ESG investing has been widely discussed in recent years, and many financial institutions have raced to roll out investment products that are designed to support the ESG agenda.    ESG stands for Environmental, Social & Corporate Governance.   While that is what the acronym stands for, what does it actually mean in reality?   In fact, there is quite a bit of controversy as to what ESG really represents and how effective it actually is in affecting any real change.

Environmental

The environmental and social aspect of ESG investing is highly subjective depending on one’s perspective.   What one person might consider to be environmentally friendly, another person may view as hazardous to the environment.  As an example, the push for electric vehicles is heavily motivated by the desire to lower CO2 emissions and more renewable energy sources.  However, the batteries required to power these electric vehicles are typically lithium-ion batteries.  The recent demand has driven the cost of lithium carbonate up from about $10,000 per metric ton, to over $60,000 per metric ton.  The larger issue is how this impacts the environment.

Lithium disposal is extremely bad for the environment.  Recycling lithium from its recycled state as lithium sulphate and converting it into a reusable state as lithium carbonate is an expensive process.  This is because lithium is very volatile, as it has a tendency to explode, making it costly to recycle.  As a result, a recent study done by the Journal of Indian Institute of Science found that less than 1 percent of lithium-ion batteries get recycled in the US and EU compared to 99 percent of lead-acid batteries.   Some studies have shown higher recycling rates.  Those batteries that do get recycled undergo an intensive process of high temperature melting and extraction, or smelting.  These operations themselves are very energy intensive.  While new technology might increase the percentage of recycled lithium, the current mining for lithium, as well as other necessary components in electric vehicles like cobalt and nickel also comes at a great environmental cost to the regions being mined.    As a result, it’s easy to see why some may not see investing in electric vehicles as environmentally friendly as advertised in their current form under the current technology.

Social

The social aspect of investing is also highly subjective.  One person might find the manufacturing of weapons-based systems by companies that service government military contracts such as Boeing or Lockheed Martin as vital and necessary to our national defense.   While another person that may be opposed to the military industrial complex might find the creation of these weapons of war to be objectionable.    The same could be said about companies that stake out a particular position on any number of issues, such as firearms or abortion.  Many investors might be surprised to find out how many of the most widely held stocks in ESG funds contract companies in their supply chain production that use slave labor in countries like China.  Ultimately, what one person considers to be socially responsible, another may consider to be irresponsible and even offensive.

Governance

What about governance?  This is an area that seemingly makes the most sense, as there should theoretically be limited debate about the need for some basic good governance around things like proper disclosure, accounting procedures and quality controls.   However, in the wake of the recent implosion of FTX and its bankruptcy, it has come to light that FTX maintained a higher ESG score than Exxon Mobil.  FTX was at best an example of an incredibly bad lack of quality controls, and at worst a very large insolvent entity engaged in more nefarious behavior.  The latter seems to be the more likely.

John Ray, the newly appointed CEO of FTX to see it through bankruptcy proceedings recently had this to say:

“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”

The real question is how did this ESG score miss the lack of quality controls along with all of the governance problems associated with FTX?   Perhaps the score has little to do with what is actually happening within the company.

Ultimately it appears that there is quite a bit of “greenwashing” happening.  That’s a process by which companies go to a great deal of trouble to portray their actions as environmentally friendly even when they are not in order to receive a higher ESG score in order to make their stock more attractive to a rating agency.   In fact, much of these ratings seem to resemble the poor job that was done by the rating agencies around the quality of debt leading up to the 2008 financial crisis.

If there is one thing that is certain, financial institutions are more than willing to create a product offering for whatever the latest demand happens to be, regardless of whether it is logical or not.  In some cases, financial institutions create that demand artificially with fear.   If enough people are willing to buy it, they will market it and sell it.   This is not unlike annuities, where the majority of variable annuities marketing a living benefit income rider carry excessive annual costs in exchange for a guarantee that you’ll likely never realize in most cases.

In the case of ESG investment funds, fund companies charge about 40% more on average for ESG products than for traditional investment solutions according to a recent publication by the Harvard Business Review.  As an example, the Vanguard S&P 500 index is offered with an expense ratio of just 0.03%.   Vanguard also offers their ESG US Stock ETF at a cost of 0.12%.  However, the two funds have a 99.7% correlation, with the top weightings that drive the bulk of the portfolio return being nearly identical.

In 2020, the Center for Retirement Research at Boston College completed a study on the impact of ESG investing in public pensions.   What they found was that investors clearly sacrificed long term returns, endured higher expenses, and had no material impact on social change.  They also found these vehicles to be inappropriate for public pensions, since it is unlikely that all of the pension beneficiaries would hold the same ideological values.

Most importantly, as a fiduciary our job is to represent what is in our client’s best financial interest.   Personal preferences around environmental issues, social issues or religious issues are best addressed individually by contributing to causes that you personally feel are of importance, or by possibly volunteering your time to an organization that holds your values.    We are highly skeptical of not only ESG products and the way they are marketed, but also of the notion that an advisor that is building such a portfolio is actually achieving any of the stated objectives.

  Filed under: Articles
  Comments: Comments Off on ESG Investing: Is it Impactful or Reliable?