governance (ESG) investing recently and I think the topic has such widespread consensus support it’s worth taking a more skeptical approach. First - a quick disclaimer: I am still a supporter of ESG investing and as a rule of thumb will not invest in companies that I’m not morally aligned with. That said, I don’t think ESG investing is the most effective mechanism to promote companies with positive missions, and I think in some cases it can have the opposite effect of what investors intend.
The reason for my ESG skepticism is that changing asset prices – what ESG does – is very different than changing company cash flows. The impact of changing asset prices based on criterion other than cash flow has unknowable effects. ESG allocates capital based on the murky notion of environmental or social responsibility, which is impossible to measure. For instance, is it responsible to sell carbon credits to polluting companies? Is it responsible to invest in nascent technologies that have unproven economics but could have some positive environmental impact? Measuring ESG goodness is hard.
A quick overview of how ESG investing changes asset prices. Investors who support ESG-causes invest in ESG equities and therefore increase the price of these stocks. Conversely, they either don’t buy the stock of or even short anti-ESG equities, stagnating or driving down these equity prices. The same thing could also happen with bonds, warrants or other financial instruments companies use to raise capital.
Importantly, changing these asset prices does impact companies’ ability to raise capital. Higher stock prices mean companies can raise more equity for the same amount of shares. Higher stock prices thus decrease a company’s cost of equity, which along with cost of debt is used to determine its cost of capital.
If you believe corporate finance theory plays out in the real world, companies will only invest in projects that have a higher return than their cost of capital. Not doing this means they lose money on projects. Take a look at the little example below:
Assuming cash flow is re-invested each year, cost of funds going from 10% to 20% makes a 5 year project that returns 25% go to -25%.
ESG investing lowers the cost of capital for ESG companies and increases it for anti-ESG ones. As a result, more projects now look attractive for “good” companies and less projects are worth investing in for “bad” companies.
So what could happen as a result of the changed cost of capital across the board? ESG companies will take more risk since their hurdle rate is lower. In a best case scenario, the added risk plays out well and these companies see their returns exceed the low cost of capital. In the worst case scenario, these risk-on projects bear no fruit and companies waste the capital they raised. Investors lose trust and the ESG halo effect disappears. As an aside, depending on who you talk to this scenario has already played out - check out discussions about The Green Bubble and implosions of scores of green-energy companies.
On the other side, anti-ESG companies will invest in fewer projects given a higher cost of capital. Cash from earnings as a result will have fewer places to go. It’s even possible it will have no projects to go to, in which case management can keep it on balance sheet or return it to shareholders via dividends or buybacks. Again, depending on who you talk to, this has already happened with public tobacco companies. These companies generally have significantly-higher-than-average dividends and free cash flow yields. Several of them have even significantly outperformed relative to market averages.
One more note on anti-ESG companies - as long as there are investors who don’t mind investing in anti-ESG companies, depressing their stock prices always opens the door to such investors buying assets for pennies on the dollar and taking them private. These investors then can take the cash flow from the assets and use them for whatever causes they want. Said another way, artificially depressing anti-ESG asset prices opens the door for investors to come in and make outsized profits.
So do I have a better proposal for promoting ESG causes than ESG investing? It’s easier said than done, but I think targeting cash flow directly is the best way to reward ESG companies and punish anti-ESG companies in the long run. At a consumer and investor level, this is as simple as deciding to not buy goods or services from anti-ESG and buy as much as possible from pro-ESG. If you’re a supplier, consultant or someone who sells to companies, it’s discounting your ESG customers. These behaviors are guaranteed to impact the bottom lines of companies as opposed to changing their cost of capital. Better yet, they change the return rate on existing and new projects in a way not tied to the market (cost of equity and debt are both linked to market forces).
Think of it this way - if a project returns -1% instead of 5%, no cost of funds will justify it. The way to get bad companies to face this -1% is to stop buying their products and make them face higher costs for their inputs. Conversely, if a project returns 10% instead of 5%, suddenly a cost of funds of up to 9% and change is acceptable. ESG companies now can access all types of new capital since their expected return from available projects is higher.
In conclusion, I’m less supportive at this point of writing blank checks to ESG-companies than I am of buying products that were made in a socially and environmentally responsible manner. ESG investing is a very blunt instrument for changing how companies do business compared to the sharp instrument of changes in customer and supplier behavior.