ESG Investing – Is it worth the ‘Greenium’?

ESG Investing – Is it worth the ‘Greenium’?

By Jan-Henri van den Berg

In recent years, Environment, Sustainability & Governance investing, commonly referred to as ESG investing, has taken the finance industry by storm. Public companies have shifted from solely focusing on their stock price to improving their ESG rating to remain attractive to investors, as more and more investors are looking to let their wallets speak for them. The common idea is that sustainability pioneers of today will show stronger economic performance in the future compared to those lagging behind. Higher expected returns, in combination with its immense popularity, have resulted in investors having to pay a ‘greenium’ to partake in ESG investing. At first glance, paying a premium for higher quality investments seems fair, however people within the finance industry have started questioning ESG funds’ returns and even their societal impact as a whole. In this article, I will address these criticisms to answer the simple question: ESG investing – is it worth it?

First, it is important to understand what the concept of ESG investing precisely entails. Remy Briand, managing director of the MSCI ESG research institute, defines ESG investing as “the consideration of environmental, social and governance factors alongside financial factors in the investment decision-making process.” (MSCI, 2022) Adopting such an approach may lead to investors refraining from investing in companies such as Philip Morris, due to their negative impact on society. To assist investors in determining which companies face significant risk when it comes to increasing social- and environmental regulations, stocks are given an ESG risk score. For example, MSCI’s ranking goes from CCC (laggard) to AAA (leader). These scores are often relative for the industry in which the company is active, meaning it is difficult to measure intra-industry performance.

Determining a company’s ESG score does not go without controversy. Earlier this year, Tesla CEO Elon Musk stated that ESG was a “scam” and rating agencies had “lost their integrity” after Tesla was excluded from S&P’s largest ESG index. (Jessop & Kerber, 2022) Even though S&P had its reasons to exclude Tesla, it does highlight the problem some people have with ESG scores in the form of its arbitrary nature.

Arbitrary or not, ESG investment products are taking off, and all major investment companies are capitalizing on it. BlackRock, the self-proclaimed leader when it comes to ESG investing, launched a variety of ESG funds in recent years and is currently managing the world’s largest ESG fund, with other companies such as Vanguard and S&P following suit. (Simpson & Kishan, 2021)

On the one hand, it can be argued that investment companies are simply creating the products investors demand, with BlackRock CEO Larry Fink linking ESG investing’s popularity to the shift towards a ‘shareholder democracy’ in which shareholders are actively encouraging companies to act upon climate change and social issues. (Brush, 2022) On the other hand, it should be noted that these funds are a great source of profit for investment companies, since they typically charge fees 40% higher than those for other funds, a so-called ‘greenium’. (Pucker & King, 2022)

In 2021, BlackRock’s former CIO for sustainable investing came out and said that ESG is a “dangerous placebo”, and people are being “actively misled”, implying that ESG funds and the ESG concept itself in practice do not contribute to a better world. (Armstrong, 2021) Whilst right now it is probably too early to properly assess if ESG investing has a significant positive impact, there are currently no signs to indicate this may be the case.

If performance of ESG funds is better than that of normal funds, it might still be worth the ‘greenium’. However, it seems like, as of right now, there is no reason to believe ESG funds perform considerably better. In the last five years, global ESG funds delivered an average return of 6.3% per year, whilst broader funds returned an average of 8.9%. ESG funds are also more volatile, with a strong focus on technology companies. On a more positive note, it does look like investors are more committed to ESG funds, with its losses being lower than those of other funds for last year. (White & Pam, 2022) Additionally, performance of companies undertaking considerable ESG efforts is expected to improve in the future as more investors are starting to incorporate ESG scores into their analysis. (Kenan Institute, 2022)

To conclude, ESG investing in its current state is probably not worth the ‘greenium’. That is not to say it is necessarily a mistake to partake in ESG investing, or the whole ESG concept is bad in general. The fact that companies are being judged and incentivized to act upon their sustainability efforts is a positive development, as is investors becoming more aware of the impact their investments have. With ESG funds becoming more refined and costs coming down, it will not be long before they offer a viable alternative to broader funds when it comes to profitability. Until then, it is up to investors themselves to decide whether a ‘cleaner’ portfolio is worth the lower return.

29-11-2022

 

References:

Armstrong, R. (2021, August 24). The ESG investing industry is dangerous. Financial Times. https://www.ft.com/content/ec02fd5d-e8bd-45bd-b015-a5799ae820cf

Brush, S. (2022, November 3). ESG-boosting billionaire Larry Fink sees the ‘revolution in shareholder democracy’ changing the ‘foundations of capitalism.’ Fortune. https://fortune.com/2022/11/03/esg-investing-larry-fink-blackrock-revolution-shareholder-democracy-capitalism/

Does ESG Investing Generate Higher Returns? (n.d.). kenaninstitute.unc.edu. https://kenaninstitute.unc.edu/kenan-insight/does-esg-investing-generate-higher-returns/

ESG 101: What is Environmental, Social and Governance? (n.d.). MSCI. https://www.msci.com/esg-101-what-is-esg

Pucker, K., & King, A. ESG Investing Isn’t Designed to Save the Planet. (2022, November 7). Harvard Business Review. https://hbr.org/2022/08/esg-investing-isnt-designed-to-save-the-planet

Jessop, S., & Kerber, R. (2022, May 20). Analysis: Musk’s ESG attack spotlights $35 trillion industry confusion. Reuters. https://www.reuters.com/business/sustainable-business/musks-esg-attack-spotlights-35-trillion-industry-confusion-2022-05-20/

Simpson, C., & Kishan, S. (2021, December 31). How BlackRock Made ESG the Hottest Ticket on Wall Street. Bloomberg. https://www.bloomberg.com/tosv2.html?vid=&uuid=63bddfae-6f56-11ed-9fbc77615845666b&url=L25ld3MvYXJ0aWNsZXMvMjAyMS0xMi0zMS9ob3ct
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White, N., & Pham, L. (2022, June 18). ESG Funds Resist Worst of Downturn But Investors Are Spooked. Bloomberg. https://www.bloomberg.com/news/articles/2022-06-18/esg-funds-are-losing-less-in-the-market-slump-so-far?leadSource=uverify%20wall