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Leaders | Sustainable investing

ESG should be boiled down to one simple measure: emissions

Three letters that won't save the planet

[20220723_L][20220723_L]
Jul 21st 2022
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If you are the type of person who is loth to invest in firms that
pollute the planet, mistreat workers and stuff their boards with
cronies, you will no doubt be aware of one of the hottest trends in
finance: environmental, social and governance (esg) investing. It is
an attempt to make capitalism work better and deal with the grave
threat posed by climate change. It has ballooned in recent years; the
titans of investment management claim that more than a third of their
assets, or $35trn in total, are monitored through one esg lens or
another. It is on the lips of bosses and officials everywhere.

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You might hope that big things would come from this. You would be
wrong. Sadly those three letters have morphed into shorthand for hype
and controversy. Right-wing American politicians blame a "climate
cartel" for soaring prices at the petrol pump. Whistleblowers accuse
the industry of "greenwashing" by deceiving its clients. Firms from
Goldman Sachs to Deutsche Bank face regulatory probes. As our special
report this week concludes, although esg is often well-meaning it is
deeply flawed. It risks setting conflicting goals for firms, fleecing
savers and distracting from the vital task of tackling climate
change. It is an unholy mess that needs to be ruthlessly streamlined.

The term esg dates as far back as 2004. The idea is that investors
should evaluate firms based not just on their commercial performance
but also on their environmental and social record and their
governance, typically using numerical scores. Several forces have
thrust it into the mainstream. More people want to invest in a way
that aligns with their concerns about global warming and injustice.
More companies, including a sister firm of The Economist, offer esg 
analysis. With governments often gridlocked, many people feel
business should solve society's problems and serve all stakeholders,
including suppliers and workers, not just shareholders. And then
there is the self-interest of an asset-management industry never
known to look a gift horse in the mouth: selling sustainability
products allows it to charge more, easing a long blight of falling
fees.

Unfortunately esg suffers from three fundamental problems. First,
because it lumps together a dizzying array of objectives, it provides
no coherent guide for investors and firms to make the trade-offs that
are inevitable in any society. Elon Musk of Tesla is a
corporate-governance nightmare, but by popularising electric cars he
is helping tackle climate change. Closing down a coalmining firm is
good for the climate but awful for its suppliers and workers. Is it
really possible to build vast numbers of wind farms quickly without
damaging local ecology? By suggesting that these conflicts do not
exist or can be easily resolved, esg fosters delusion.

The industry's second problem is that it is not being straight about
incentives. It claims that good behaviour is more lucrative for firms
and investors. In fact, if you can stand the stigma, it is often very
profitable for a business to externalise costs, such as pollution,
onto society rather than bear them directly. As a result the link
between virtue and financial outperformance is suspect. Finally esg 
has a measurement problem: the various scoring systems have gaping
inconsistencies and are easily gamed. Credit ratings have a 99%
correlation across rating agencies. By contrast, esg ratings tally
little more than half the time. Firms can improve their esg score by
selling assets to a different owner who keeps running them just as
before.

As investors become wiser to such flim-flam, they are growing more
sceptical. This, coupled with turmoil in financial markets, is
slowing the influx of money into sustainable funds. It is surely
time, then, for a rethink. The first step is to unbundle those three
letters: e, s and g. The more targets there are to hit, the less
chance of bullseye-ing any of them. Regarding s, in a dynamic,
decentralised economy individual firms will make different decisions
about their social conduct in the pursuit of long-run profits within
the law. Tech firms may appeal to the values of young employees to
retain them; firms in declining industries may have to lay people
off. There is no one template. The art of management, or g, is too
subtle to be captured by box-ticking. Britain's listed firms have an
elaborate governance code--and dismal performance.

It is better to focus simply on the e. Yet even that is not precise
enough. The environment is an all-encompassing term, including
biodiversity, water scarcity and so on. By far the most significant
danger is from emissions, particularly those generated by
carbon-belching industries. Put simply, the e should stand not for
environmental factors, but for emissions alone. Investors and
regulators are already pushing to make disclosure by firms of their
emissions more uniform and universal. The more standardised they are,
the easier it will be to assess which companies are large carbon
culprits--and which are doing most to reduce emissions. Fund managers
and banks should be better able to track the carbon footprints of
their portfolios and whether they shrink over time.

Unsustainable

Better information alone will help in the struggle against global
warming. By revealing more accurately which firms pollute, it will
help the public understand what really makes a difference to the
climate. A growing number of altruistic consumers and investors may
choose to favour clean firms even if it costs them financially. And
even if they can get away with polluting today, many firms and
investors expect that tighter regulation of carbon emissions will
eventually come and want to measure their risks and adapt their
business models.

Make no mistake, though: tougher government action is essential now.
We have long argued for much higher carbon prices that would harness
the market to save the planet. Today pricing schemes cover 23% of
global emissions, about double the level of five years ago. But far
more needs to be done, not least in America. It is government action,
combined with clear and consistent disclosure, that can save the
planet, not an abbreviation that is in danger of standing for
exaggerated, superficial guff. #

For subscribers only: to see how we design each week's cover, sign up
to our weekly Cover Story newsletter. For more on why ESG is in need
of a rethink, listen to our "Money Talks" podcast. For more coverage
of climate change, register for The Climate Issue, our fortnightly
newsletter, or visit our climate-change hub.

This article appeared in the Leaders section of the print edition
under the headline "Three letters that won't save the planet"

Leaders July 23rd 2022

  * The Tory leadership race and Britain's growth challenge
  * ESG should be boiled down to one simple measure: emissions
  * Today's heatwaves are a warning of worse to come
  * Emerging-market crises have become harder to resolve
  * Lessons from Turkey on the evils of high inflation

ESG: Three letters that won't save the planetESG: Three letters that
won't save the planet

From the July 23rd 2022 edition

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