ESG investment strategies can see investors giving up financial returns for no societal gain. In the second of his four part review of Terrence Keeley’s Sustainable, Rupert Darwall explores the implications of investment theory for ESG artificially constraining investment opportunities; the risks of regulators worsening an already inflated ESG bubble; and the distortions that arise from the widespread adoption of sustainability as an investment concept lacking an objective definition.
Terrence Keeley’s burial of ESG commences with an acknowledgment of sin. Specifically: contrary to the ESG investment postulate that shunning so-called sin stocks is good for society and boosts investor returns, sin stock exclusion does neither. “Social activists seem impervious to one common-sense principle of finance: adequate funding is invariably found when the underlying commercial activity it supports is broadly legal and generates acceptable returns.” Academic studies evaluating investor returns show that it is often better to be “bad” than “good,” and sin shares have historically outperformed the broader market, their higher dividends benefiting investors who chose not to divest.
Because Keeley is a former advisor to some of the world’s largest foundations, his discussion of the virtue competition of leading university foundations is withering. Having declared climate change, ecological destruction, and biodiversity loss an existential threat, Cambridge University’s investment office is ending all direct and indirect investment in fossil fuels by 2030 and pursuing an investment strategy to support the transition to a carbon-neutral global economy. “Given that the volume of assets that will not follow Cambridge’s divestment strategy is so large, the direct financial impact on any company they may choose to include or exclude is statistically meaningless,” Keeley says. There was no compelling evidence or new studies suggesting higher returns from the strategy, but it does necessitate a change in the university’s investment model that implies a reduction in investment returns of £40 million ($48 million) a year. What is Cambridge getting in return for this loss of income, which, Keeley suggests, could fund research into carbon-reduction technologies or scholarships for underprivileged students? The sum of £40 million a year is an awful lot of money for a university to spend on purchasing virtue protection from its own members.
Cambridge’s decision to throw away investment returns contrasts with Stanford’s ethical investment framework, which obliges its investment managers to place proper weight on ethical issues that can have a bearing on economic results “but not to use the endowment to pursue other agendas.” Indeed, it’s hard to improve on Stanford’s approach to investment: “The businesses in our portfolio provide highly valuable goods and services to the world. We believe that well-run companies which respond to genuine consumer needs in a responsible fashion have a beneficial impact on society.” The difference between Cambridge and Stanford highlights a hard truth about ESG investment. Reflecting the dualism inherent in ESG investing, Cambridge’s commingling of investment objectives—supporting a global energy transition and investment return—sacrifices investor returns for zero societal impact beyond the mental well-being of a limited number of individuals versus the purity of Stanford’s focus on risk-adjusted investor returns.
Keeley’s evaluation of rival university investment strategies leads up to the two most important sentences in the book:
Limiting one’s income-generating opportunity set without advancing one’s values or environmental goals merits deeper reflection. It could even be self-defeating, given others with contrary views and values could profit from one’s self-imposed and strategically ineffective restrictions.
The first sentence accords with modern investment theory, which emphasizes the importance of portfolio diversification to maximize—Keeley tends to use word “optimize”—risk-adjusted returns. It forms the theoretical basis for investing in broad, index-tracking products, a theory validated by empirical data, when less than 15% of active stock managers beat a broad index over any five-year period, and is the basis of the spectacular growth of the three largest index investment managers: BlackRock, Vanguard, and State Street.
By inference, it casts as anomalous ESG index-tracking products that radically constrain portfolio diversification. These have turned out to be bets on tech rather than ESG. According to Keeley, Google owner Alphabet, Amazon, Apple, Meta, and Microsoft compose 22% of the S&P 500 but often make up 30% or more of most indexed ESG and active strategies, a bet that, until recently, paid off.
The ESG constraint also runs into a logical objection. An ESG-constrained investor cannot be better off than an unconstrained one. In principle, an unconstrained investor can replicate exactly the same portfolio as an ESG-constrained investor, whereas the latter is barred from the range of investment choices open to the unconstrained investor. As a result, the unconstrained investor will always possess an advantage, as Professors Bradford Cornell and Aswath Damodaran explain in their March 2020 paper “Valuing ESG: Doing Good or Sounding Good?”:
[T]he notion that adding an ESG constraint to investing increases expected returns is counter intuitive. After all, a constrained optimum can, at best, match an unconstrained one, and most of the time, the constraint will create a cost.
In addition to the likelihood of financial detriment to investors from pursuing exclusionary ESG policies, Keeley explores the systemic implications of ESG for financial stability from crowded trades. Does the world have upward of $120 trillion of conscientious companies and proven ESG strategies to invest in? “No, it does not.” He cautions regulators against branding an investment product as sustainable:
[T]he official designation of any investment as “sustainable” officially suggests that its value will be sustained. Official certifications like these lure investors who might otherwise be more skeptical and discerning to reposition their capital; why, after all, would any regulator encourage the public to buy something that was unsafe? But the prices of all securities and products—sustainable or not—are destined to incur volatility. When they do—not if but when—the most overvalued securities invariably fall the most.
Volatility indicates risk. Normally, it would be expected that increased disclosure, by enabling more information to be incorporated into the prices of securities, would reduce volatility. Paradoxically, this appears not to happen with sustainability and ESG disclosures. Keeley reports that researchers from the University of Oregon and Harvard Business School found that increased ESG disclosures made corporate valuations more volatile and led to greater disagreements among various ESG raters.
Why is this? Keeley suggests that these problems might recede over time; but there is a fundamental problem that time won’t cure. Sustainability (the “E” in ESG) is not an objective property of a company, unlike a credit rating, which attempts to measure a company’s ability to service and repay its debt. Neither does sustainability necessarily drive stock prices, unlike the creditworthiness of a company, enabling the accuracy of a credit rating to be observed against the market prices of a company’s debt securities.
There is a neat parallel with the labeling of organic food. Keeley recounts that it took 10 years from the passage of the Organic Foods Production Act in 1990 to finalize rules on what counted as organic. The purpose of the law, Keeley writes, was to protect organic food artisans from “organic quacks.” But, some might argue, since the concept of organic produce is nonscientific—itself derived from quackery—what counts and doesn’t count as organic is a matter of opinion that now has legal backing. Sustainability, too, is a nonscientific concept, as can be seen by reference to its origin in the report of the UN World Commission on Environment and Development, better known as the Brundtland Report, in 1987:
In essence, sustainable development is a process of change in which the exploitation of resources, the direction of investments, the orientation of technological development, and institutional change are all in harmony and enhance both current and future potential to meet human needs and aspirations.
Does it need saying that harmony and enhancing current and future human needs and aspirations permit a vast range of different, even contradictory, interpretations? Nowadays, sustainability has come to be defined almost exclusively in terms of reducing greenhouse gas emissions, principally carbon dioxide, and switching energy generation from hydrocarbons to renewable sources, principally wind and solar. In How the World Really Works, scientist and polymath Vaclav Smil notes that today’s list of what constitutes planetary boundaries is very different from what would have counted 40 years ago. Acid rain would have topped the list because “a broad consensus of the early 1980s saw it as the leading environmental problem.” (Acid rain is an example of a strong scientific consensus that turned out to be mistaken—acidification of streams and lakes was caused by changes in land use, not power-station emissions.)
Adopting 100% renewable scenarios (“essentially the academic equivalents of science fiction,” says Smil) would have global consequences for land use and mineral extraction—never mind its sheer impracticality and detriment to human welfare. There is growing evidence of the negative impacts of renewable energy on biodiversity, in what the eco-modernist Michael Shellenberger calls “wind energy’s war on nature.” The American Bird Conservancy reckons that bird deaths caused by collisions with wind turbine blades exceed 1 million annually. Wind farms are one of the leading causes of bat mortality in North America and Europe, increasing the risk of extinction of some species. A German study estimates that German wind farms kill 1,200 tons of insects a year, with knock-on detriments to insect-eating bird and bat populations higher up the food chain.
