Cover Story – Can ESG Investing really help Climate Action?

The story of the boiling frog describes a frog that is initially dropped into tepid water and is slowly boiled alive. If the same frog had directly been dropped into boiling water, it would have instantly jumped out. The idea is that a gradual degradation of circumstances is not correctly perceived, and the frog does not take corrective action in time. The trajectory of humanity with respect to climate change is a perfect analogue.

Compared to the rapid changes in society and technology that we are used to, climate change and its effects on the planet and human life are a long drawn out process. The worst outcomes are expected to occur in the latter half of this century, and the consequences are expected to be distributed unevenly around the planet. One of the common characteristics of most climate change related risks is how far out in the future, hard to measure, and fat-tailed they are. It is, therefore, easy for perfectly normal people to underreact in preparation for the coming challenges.

The extraordinary efforts of several organizations and individuals have brought climate change into mainstream consciousness. The tectonic transition in business is attributed to policy and regulatory changes, a shift in consumer preferences, market risk, and technology risk associated with climate change.  Consumer preferences worldwide are shifting towards environment-friendly products. Policy and regulation is punishing carbon intensive business, while rewarding carbon-reducing or carbon-neutral businesses.  However, even these forces can take a long time to play out. Regulators in developing countries may be slow to respond or enforce climate-related rules. Customers in countries with low incomes might currently be unwilling to pay the higher prices that climate-friendly products demand. With capital markets often being very short-term oriented, corporate managements may have little incentive to take corrective action immediately to mitigate these risks.

This is where ESG investing plays a role. While ESG risks may be very long-term in nature, ESG-focused investors estimate and price risks into the value of a security today. By quantifying and embedding these risks into corporate valuations, ESG investors bring them into sharp focus. This forces managements to develop clean technologies, new business models around climate change, and make the businesses less-carbon intensive, and make it climate resilient. The payoffs for these changes can often be far out in the future. By rewarding these developments with higher valuations and cheaper financing today, ESG investors accelerate the transition to a sustainable future.

Consider Tesla Motors. The company produces less than one percent of the total cars in the world, and yet is currently valued at more than the combined value of several of the world’s largest car manufacturers. Whether or not the company will live up to this high valuation remains to be seen. However, it is easy to argue that the high valuation granted to the company has accelerated the EV plans for all the auto majors by several years.

Another way ESG investors bring about change is by forcing disclosures from companies. In their recently proposed climate change disclosure rules, the US SEC has acknowledged that institutional and other investors now demand clear climate-related disclosures, because they are considered material to companies’ financial performance. With clear and consistent disclosures come accountability. If a company is forced to explicitly acknowledge that it does not have an ESG risk management strategy, odds are its stock price will be punished. That is a strong incentive for companies to clean up their acts.

While ESG investing thus promises to help the global agenda to avert a climate disaster, the implementation of this practice can leave a lot to be desired. For starters, as investor interest has increased, the number of ESG funds on offer has proliferated. These are often based not on a deep understanding of ESG issues, but simply on ESG scores sourced from third parties. A lot of ESG-aware index funds have drawn ridicule for their portfolios being barely distinguishable from their non-ESG counterparts. And yet these products continue to attract investor dollars, doing little to actually impact the issues they set out to address.

ESG scores themselves have drawn considerable criticism for being inconsistent, or for their lack of comprehensiveness. This is understandable as the data required to build these scores is not uniformly available, and opinions on what constitutes “good” ESG itself is up for debate on various dimensions. And finally, there is the issue of greenwashing. As ESG investors focus on specific metrics, companies are adapting to manage to those metrics. This has further damaged the reputation of ESG investing.

None of this is new, however. Decades ago, financial disclosures were equally sketchy. The numbers were manipulated to make earnings look good, until investors learned to cross-check with cash flows. Disclosure norms were tightened, analytical tools improved, and markets became more efficient. As the world begins to care about more than just profits, there is no reason why the same cannot happen with ESG disclosures. There just needs to be consistent and effective pressure to make it happen. The recent rules proposed by the SEC around climate-related disclosures is a big positive step in that direction.

For all the variety of ESG investment strategies today – blacklists, ESG improvers, ESG integration, ESG engagement – climate change is ultimately not merely a portfolio issue. A climate disaster can only be averted by actual changes in how businesses operate. The real pressures will come from regulators, consumers, and from the environment itself. However, improving disclosures and an increasingly capable  ESG investing community will be an effective force to channel these pressures to bear on the people and businesses that can make those changes happen.

Disclaimer: “Any views or opinions represented in this blog are personal and belong solely to the author and do not represent views of CFA Society India or those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity, unless explicitly stated.”

About the Author:

Parijat Garg, CFA is a public equities portfolio manager.  He has over 14 years of experience in the financial services industry including portfolio management, algorithmic trading, stock broking, and financial data services. Mr. Garg is a computer science engineer from IIT Bombay and a CFA charterholder.