Making sense of ESG investing

*This content is brought to you by Overberg Asset Management

By Carel la Cock* 

Environmental Social and Governance (ESG) investing is gathering momentum. The industry has grown from $3trn in 2010 to $17trn at the end of 2019. Last year saw $51.1bn net inflows into ESG funds in the US alone, according to Morningstar. Investors are concerned about the environment and the impact of large companies on sustainability. Large fund managers have seized the opportunity to make a difference by investing their clients’ funds for good. But are they making a difference or has ESG investing become an elaborate marketing campaign that has clients fleeced?

BlackRock, the world’s largest fund manager recently stated that “sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors.” Robert Armstrong, US financial commentator and self-proclaimed ESG naysayer states “It is true that at some point in the indefinite future, the social good and financial interests must converge. There are no investment returns at all on a planet left uninhabitable by climate change.” However, there is a timing mismatch between the time horizon for the average investor, the planning horizon of most corporations and the much longer term ESG and ultimate climate catastrophe, which is just too far out for most investment strategies to capture.

At the heart of most ESG strategies is divestment from companies seen to do harm. When an investor sells shares in the secondary market, someone else is buying them. ESG sellers might drive the price down to a point where it becomes so cheap that the market will start investing again to earn profits. Divestment from a company that does harm is not the same as boycotting its products or services. When an ESG investor decides not to buy a company’s stock in the secondary market, it has no immediate impact on the company. Eventually when enough ESG investors overlook the stock, the share price might fall, and the cost of capital will rise making it more expensive to engage in harmful projects. By the same token the cost of capital for ESG friendly companies will fall, but the flip side is that the price of the stock will rise, petri paribus, diminishing future returns for new ESG investors and with lower expected returns the profit seeking market will again invest in non-ESG firms.

For ESG funds to really make an impact by divestment it would need to be orders of magnitude bigger. The average ESG fund of $2bn is about 180,000 times smaller than overall global wealth. However, you don’t always have to be big to make a change. ExxonMobil, the oil giant, faced the proverbial David, in the form of Engine No 1, the start-up hedge fund from San Francisco named after a firehouse, when Engine No 1 nominated 3 board members in a proxy battle to force ExxonMobil to ease on its commitment to fossil fuels. Engine No 1 was ultimately successful in gaining 2 board seats with the backing of some major pension funds. The proxy battle has been a wake-up call for many other companies that are reluctant to act on climate change.

Divestment from harmful assets is not in all cases the best strategy for companies. Selling a harmful asset means someone else must buy it and there is no control in what that party does with it. Recently BHP, the world’s largest miner, was urged by Market Forces, a shareholder activist group, to run down its fossil fuel assets rather than sell them outright. The group is concerned that selling assets, such as its thermal coal mines, could lead to increased production by smaller companies with less scruples and ultimately lead to more pollution. Environmentalists have changed their views on large multinationals, because they realise that big companies can more easily align with global climate goals and eventually phase out production.

The recent global energy crisis is said to be largely due to the underinvestment in fossil fuels where capital expenditure has been falling for years. Investors in US oil and gas are demanding that capital be returned in the form of dividends rather than spent on new projects which has caused a steady fall in oil and gas supply. While green energy projects have flourished there is currently no viable solution at scale for the storage of excess green energy. Therefore, the energy mix for most countries will contain some form of fossil fuel until it is phased out in the second half of this century. This will lead to increased volatility in energy prices and price spikes for oil, gas and thermal coal. Although higher fossil fuel prices will help converge the cost between green and brown energy generation, it will also lead to superior returns for non-ESG funds.

Some view ESG investing as a distraction from what is really needed, and that is government regulation. A carbon tax for instance will make it more costly for polluting companies to operate and markets, seeking to maximise profits, will ultimately gravitate away from these firms as returns diminish. There are many companies that have embraced sustainability and they will likely prosper not because of ESG investing and their shares trading in the secondary market, but rather because these companies align with people’s values and customers want to buy their products. And therein lies the truth of the matter: as consumers and inhabitants of this planet we can all make a difference by the choices we make and how we live. Simply buying shares in the secondary market is no substitute for taking care of our natural and social environment.

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*Carel la Cock is COO and Director of Overberg Asset Management

• All writers’ opinions are their own and do not constitute investment recommendations or financial advice. Speaking to a qualified wealth and investment professional is crucial before making financial decisions.
• ‘Overberg Asset Management (Pty) Ltd. is an authorised financial services provider: 783’