Criticism of ESG has become so widespread that it has managed to unite Elon Musk, Aswath Damodaran (the ‘Dean of Valuation’) and the Economist.
While each has expressed their ire in different ways, from the provocative tweet of the billionaire and the thoughtful analysis of an academic to the multi-page special of the newspaper, the message is broadly the same: ESG is poorly defined, inconsistent in its application and makes claims that cannot be substantiated.
See also: – Green Dream with RadiantESG co-founder Kathryn McDonald
Although each of these challenges are being rigorously rebuffed by proponents of ESG, we are left with the deeper question – does it matter? Or to put it another way, do the views of ESG critics represent heresies that must be rejected to maintain our orthodoxy as ESG investors or legitimate challenges that can help ESG evolve into something more for effective for investors.
While this debate is unlikely to be solved quickly, if at all, and requires far more space than can be provided in a single article, there is one aspect of the challenge that we can explore more deeply and that is the impact of ESG risk on returns for investors.
If the critics are correct, the application of ESG research will have a neutral or negative impact on returns while the opposite is true if the proponents of ESG are more accurate. The obvious way to settle this debate is to look at the mountains of academic and practitioner research that has been written on this topic and weigh the conclusions by the rigor and quantity of the research supporting each conclusion.
However, it is important to remember that such research is inevitably backward looking and therefore ‘path dependent’. Such research is useful but is of limited use to investors who can’t access returns in the past and therefore are solely concerned about the future. This, in turn, is uncertain rather than deterministic and so must be considered probabilistically.
As we do this, we know that for most investors, future returns will be determined by the growth rate and timing of the cashflows of the investment together with the rate at which these future cashflows are discounted into the present. The former is determined by the fundamental strength of the asset, while the latter is dependent upon the sentiment of investors.
Overarching both are the risks that directly affect the asset and those that exist at a broader macro-economic level. Consequently, the higher the risk, the lower the ‘fair’ value of the asset. We also know that risk is frequently miscalculated, leading to assets that under or over-priced relative to a sober assessment of their fair value. Identifying those assets with attractive expected return relative to the risk of ownership is therefore the core of successful investing.
As regulation and consumer preferences change, ESG risk is becoming increasingly important among the risk that need to be considered and therefore a growing proportion of professional investors, including Morningstar Investment Management, are taking account of material ESG risks when estimating the fair value of the assets in which we invest.
As all risk assessments are forward looking and therefore probabilistic, it is natural that the assessment of ESG risk varies across those who are engaged in the research. Some will inevitably over-emphasize a risk while others with under-emphasize it. Even when two researchers agree, a risk may not materialize into an event that will have an impact on returns. An overly-conservative risk assessment may result in a low valuation and consequently, a higher than average return and vice versa.
When selecting dedicated ESG investment strategies or products, the key question for investors to ask is whether reduction in the ESG risk of these investments have been correctly discounted in the price? If not, then investors wishing to incorporate ESG values into their portfolios may have a lower (or higher) expected return.
While the realisation of a lower return may provoke the opprobrium or Musk et al, it is important to recognise that most valuation anomalies are temporary and likely to be reversed over time. As a result, we may enter a period when low ESG risk is under-compensated and consequently presents an opportunity for higher expected returns.
Equally it is important to consider the perspective of end investors. While lower expected returns may be unacceptable to those without strong values that they wish to express in their portfolio, it may be considered a price worth paying to those who set their values above the maximisation of financial returns. The key when helping investors make the right decisions is to be transparent about the potential trade-offs and the inevitable cyclicality of capital markets.
In contrast, adopting a dogmatic approach that sees all challenges as heresy tends to lead to division and conflict. Open-minded engagement is more likely to benefit both advisers and the wider community.
