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The BS in ESG: Ratings, Greenwashing, Et Al

The Game Hasn’t Even Begun Yet

Despite all the recent press and attention that ESG investing has received, the reality is that the game hasn’t even really begun yet. From investors to companies to academics to public and private fiduciaries, all of these important players are just beginning to understand the opportunities and risks ahead for each of them. Predictably and sadly, the investment industry has adopted an evolutionary and adaptation strategy sprinkled with a whole bunch of marketing sleight of hand, grand pronouncements, and tactical opportunism. Companies are not that much better as they have responded with a similar mixture of bluster and public relations friendly doublespeak. Investors, both institutional and individual, also have not exactly been out in front either. Regulatory changes are afoot from the EU that will put a framework around ESG, but the near-term impact on the markets will probably be muted.

So, What’s Exactly Going on Here?

Looking underneath the surface, the $1.6 trillion that has flowed into ESG funds in recent years are largely the result of fund rebranding. In other words, mutual funds have just changed the names of underperforming funds or funds whose styles, sectors, or strategies that are out of favor. It’s a win/win strategy … for the mutual fund company, and it is extremely short-sighted and reactionary. This is understandable. The finance industry is reacting in the only way they know how – profit maximization, reducing marginal costs, and protecting their existing infrastructure and business models. This is called modern capitalism. It is what it is.

Laziness and the Lowest Common Denominator

We humans are lazy for the most part. This goes for all living creatures at the end of the day. We like to call it “efficiency”, but really it just means that we want the most bang for the buck – and we want to spend the least amount of bucks possible for the bang. We love upside, but not as much as we hate downside.

This is where the ESG ratings agencies come into play. An entire cottage industry has sprung up the past decade or so to service the demand for ESG investing. Theoretically, they are supposed to provide ESG insights to institutional investors and such, but their real value proposition is in creating a shorthand methodology so that they really don’t have to do the work (i.e. ESG ratings scores). We can get into how flawed these scores are at a later time but suffice it to say that it is just another example of “scalable” solutions that address business model viability and profitability rather than addressing the real underlying value proposition of what ESG investing should be about.

Fund management companies find these solutions attractive because they can just plug and play it into their existing business models. Slap “ESG” or “Sustainable” or “Green” somewhere in the title of their fund and off you go, and make sure that the ESG score of your holdings are higher than the average of the S&P 500. Oh, and make sure you insert as many phrases like “we take ESG factors into account” as possible in your prospectus. And let the marketing machine peddle it to the masses. Rinse and repeat.

We Know, We Know; We’re Being Too Harsh, But …

We know we’re being too harsh here. The vast majority of people involved in the business of ESG are well meaning and believe they are doing the right thing and pursuing win/win outcomes. Our point is that most efforts are focused on “business models” rather than focusing on what the “customers” really want or would really want if they were given other choices. We wonder if truly innovative solutions can come from existing providers given their economic, fiduciary, governance, and political constraints.

2020: The Year When ESG Really Took Off … From a PR Standpoint

We would argue that 2020 was the year that ESG really took off … mostly from a public relations standpoint. For some reason, the news coming out of Davos this year hit the public consciousness more than previous years. The headlines were driven by BlackRock, but what they said really didn’t materially differ from what they have said in previous years. No matter, we’ll take what we can get, and this PR momentum was aided on the corporate side by other pronouncements from Amazon, Microsoft, and even BP. The problem here is that the motivations for these announcements were largely PR driven (surprise, surprise), and while there is nothing inherently wrong with that, the danger is that this exacerbates the already cynical view of customers and everyday people of corporate motivations, and one could end up doing more harm than good.

Greenwashing – A Terrible Corporate Habit We Must Stop

Greenwashing is a big problem and it is probably one of the biggest threats to progress. It comes in many forms and guises, but the most egregious ESG example is what BP has announced recently. To summarize, BP’s ambition is to be a “net zero” company by 2050 or sooner. They have quantified this by saying that they will eliminate 415 million tons of carbon emissions. Sounds impressive, no? While we believe that the company believes they are being sincere, it’s like saying a drug dealer is going to sell less addictive drugs, will drive a Tesla while distributing said drugs, and will also buy carbon offsets from the profits off the suffering of his/her customers. It is difficult not to get angry at such corporate tone deafness and underlying smugness.

The Microsoft and Amazon examples are better, and more realistic and achievable. Microsoft has a goal of being net negative by 2030 and to remove all of the carbon the company has emitted since its founding by 2050. Amazon made a long-term commitment to be 100% renewable by 2030 and net zero carbon by 2040 regarding their global infrastructure, and 50% net neutral on all shipments by 2030. To state the obvious, it is much easier to be carbon friendly when one’s core business is not in selling carbon.

Global Warming is a Political, Economic, and Social Problem

The main point here is that a significant portion of the carbon savings proposed by companies comes from future carbon capture technology, which is still very much unproven. And/or there is a reliance on reforestation to offset carbon (i.e. the planting of 1 trillion trees), which while being intuitively appealing, the practical real-world impact is still very much unclear – it can actually make global warming worse! This problem is too complex to solve be pushing one arbitrary variable – for those of you who disagree, please refer to the Dunning-Kruger Effect.

So just like we humans always do, we want a quick solution. A quick diet pill to swallow that will do away with our preventable habit of overeating and not exercising. There are things we can do right now that could fix the problem. To continue the health analogy – eat in moderation, move around a bit, get off our phones and develop better social bonds with people, etc. But unfortunately, these solutions are boring, require consistent commitment, and are a buzz kill. And we humans definitely don’t like that.

ESG is Not a Diet Pill

Carrying it over to ESG, we don’t have to put profit before everything else. We can internalize externalities within the parties that create the problems, so that those assets can be more efficiently priced (i.e. stop subsidizing global oil and start “taxing” them for environmental costs that they exert on the environment and society). Citizens and employees can demand better corporate governance that can create win/win employer/employee relationships, and the capital markets can reinforce this by voting with their wallets because it knows that a better, happier workforce equals better competitive positioning and profitability.

This is not rocket surgery. But oftentimes, the obvious is not so obvious, and the need for silver bullets supersede the drudgery associated with implementing sustainable, long term habits. And when diet pills don’t work, we turn to more drastic “solutions”.

Regulation is a Definite Necessity; However, It Can’t Stand Alone

Our final point is that when things go awry, there is always the tendency to over-regulate and this is definitely going to happen in ESG to some extent. This is understandable given the lack of progress and the foot-dragging by the finance industry and corporations. However, we’re not sure that regulation is the answer as it is not an inherent motivator – it is negative enforcement, not a positive reinforcement. One will have to comply, but we’re not sure that this by itself will create a vibrant atmosphere of innovation and change.

And we’re also not sure that utilizing central bank balance sheets is the answer as well. We’ll have more on Green Quantitative Easing (QE) and other related proposed initiatives in future notes.

Overall, the good news is that change is accelerating and that the “customer” is demanding change, and this will force everyone to adapt whether they like it or not. Let’s hope this happens sooner than later because we are quickly running out of time environmentally, socially, politically, and economically.

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