THE PHENOMENAL RISE OF ESG INVESTING HAS A FLIP SIDE

Article By

V.P. Nandakumar

MD & CEO of Manappuram Finance Ltd

These days, we hear a lot about a trend in the markets called ESG investing, and about all the money flowing into it globally. ESG stands for Environmental, Social, and Governance, being the three broad areas of concern that drive certain market players who regard themselves as “socially responsible investors.” They believe in going beyond the traditional concerns related to the profitability and risks of the business to also give due importance to ESG factors when evaluating an investment opportunity.

On the face of it, there appears nothing wrong in looking beyond narrow considerations of profitability at larger factors such as the impact of the business on the environment and the society. But then, my curiosity was piqued when Mr. Aswath Damodaran, a well-known professor of finance at the Stern School of Business (New York University), created a stir recently by writing that the growing trend of ESG investing would end up costing companies and investors dearly. Without mincing words, he declared that ESG is a mistake that will cost companies and investors money, while making the world worse off as it creates more harm than good for society. But before going into Mr. Damodaran’s critique of ESG, let’s first look at what ESG investing is
all about, and why so many are convinced it is the future of investing.

Environmental: There is no doubt that our environment faces the risk of continuing deterioration from various factors such as the burning of fossil fuels or the indiscriminate use of plastic. The earth’s forest cover is steadily eroding while our seas and rivers are polluted with toxic wastes which imperils the fragile ecological balance of our water bodies. With growing emissions of carbon dioxide, global warming is a reality which causes our glaciers to melt so
much that we face the prospect of rising sea levels submerging low lying coastal areas in the not-too-distant future. Therefore, it stands to order that companies that choose to adhere to the best practices for energy conservation and preserving the environment deserve our encouragement.

Social: Businesses have a common tendency to focus narrowly on their profits. When making more profit becomes the paramount objective, companies may engage in unhealthy and unethical practices. Essentially a business deploys the various factors of production such as land, water, raw materials, labour, capital etc. to produce goods and services of value. In the quest to maximize output and profits, these resources can be used irresponsibly, as happens
when labour is exploited without paying just wages, or when pollutants are discharged into water bodies without the requisite treatment to save on costs.

Corporate Governance: It’s a fact that corporate governance lies at the heart of a modern-day business, and it refers to the processes, practices and policies followed by a company’s directors and executives related to all the decision-making that go into managing the company. Investors are well-advised to invest in companies that adhere to high standards of corporate governance because the evidence reveals that companies that value transparency and
compliance with statutory norms show better prospects for sustainable growth. Good corporate governance helps companies build trust with investors as also with all other stakeholders. Consequently, corporate governance helps promote financial viability by creating a long-term investment opportunity for market participants. What’s more, by adhering to
higher standards of compliance and transparency, a company minimizes the risk of a major fraud or scandal that can put the whole business at risk. In this way, the business also become more “sustainable.”

Recent trends in ESG investing
ESG investing has been growing steadily over the last few years and the recent pandemic has accelerated the trend. It is reported that globally about US$2.96 trillion is currently invested in funds that carry the ESG tag. Global inflows into sustainable funds went up by 88% in the fourth quarter of calendar year 2020 to cross $150 billion. Europe accounted for about 80% of these inflows, the US share stood at $13.4 billion, while flows for Canada, Australia and New Zealand, Japan, and Asia combined stood at $11.1 billion. According to a report by the Climate Bond Initiative, global issuance of green bonds is on track to reach between $400 billion and $500 billion in 2021, nearly double the record high of $270 billion in 2020. In India, ESG investing is still in its early stages. However, it is rapidly gaining ground with mutual funds pushing it with young investors. Inflows into ESG funds increased by 76% to ₹3,686 crore in FY21 against ₹2,094 crore in FY20. ESG funds together had an asset base of nearly ₹9,900 crore at the end of FY 2021. The increasing inflows are said to point to growing investor interest as the disruption caused by the pandemic draws attention to the need for sustainable and resilient business models that respond to multiple stakeholders.
What’s the flip side?
I began this article by referring to Prof. Aswath Damodaran’s critique of ESG investing. A common criticism of the concept of ESG investing has to do with its lack of precision, and the fact that it can accommodate many different investing strategies within its ambit. For example, there were 400 climate-focused funds at the end of 2020, sub-divided into five different categories: low carbon, climate conscious, green bond, climate solutions and clean energy/technology.

It’s also pointed out that the bar for what constitutes a good corporate citizen is quite low. Contrary to what many investors think, most ESG ratings have little to do with corporate responsibility towards ESG factors. Instead, what is sought to be measured is the degree to which a company’s economic value is at risk due to ESG factors. It’s been pointed out that a polluting company can still get a respectable ESG score if the rating agency takes the view that the pollution is managed well and that there is no risk to the company’s market value.

Champions of ESG investing often point to studies suggesting that there is a positive relationship between ESG performance and financial performance, with ESG compliant companies likely to deliver higher profits and better returns for investors. However, critics point out that such positive linkages are tenuous and sensitive to how profits are measured and over what period. Often, the positive correlation is based on a ratings methodology which makes it easy to obtain good scores without much effort. In this context, Prof. Aswath Damodaran sees a weak link between ESG and operating performance (growth and profitability) as the notion that adding an ESG constraint to investing will increase expected returns is counter intuitive. He says that while some firms benefit from being good, many do not. The evidence is stronger that bad
firms get punished, either with higher funding costs or with a greater incidence of disasters and shocks. “ESG advocates are on much stronger ground telling companies not to be bad, than telling companies to be good,” he concludes.

Prof. Damodaran also counters the implicit presumption that unless companies are explicitly committed to ESG, they cannot contribute to society. He points to the examples of Bill Gates and Warren Buffett as two businessmen who built hugely valuable companies that would have considered goodness as a factor in their decision making only if it was good for their business (i.e., without allowing extraneous considerations to affect their decision-making). Having done that, they have both committed to donating a substantial portion of their wealth to charitable causes and they have also made their shareholders wealthy, with many shareholders going on to give money back to society. According to Prof. Damodaran, the difference between the “old” model of business exemplified by Gates and Buffet and the “new ESG” version lies in who does the giving back to society, with corporate CEOs and management taking over that responsibility from shareholders.

Prof. Damodaran also has a word of caution for investors drawn to ESG funds in the quest for higher returns while seeking to lessen the burden on their social consciousness. If the market gets carried away and overprices how much being “good” will add to a company’s profitability, then investing in “good” companies will generate lower risk-adjusted returns than investing in “bad” companies.

Prof. Damodaran’s critique is quite exhaustive and makes many valid points. In this article, I have been able to convey only a gist of what I thought were his key points. I would urge interested readers to check out his blog post of September 14, 2021, under the title “The ESG Movement: The “Goodness” Gravy Train Rolls On!” In this blog he refers to an earlier post on the same subject dated September 21, 2020, which also makes for compelling reading. This blog carries the title “Sounding good or Doing good? A Skeptical Look at ESG” and that just about sums up the entire case against carrying ESG investing too far.

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