Why ESG is Good But Insufficient

It seems simple: Invest for capital preservation and growth, but also to have impact on an issue you care about. But in practice, this is difficult for individual investors and professionals alike, because there are as many definitions of impact as there are practitioners, and because most stock strategies work to mimic the returns of the business-as-usual (BAU) economy, so their ability to differ from that economy in meaningful ways is limited.

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Thus most stock investing strategies end up having little, if any, impact. ESG criteria exist, but they’re used primarily to make marginal improvements to BAU portfolios. They do this by ranking companies from better to worse, say, from “greener” to “less green,” and overlay that on legacy economy portfolios. In a large cap, U.S. strategy, for example, what you get is the S&P 500 with a few objectionable companies removed; more or less the same approach that non-ESG managers use. ESG works for corporate sorting but is insufficient for addressing the climate crisis.

“As opposed to what?” the reasonable reader may ask. “Indexing is the best way to invest, so the best we can do is green it up around the edges.” Well, as opposed to the absolutism the climate response requires. Markets are not distinct from the world economy; on the contrary, the world economy is composed of the industries that receive the most investment. Under BAU, the processes that are causing the climate crisis are built into the world economy. If you get the economy you invest in (you do), the direction of change now needs to be an explicit conversation. The economy is evolving, but the direction of that evolution depends on where money flows. For all the world’s efforts, in reality we are headed for climate catastrophe, and so far no one has done enough to avert it, investors included. Climate has emerged as bar none the most important risk in asset management, and the main threat to investments today is in owning the causes of the climate crisis. Similarly, de-risking a portfolio means not owning these key threats to economic stability.

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To put it bluntly: There exists an objective right and an objective wrong way to define, and therefore to invest in, sustainability. Science, more than the conventional wisdom of indexing, is our main path to knowledge, and science tells us carbon-exposed industries like internal combustion engine manufacture have to rapidly shrink, even if some of the companies in those industries have great ESG scores. When you’re managing risk, you must both contain the cause of the risk and do whatever you can to get to the fix; a BAU index fund—even with an ESG overlay—does neither well with respect to the climate crisis. ESG’s relativism is therefore a nonstarter. Asset management, including ESG-based managers, needs to quit signaling that things like fossil-fuels-burning utilities, natural gas exploration and internal combustion cars are okay. Risk and return are related, and there’s no risk more daunting to the global economy than the climate crisis.

Therefore, rather than investing via tinkering with the business-as-usual economy with often ill-defined criteria, we need to redefine our conceptions about how investing can work, and we can only begin that process by starting at a high conceptual level. Ask, what are our potential economic endgames? Do we arrive at a place where indefinite stability of economy and climate are possible, or do we face some form of collapse? Knowing which we prefer, how do we invest for that?

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We do it with more rigorous, basic-principles-derived equity strategies designed with the end game of sustainability in mind. We judge individual firms on their merits, rather than falling back on the ease of index tracking. We use disinterested, objective principles to make better choices. Rather than check an ESG score, we analyze sources of revenue: Is a firm paid to de-risk the global economy, or is it paid to increase our risks? As an example: It’s clear that internal combustion engine makers are greatly contributing to the climate crisis and doing precious little to fix it. No amount of rationalizing owning the causes of the climate crisis is going to change BAU, and companies increasing global risk won’t have long-term value. Portfolio theory’s old qualms about prudent diversification including fossil fuels and other carbon-exposed industries don’t matter now; if a new means of production isn’t advancing decarbonization, electrification and/or dematerialization, it isn’t likely to grow or exhibit significant value as we confront our planetary crisis.

Although some may be uncomfortable with the absolutism this method of investing requires, the goals of an indefinitely thriving economy and biosphere are of historic importance for our civilization, and they will bring an incalculable amount of good into our world, to say nothing of returns to the owners of firms making those goals achievable.

To use hedge fund speak, investing’s new “winning factor” is clear: Figure out what will enable the global economic production function to work indefinitely and phenomenally well, without overtopping planetary tolerances; then, own as much IP related to enabling that economy as possible. Or, more simply: Avoid economic risks of climate disruption and benefit from the proliferation of solutions.

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