Podcast Tom Gosling / Alex Edmans: Does ESG Investing Work? How?

I did a recent series of posts summarizing the key insights from the podcast "Grow the Pie - Does ESG Investing Work? How?" with Tom Gosling and Alex Edmans, available here:

Podcast: Does ESG Investing Work? How?

Below you'll also find all the insights from my posts listed in one handy document.

Effectively this is a 50-minute summary of where we - academics and practitioners - have gotten to in terms of understanding what "works" in ESG. And what doesn't.

In the podcast Tom & Alex provide loads of detail & background, and cite many of the academic papers that these insights are derived from. Essential listening for any ESG practitioner or people who want to become one!

Also, this is highly aligned with my own 1-slide overview of What's Working in ESG and What’s Not:

Divestment

- Best way to practice ESG investing: not to create red lines you can’t cross, but to broaden the information to make more informed investment decisions.

- Even if your goal is non-financial you still don't want to completely exclude fossil fuel companies because to engage you need to have a seat at the table.

2 types of divestment:

(1) Blanket: completely exclude an industry; can only work if you’re changing the cost of capital–if companies need to raise more money they can’t raise as much. Not a powerful channel because e.g. oil companies are flush with cash. And plenty of other investors willing to hold the stock.

(2) Tilting: underweighting a sector, holding companies that are best in class. That’s powerful even if the company doesn't want to raise capital; the CEO cares about the stock price; has incentives to be best-in-class. More likely to effect change in a company.

Engagement / “activism”

- Could be for 2 reasons: (1) believe it increases long term value of your shares, or (2) non-financial objectives–you want companies to deliver not only financial but also social performance.

- Two types of engagement:

(1) Generalized: take an issue and apply across a large number of companies - don’t need to tailor it to a company specifically. Limitations to this approach because it might be that an ESG issue, e.g. carbon footprint, should not be rolled out to each company because for some it might be more a distraction than something central.

(2) Specialized: bottom-up, tailored to specifics of a company.

- There’s evidence when an activist engages with one company in an industry there are spillover effects on the behavior of others in that industry.

Impact

- It’s really difficult for public markets investors to have impact. When trading shares you don’t actually provide a company with new capital.

- The real way for an investor to have impact is to engage with companies but does require either a large company stake to be able to undertake specialized engagement or to undertake generalized engagement, but be clear there’s evidence that this form of generalized engagement improves performance.

- Evidence shows that activism creates value for shareholders and society in a number of cases.

Materiality / Link ESG-performance / ESG priced in?

- The importance of materiality: ESG issues are only linked to long-term performance if they’re material for that company’s business model. E.g. climate change is not important for every company-you don’t always want to look at a company’s carbon footprint or climate impact because it might not be material.

- A blanket statement “ESG always pays off” is as misleading as saying “Food is good for you” – it depends on the type of food. To make claims like that is attractive because clients will be willing to invest in ESG funds that are typically more expensive. This is where regulators should step in to scrutinize ESG claims.

- The evidence is much more favorable on the G than the E&S, even if the E&S get all the attention. Stronger shareholder rights, board independence & size and overboarding find links to shareholder value.

Stronger shareholder rights, board independence & size and overboarding find links to shareholder value.

- The S is more mixed. But companies that treat workers well do better in the long term.

- In some cases material factors will become recognized by the market and get priced in. It’s plausible that for a number of ESG issues we’ve gone through a period where investors have started taking notice of these issues they previously ignored, but then subsequently they've become fully priced in and so won’t lead to outperformance in the future.

- Not all ESG factors have been priced into the market; because people are focusing on the wrong ESG dimensions (possibly because popular but not rigorous research saying we should consider e.g. pay ratios or employee turnover and not the more fundamental dimensions) or because they're not as easy to implement as the factors that ESG people are trumpeting.

- Much outperformance attributed to ESG is with companies that score high on ESG but also have other factors that have done well; once you take that into account the ESG outperformance goes away.

- We still need to take valuation into account: if ESG matters it must matter in terms of affecting valuation. E.g. maybe a company has great employee satisfaction but might already be priced in, so we need to look at the current valuation.

- When we want to integrate ESG we need to integrate it alongside financial factors rather than looking at it in isolation.

When we want to integrate ESG we need to integrate it alongside financial factors rather than looking at it in isolation.

Biases & Motives

- It’s important to highlight the biases which lead to some of the misleading claims that are often made today, such as "ESG always pays off":

(1) Confirmation bias, where people have a preconceived idea of ESG and therefore will be inclined to believe any study that confirms ESG pays off. However, we should assess studies not by whether we like the conclusion but by the rigor of the methodology.

(2) Black or white thinking: we like to classify things as being either good or bad.

- Some investors might take ESG factors into account even if they’re not material and if they’re not going to lead to financial performance. Why might they do that?

(1) Objectives: the challenge with ESG is that some investors might have non-financial motives.

(2) Ignorance – there are so many claims ESG always pay off and there's confirmation bias – some investors want to improve returns but use immaterial factors because they believe the research.

(3) Commercial: the goal for some is not to maximize shareholder value but to maximize fund flows.

(4) Client demand: some investors engage on these issues because clients care about them.

ESG Bubble?

 - We could get into an ESG bubble, just like previously we got into a tech bubble. If people think ESG will always lead to outperformance they could be piling into companies in order to improve their ESG scores and that could lead to them overpricing companies that do well on certain ESG metrics. Indeed there is a paper showing that after Morningstar introduced sustainability ratings certain funds started buying into high-ESG companies to improve their ratings and that led to those companies becoming overpriced.

ESG, Cost of Capital & Performance

- The return you get as shareholder is the cost of capital to the company - these things are two sides of the same coin. And so if ESG is good for the shareholder it’s probably not actually good for the company and vice versa.

- If ESG people pile into your stock, you can offer them lower returns; if that is the case then an ESG strategy gives you lower returns, in contrast to the common claim that ESG leads to outperformance.