ESG and Tradeoffs

Cliff Asness has the class piece on how ESG might sort of impact corporate decision making when it comes to climate change in “Virtue Is its Own Reward: Or, One Man’s Ceiling Is Another Man’s Floor.” Negative screening is not a free lunch. “Accepting a lower expected return is not just an unfortunate ancillary consequence to ESG investing, it’s precisely the point.” Higher returns for non-ESG investors are the other side of a high cost of capital for offending firms.

Matt Levine expands on the idea in a discussion of how a fund manager was coached by his sales team to answer questions about how a new ESG fund actually reduced emissions.

The first paragraph hits the same notes as the above summary. The second paragraph is a good admonishment of green washing of ESG investing that asks for no tradeoffs.

One is the answer [to how an ESG strategy reduces emissions] that Fancy gave to his client: “This low-carbon fund reduces emissions by raising the cost of capital of high-carbon emitters, leading them to shift to lower-emissions businesses.” This is an appealing theory because it makes some rough sense as a matter of economics. It has problems though. For one thing, you have to have a lot of low-carbon funds to meaningfully increase the cost of capital of high-emissions businesses; it’s not like any one fund manager — even at BlackRock — can point to coal companies that he put out of business just by refusing to buy their stock. For another thing, “raising the cost of capital of high-carbon emitters” means increasing the returns on their stocks, which implicitly means ”our ESG fund will get a lower return than a non-ESG fund, because we hope to raise the returns of non-ESG stocks.” This answers the client’s question — ”how does this fund reduce emissions?” — but not necessarily in the way that the client wants to hear: “We reduce emissions by giving you a lower return on your investments.” You can see why the salesman might have been mad.

The other theory is: “This low-carbon fund profits from the coming long-term shift to clean energy, giving it a higher return than funds that foolishly invest in fossil-fuel assets that will be stranded when regulations and societal norms change.” That tells the client a good story — “you can do good and make money too” — but, you’ll notice, doesn’t answer the question. “How does this fund reduce emissions?” “It profits when governments move faster than expected to regulate emissions.” “Yes but how does the fund cause that to happen?” It doesn’t, really.

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