Putting a “green” ESG screen over an old-line index of companies won’t achieve a truly sustainable portfolio prepared for future economic risks.
If you’re interested in a sustainability focus, or other forms of impact investing, that’s great. Personally I believe we should all consider some allocation to the solutions for our primary risks.
However, it’s not as straightforward as it may seem. Don’t be too impressed with a fund just because it purports to use ‘ESG’ – Environmental, Social, and Governance – criteria as a filter. While ESG measures can be a valuable tool, the value quickly dissipates when they are simply overlaid on backward-looking investment analysis.
Investing in a pool of legacy businesses—like fossil fuel extractors or toxic agrochemical corporations–that may possess some positive ESG factors is neither necessarily ethically responsible, nor a satisfactory strategy for long-term performance. Achieving a truly sustainable portfolio with strong long-term returns must be more than simply screening an established index and adding a green, pink, or any other color wrapper.
ESG, as generally practiced, still falls for the old trope that your portfolio has to shadow a benchmark to be considered low risk (as though risk and volatility are the same thing!). But such facile utilization of ESG rankings relies on backward-looking analysis of legacy businesses and technologies, some of which will not have much valence in the near future. If we take a closer look at which types of businesses are creating value, these winners-of-yesterday aren’t as likely to generate competitive long-term performance going forward, whatever their ESG scores may be.
My Green Alpha co-founder, Jeremy Deems, and I managed a couple of negatively screened, more-or-less typical “green” ESG funds from 2002 to 2007, prior to our founding of Green Alpha.
We found that starting with a defined universe like the S&P 500—without much opportunity to seek interesting, sustainability-driving companies outside that index—was limiting, both in terms of potential performance and achieving sustainability goals. Being given a list of stocks and told to make it greener, as opposed to looking for a growing basket of green stocks across the market, does not result in a sustainability-facing portfolio. Applying ESG criteria to an existing old-economy index is simply insufficient relative to the growth opportunities available outside of those indices, and to the scale of the risks of delaying sustainability.
So it’s not that ESG metrics aren’t valuable, but they can only have valence within the context of investing in companies that are advancing sustainability to start with. In the solar industry or sustainable agriculture, for example, ESG metrics like efficiency of water-use can assist in identifying leaders. On the other hand, relative ESG rankings within industries like fossil fuels-burning utilities or topsoil-depleting agricultural chemical companies don’t mean much, yet these firms routinely end up in ‘ESG’ labeled portfolios.
Consider the following ad, snipped from my Bloomberg Terminal:
I applaud Bloomberg for developing the advertised app, as it surely is interesting to know which fossil fuels companies are attempting to moderate their destructive behaviors, however marginally.
But no level of awareness of the relative carbon intensity of your oil and gas holdings can de-risk your portfolio from the downsides of climate change, water degradation, and premature death from pollution as well as simply not holding oil and gas securities. But this is the mindset engendered by our collective inherited paradigm: as long as I’m able to represent that I hold a relatively “good” tar sands extraction company, I can claim my portfolio is highly rated by ESG standards.
At the end of the day, a firm’s absolute performance in leading the way toward a sustainable economy is what matters, rather than its narrowly-defined, industry-relative ‘progress’ toward a vague goal.
It’s easy to simply say I don’t like the system. But I have to actually propose something else, an alternative.
To think about a portfolio, we have to think through the economy that portfolio will reflect. The global economy will only self-perpetuate and grow under certain conditions, given a first principles view of the current political-economic situation. Therefore, a sustainable, efficient, and value-creating economy must stand on four pillars:
- exclusive use of true zero-carbon, cheap renewable energies,
- waste-to-value economics to reduce and ultimately nearly eliminate our reliance on destructive resourcing of materials from primary geological and natural sources,
- ever-accelerating productivity gains, ultimately to the point where there are so many economic outputs from so few inputs that we can thrive and even grow indefinitely while shrinking the economy’s ecological footprint, and
- equitable ownership of these new means of production.
The emerging and accelerating growth of an economy built on these tenets will greatly diminish the chances of global civilization succumbing to one or more existential-level systemic risks, while simultaneously creating wealth and even abundance. We call this Next Economics, and we’ve predictably dubbed its practical application Next Economy Portfolio Theory.
Next Economy Portfolio Theory begins by positing that any company that is not contributing to the advancement of one of these four pillars, or does not have a viable and preferably exciting business model, is more likely than not a bad equity investment, especially for the long term. Why? Because any investment that doesn’t serve the de-risking of the global economy while simultaneously generating productivity and therefore wealth will, by definition, eventually self-destruct. For example, attempting to double world GDP over the next couple decades on the basis of high-carbon energy inputs will cause that economy to struggle and likely fail. For us then, avoiding investing in the causes of major problems, in preference to investing in companies driving the Next Economy, is just common sense.
Does ESG matter? Yes, but you can achieve a much more potent impact investing style by utilizing ESG only within the context of the already-sustainable economy— by simply focusing on what’s next. If the fact that the four pillars of the Next Economy serve the cause of sustainability means you equate Next Economy investing to ESG, that’s fine, but don’t imagine that ESG methods and rankings alone will get us there. It takes way more.
Green Alpha portfolios do not have any positions, long or short, in Exxon Mobil. The S&P 500 Index is an unmanaged index of 500 common stocks chosen for market size, liquidity and industry group representation. It is a market-value weighted index. Investors cannot invest directly in this index. For more information, please visit https://greenalphaadvisors.com/about-us/legal-disclaimers/