ESG’s role in never-ending quest for alpha (2024)

The ESG movement is indeed “facing a mountain of troubles” as Aswath Damodaran highlights in his recent Financial Times opinion piece entitled "ESG Is Beyond Redemption: May it RIP". While we agree on the presence of troubles, his piece, rather than the ESG movement, strikes me as “born in sanctimony nurtured with hypocrisy and sold with sophistry.” In an effort to correct the record with better substantiated claims I offer the following alternative account of the rise, fall and consolidation of the ESG movement, a condensed version of which was published as a letter in the Financial Times .

The ESG movement, as detailed by University of Pennsylvania Carey Law School ProfessorElizabeth Pollman, started as part of an effort by the United Nations to reach out to business and, in particular, finance. The term was coined in a report cosigned by 18 financial institutions with $6 Trillion of AUM. ESG factors were incorporated in investment decisions by asset managers who sought “stronger and more resilient financial markets” that would “contribute to shareholder value creation.”

As Pollman further highlights, it is true that ESGmarket participants have been opportunistic with the application of and arguments for ESG investing in their quest for investment dollars and legitimacy.

Increased investment in ESG factors cannot always generate value but may do so under some conditions.

• In the same manner as a growing body of research highlights the potential returns ofshareholder activism that alters management practices or firms’ allocation of capital across uses with higher or lower returns, ESG activism or engagement can similarly improve returns and reduce risk. Consider Engine No. 1 's engagement with ExxonMobil which led investors to reassess the link between that company’s shareprice underperformance and its pattern of aggressive spending on fossil fuels which delivered negative returns on invested capital. Higher profits and lower risks can obtain where the relationship between certain ESG factors and long-term performance is incompletely understood, and expensive to discern. It may be uncovered first by an investor or internally by management. In either case, strategic or leadership change that better allocates capital to address ESG risks and opportunities can improve future performance and reduce risk.
• In the same manner as investors seek to constrain their investment universe against incompetent CEOs or Boards or companies who poorly incentivize their workers (i.e., seek to identify a quality factor), constraining investments to avoid companies destroying value through inattentiveness to ESG factors can be value enhancing. The challenge remains that, like managerial competence or incentives, we struggle to measure ESG performance. Furthermore, ESG tilts will overperform under some market conditions and underperform in others. That does not imply, however, that we should abandon efforts to improve the measurement of ESG performance or pass regulatory prohibitions on doing so. Dan Garrett 's research demonstrates that such restrictions on investment practices destroy value.
• The material risks and opportunities associated with climate change are increasingly evident and priced in markets. Research by Ben Keys shows the impact on Florida real estate markets. A series of papers highlight that increasing disclosure of pollution causes firms to reduce their negative externalities (at a cost to shareholders). Firms with higher carbon intensity pay a carbon risk premium especially when beliefs on climate shift among investors. Investments in the climate transition are associated with jobs and green patents that are rewarded by investors. As a result, we are not as dependent on fossil fuels as we were a decade or two ago. The share of energy generated globally by renewable energy has soared and is expected to continue to rise according to theInternational Energy Agency (2023).

Where we differ most fundamentally, is in our conclusion. He claims that his error prone depiction of ESG is beyond redemption. I see the ESG movement as navigating a shakeout in which virtue claiming, greenwash and hype slowly begin to lose out to the effort to add ESG factors to the playbook of activism, engagement, portfolio construction and factor models. ESG investing will never consistently outperform the market any more than any investment strategy or criteria can. However, ESG factors will increasingly be a central element of the toolkit that we use in training the investors and professors of the future and that they use in the never-ending quest for alpha. This incorporation will generate some extremely profitable trading opportunities for some investors and losses for others with the effect of increasing the efficiency in the long-term allocation of capital.