What's Hiding Under Those ESG Labels?

A major financial firm that manages over $2T recently boasted of their ESG research team and methods. Among other, less ambiguous points of pride, this firm chose to emphasize:

1. The size of the team, which is about 0.03% of all employees.

2. That the team had successfully averaged together ESG scores from multiple vendors.

Given the current trajectory of socially responsible investing – about a third of all assets managed in the US involve ESG considerations (1) (2) – I believe these points betray, with respect to ESG research, that finance has failed to meet the moment.

How does the finance industry spend four decades hiring science PhDs and then compete for $18T in socially responsible assets with this underwhelming display of information synthesis? I believe the problem is partly linguistic; the field so far has appeared to address the demand for socially responsible investing with clever terms for insiders and neat product packaging for consumers.

When discussing a child's science textbook, physicist Richard Feynman provided the insight:

"[T]here was a book that started out with four pictures: first there was a wind-up toy; then there was an automobile; then there was a boy riding a bicycle; then there was something else. And underneath each picture, it said 'What makes it go?'

…. I turned the page. The answer was, for the wind-up toy, 'Energy makes it go.' And for the boy on the bicycle, 'Energy makes it go.' For everything 'Energy makes it go.'

Now that doesn't mean anything. Suppose it's 'Wakalixes.' That's the general principle: 'Wakalixes makes it go.' There is no knowledge coming in. The child doesn't learn anything; it's just a word." (3)

Today, an investor seeking a socially responsible allocation of funds might come upon a marketing campaign for an ESG ratings agency: images of kids playing with toys, people riding bicycles, and frontline employees brimming with job satisfaction are combined with the question "What makes an investment portfolio good?" "ESG makes it good." Has the investor learned anything, or is it just a greenwashed marketing label? Are there Wakalixes hiding in socially responsible portfolios?

I believe both the child's textbook and the glossy advertisement leave us in "a little knowledge is a dangerous thing" territory: Energy really does "make things go," and ESG considerations ostensibly widen the scope of investment goals to include benefit for society. But if someone only ever learns that "energy makes things go," they have not learned and appreciated the interplay of physics, chemistry, and biology as energy transfers from one form to another on Earth. And if someone only knows that their investment manager promises "ESG considerations" or "ESG integration" in their portfolio's management, then what basis do they have for understanding the material effect of their investments on society?

Sometimes, "ESG integration" refers to minimizing "ESG risk." An ESG rating company can define one such risk, "climate risk," as the risk that companies face by having plants near shorelines, where maintenance of facilities is bound to become more complex and expensive. With this metric, an inland coal mine is associated with less climate risk than a shorefront arboretum. Another ESG risk is regulation: If a hypothetical future law, such as a cap-and-trade regulation, would create higher costs for a company, their ESG risk is greater. In both examples, the concerns of an investor who wants to use their money to fight climate change are replaced by ordinary corporate valuation via expected future cash flows.

Thankfully, the "energy makes it go" nature of the ESG ratings issue extends to the solution. The young science student deserves explanations of physical, chemical, and biological transfers of energy, not to be told that all activity is the result of energy and to move on. Similarly, the ESG-minded investor deserves research about companies based on how their operations physically, chemically, biologically, psychologically, and economically interact with the planet and its inhabitants. Without these material facts, the investor might only learn "ESG makes my portfolio good."

References

1. Carlson, Debbie. ESG investing now accounts for one-third of total U.S. assets under management. MarketWatch (Online) November 17, 2020. (Cited: February 5, 2021.) https://www.marketwatch.com/story/esg-investing-now-accounts-for-one-third-of-total-u-s-assets-under-management-11605626611.

2. Bisnoff, Jason. Why Socially Responsible Investing Is Likely to Gain Momentum Under Biden. Forbes. (Online) December 14, 2020. (Cited: February 5, 2021.) https://www.forbes.com/sites/jasonbisnoff/2020/12/14/esg-investing-a-sizzling-sector-that-will-get-even--hotter-under-president-biden/?sh=20c92a413302.

3. Feynman, Richard P. Surely You're Joking, Mr. Feynman! 1985.

About The Author

Daniel Margul, Quantitative Equity Analyst at Humankind Investments, previously worked at BlackRock, where he served as a quantitative developer and supported their credit models and retirement analytics. He holds a PhD in Computational Chemistry from New York University.