By Garvin Jabusch, CIO
It seems simple: invest for capital preservation and growth, and also to have impact on an issue you care about. But in practice, this is difficult for individual investors and professionals alike, because there are as many definitions of impact as there are practitioners. Further, because most equities strategies work to mimic the returns of the business-as-usual economy (BAU), their ability to differ from that economy in meaningful ways is limited. So, most stock investing strategies end up having little, if any, impact on the economy or world as we know it.
Environmental, social, and governance (“ESG”) criteria exist, but they’re used primarily to make marginal improvements to business-as-usual portfolios. They do this by peer-ranking companies within each industry from bad to better, say, from “less green” to “more green” and are used as an overlay on legacy economy portfolios. For example, in a large-cap, U.S. strategy, what you get is the S&P 500 Index with some objectionable companies removed, yet it is more-or-less the same approach that non-ESG portfolio managers use. ESG works for corporate ranking/sorting, but is insufficient for meaningfully addressing the climate crisis. Unsustainable activities cannot be done sustainably, so the ESG practice of intra-industry ranking from poor ESG to great ESG is misleading in that it can give the impression that there are sustainable companies within unsustainable industries. The climate crisis, though, isn’t grading on a curve.
ESG is good, but insufficient
So, we argue that an ESG overlay on a BAU portfolio is insufficient. “As opposed to what?” you may ask. “Indexing is the best way to invest, so we are well served by greening up that idea around the edges.” Well, as opposed to the more direct capital allocation absolutism the climate response requires.
The processes that are causing the climate crisis are built into the world economy, which in turn is composed of the industries receiving the largest investments. If you get the economy you invest in (you do), the direction of change needs to be an explicit conversation; the economy is evolving, but the direction of that evolution depends on where the money flows. For all the world’s efforts, we are headed for climate catastrophe, and so far no one has done enough to avert it, investors included. ESG has been complicit in this failure.
Climate has emerged as bar none the most important risk in asset management, and so, the main threat to investments today is owning positions in the causes of the climate crisis. Similarly, de-risking a portfolio means not owning these key threats to economic stability. Asset management, including ESG-based managers, need to stop signaling that things like natural gas exploration and internal combustion cars are okay. When you’re managing risk, you must both contain the cause of the risk and do whatever you can to get to the fix; a BAU index fund – even with an ESG overlay – does neither with respect to the climate crisis.
To put it bluntly: there exists an objective right and an objective wrong way to define, and therefore to invest in, sustainability. Science, more than the conventional wisdom of indexing, is our main path to knowledge and science tells us that carbon-exposed industries like internal combustion engine manufacture must rapidly shrink even if some of the companies in those industries have high ESG scores. ESG’s relativism is; therefore, a nonstarter.
Therefore, rather than investing via tinkering with the business-as-usual, legacy economy with often ill-defined criteria, we need to redefine our conceptions about how investing should work, and we can only begin that process by beginning at the highest conceptual level. Ask, what are our potential economic endgames? Do we arrive at a place where indefinite stability of economy and climate are possible, or do we face some form of large-scale collapse? Knowing which we prefer, how do we invest for that?
How to have impact
The first step towards meaningful impact investing then is more rigorous, basic-principles derived equity strategies designed with the end game of sustainability in mind.
Yet, how do we know what criteria we should apply, and how do we weigh one value against another? To use hedge fund speak, the “winning factor” is clear: figure out what will enable the global economic production function to work indefinitely and phenomenally well, without overtopping planetary tolerances; then, own as much intellectual property and production capacity related to enabling that economy as possible. Or, more simply: avoid economic risks of climate disruption and benefit from the proliferation of solutions.
To do this, we must judge individual firms on their merits, as opposed to falling back on the ease of index-tracking. We can use disinterested, objective principles to make better choices. Rather than check an ESG score, we can analyze sources of revenue: is a firm paid to de-risk the global economy or is it paid to add to systemic risks? Companies increasing global risk won’t have long-term value, and no, portfolio theory’s qualms about portfolio diversification requiring fossil fuels and other carbon-exposed industries don’t matter now.
One may be uncomfortable with this level of absolutism, yet the goals of an indefinitely thriving economy and biosphere are of historic importance for our civilization, and they will bring an incalculable amount of good into our world, to say nothing of returns to its owners.
If we are building principles for sustainable investing, we need approaches which are designed to resist human error, to resist the human tendency for self-deception, and to resist our “us vs. them” tribal thinking. We can now see that against our most dangerous threats, there is just one large “us.” So, we need a doctrine we (the large “us”) can believe in, that provides a foundation for a unified approach for investing in real and indefinite economic and environmental sustainability. Markets are created by people. We get to decide what those markets look like.
How can we actualize a de-risked economy? We can invest in a de-risked economy and thereby send the unambiguous signal that only the fixes have value.
Which comes down to stock selection. Green Alpha’s methodology revolves around evaluating what a company physically does. What are its aggregate contributions to indefinite sustainability? Is a company in aggregate being paid to de-risk the global economy, or is it being paid to raise our already-dangerous risk profile? ESG scores aren’t a reliable way to get at that; rather, the clearest line of sight is simply to look at sources of revenues. If a company’s net activities do not create a better world on an ongoing basis, one should not own it. Owning the causes of our problems is not the future, it’s not where forward returns will come from, and it is certainly not impact. The world now has the means to mitigate climate disruption and investing in these means will drive investment performance as innovators gain market share from legacy predecessors.
Technology is evolving faster than our perceptions of the economy and so we need to update our prior assumptions about how things can and should work, and then invest with that new understanding in mind. Worldwide economic production will become much greater than it is today, with far fewer inputs – be those inputs natural resources, person hours or dollars – and with far fewer externalities like greenhouse gasses and other pollution. This of course will create enormous wealth for investors and other owners and will also put us on the path to indefinite sustainability, meaning a good standard of living for everyone – the 100% – without overtopping earth’s tolerances. If capitalism is going to prove it still works, it’s going to have to meet this challenge.
But this is so contrary to conventional wisdom!
Some have argued that Green Alpha’s approach effectively means economics must redefine the principles of growth. Fine: If a new means of production isn’t advancing decarbonization, electrification, digitalization and/or dematerialization, or equity among the people, it isn’t likely to grow or to exhibit significant value as we confront our planetary crises. Money, markets, and finance are about the only power with global agency; treaties, agreements, accords and international law have proven their inadequacies. Given the level of global coordination needed to rise to our challenges, it really is up to we the investors to make it happen.
And making it happen should be our endgame. What endgame? Realizing a zero-risk economy. That truly would be investing with impact.
Nothing in this publication should be construed to be individualized investment, tax, or other personalized financial advice. Please read additional important disclosures here: https://greenalphaadvisors.com/about-us/legal-disclaimers/