Bayesian Investor Blog

The ESG investing movement (environmental, social, and corporate governance) is becoming potentially important, potentially good, and potentially corrupt.

I’ll walk through some of the sources of influence on it.

Epistemic status: I have a fair amount of expertise in some related areas of investing, and modest expertise in evaluating charities, but I’m clearly an amateur at understanding what the ESG movement is doing.

Altruism

Companies that focus solely on maximizing profit tend not to be perfectly aligned with what most people want.

The clearest examples are externalities such as pollution. If we replace the goal of maximizing profits with the goals of wise technocrats, we’ll accomplish a much richer set of desiderata, potentially getting closer to having corporate goals aligned with human desires.

Other approaches to handling pollution (e.g. governments, charities) have demonstrated a less than optimal ability to solve the problems. That’s a coherent explanation of why ESG investors want to discriminate against polluters when deciding which stocks to buy.

The ESG movement has branched out to broader goals such as ensuring that companies are good places to work, promoting and discouraging innovation, promoting ideological diversity, stopping gain-of-function research, or helping people achieve a good afterlife. [Just kidding – ESG investors likely don’t think they’re powerful enough to achieve the last two, and they likely want to reduce ideological diversity.]

Do those broader goals make as much sense as a focus on pollution? There are some externalities involved in many of those goals. But economists mostly say that workers have better incentives than money managers to evaluate working conditions, and to influence them via quitting or striking.

I suspect the ESG movement reflects beliefs that workers have little power, and that money managers would have lots of power if they weren’t constrained to maximize profits. That presumes that money managers care about workers, or can be pressured into acting as if they do. I only buy very weak versions of these claims.

But why would money managers do social good that governments neglect? The most plausible answers seem to be something like: democracy is broken, and needs to be partly replaced by technocracy. I.e. something that’s not popular enough to be explicitly endorsed.

Minimizing Money Manager Blame

It’s hard to manage money for something like a pension fund, trust fund, or mutual fund. If you just buy a typical set of index funds, sit back, and relax, it’s hard to justify a full-time salary, and hard to take pride in your work. But if you do anything different you’ll be blamed for losses, with much less hope of rewards for successes. Money managers are much more likely to lose their jobs for underperforming in unusual ways than for following the crowd.

It might not be a coincidence that ESG investing became popular around the time that solar energy and electric vehicles became competitive with fossil fuels. That’s when I’d expect money managers to want to reduce their exposure to fossil fuel companies, in hopes of beating the market by avoiding an industry that’s in decline. But standard procedure says that kind of bet is risky. Who knows whether a war will cut off oil supplies, giving oil companies one last hurrah?

Under ESG, money managers have more than one metric to choose from when defending their track record. If they didn’t make money for their clients, they can point to what they did to protect clients from climate change, reduce exploitation of workers, or make the US less corrupt. One of these is likely to be true, if only by chance.

Signaling Ideological Affiliation

I’m unsure what ideology is most popular among money managers, but I’m pretty sure that the right-of-center managers tend to oppose ESG investing (possibly for ideological reasons), and that the ESG movement represents a left-of-center subset of money managers.

So we shouldn’t be very surprised to see Tesla booted from an ESG index after Musk announced plans to enable types of speech that Silicon Valley wants to ban.

This signaling could result from a desire to impose an ideology on the world. But I expect it’s more commonly defensive, the result of fear that one will be canceled, maybe as a firm, maybe as an individual within a firm, or maybe from social events unrelated to one’s job.

I see the phrase “ESG risk” somewhat often. This is one reason why I suspect that ESG tends to focus on defense against political risks.

Protecting Large Companies

Preparing an adequate ESG report requires a nontrivial amount of manpower. A company the size of Microsoft or General Motors can better afford to employ several people full-time on such a project than can a 50-person company. Small businesses occasionally complain about this.

I’m unclear on whether this provides a significant benefit to big business. But even a small benefit could be enough to prompt big businesses to cooperate with the creation of a complex bureaucracy.

This sure looks like a natural consequence of what the ESG movement is aiming for. Yet it bears little resemblance to anything that movement would endorse.

Power Grabs

Some people want more control over other people. There will be people who gain such power through the ESG movement.

Implementation Problems

I expected to find some messy problems with how ESG scores are implemented. E.g. Dropbox wastes electricity by using more CPU time on my computer than I want it to. Documenting that effect for an ESG report would seem to require something unusual – should Dropbox try to determine how often they’re responsible for causing my system’s fan to run?

The actual problems I found were a bit more basic than this.

Wikipedia suggests that Newsweek’s list of responsible companies is a leading example of ESG scores. So I’ll try to evaluate whether those scores do what I’d want.

Most of the companies near the top of the list are ones I’d have guessed are pretty average in terms of responsibility.

The first two exceptions that stood out to me were that Schlumberger (oil driller) at #28 is above the highest ranked solar company (First Solar, #98).

Lithium mining seems critical to replacing fossil fuels, yet the top lithium miner (Albemarle) is even lower (#171). Even lower on the list we find GrafTech International, which plays an important role in moving the steel industry away from coal, and toward using electricity to recycle steel.

Those are not the patterns I’d expect from a movement that gave high priority to phasing out fossil fuels. Maybe they’re doing something valuable by pressuring each company to do its fair share. But they’re at the very least neglecting some low-hanging fruit by not focusing more on shifting capital allocations to the most socially valuable industries.

Wait a minute – maybe they’re counting on greedier investors such as myself to do that? I’m currently invested somewhat heavily in solar and lithium stocks. Maybe they’re assuming that normal market forces will produce the socially optimal result here. But I don’t see why that’s more true here than with other aspects of global warming.

Biogen, at #11, is widely remembered for its failed attempt to drive Medicare to near-bankruptcy by charging $56000 per patient-year for an ineffective Alzheimer’s drug. Maybe that’s not harmful enough to outweigh the good things Biogen does. Or maybe Newsweek is slow to incorporate new evidence.

Methodology

Now I’ll dig down into Newsweek’s methodology.

30% of the score comes from public opinion surveys of the company’s reputation. I’m not optimistic about the quality of this evidence.

I’m guessing that when the public knows a good deal about a company, it scores worse than an unknown company, due to negative features being more salient. E.g. Schlumberger likely gets a rather neutral rating because it doesn’t interact with individual consumers or make much news. Whereas Walmart is highly remembered for competing with smaller stores and helping Chinese workers to compete with US workers. Fewer people are likely to recall that Walmart provided relief to Katrina victims faster than the government did.

The other 70% of score is generated via about 32 indicators, each of which appears to get approximately equal weight. They clearly try to weight the E,S, and G subscores equally, although beyond that the weighting is less clear.

If Uber saved 100 lives per year by reducing drunk driving, would it get a different ESG score than if it saved 10 lives per year? If it gets included in “Examples of social projects in CSR-report”, that’s a “yes/no” indicator, so I guess it ignores the magnitude of the benefits. It almost fits under “Human rights policy”, which is also a “yes/no” indicator. Or maybe it doesn’t belong in an ESG score because Uber is doing it out of normal greed?

In sum, Newsweek’s ESG ratings seem to be an attempt to get companies to meet some minimum standard. They seem uninterested in an Effective Altruist approach of identifying the most socially valuable companies and directing more resources toward them (i.e. reflecting the likelihood that there’s a much larger difference between the most socially valuable companies and the average, compared to the difference between the average and the worst).

I’ll comment on a few of Newsweek’s indicators:

Commitment to Science Based Targets initiative (SBTi)
This seems to refer to an organization that oversees corporate emission reduction plans.

They say that one of the benefits is “improves investor confidence”. But I don’t see anything there that looks like an attempt to give me as an investor confidence.

They require plans that supposedly will add up to what’s needed to limit warming to 1.5 degrees C. I’m pretty sure there’s some science involved in some of the steps. I’m pretty sure there’s also some politics involved in setting targets.

E.g. they list examples of company targets. Could a purely scientific process tell us that Proctor and Gamble should target a 30% reduction in scope 1 and 2 emissions by 2020, and Kellogg should target a 20% reduction in scope 3 emissions by 2030? I suspect those involve some feasibility guesses which fall outside standard notions of science.

Does this indicator reward companies for starting with high emissions? They seem to imply that a company would score low on this indicator if by the baseline year it had already done all feasible emission reductions. (Newsweek does have another indicator which likely offsets any such effect).

On a related note about a different ESG index: Tesla was removed from the S&P 500 ESG Index in part due to “Tesla’s (lack of) low carbon strategy”. There’s something wrong with S&P’s measurement if Tesla’s strategy of increasing its sales doesn’t put it in the top 5% of companies for reducing global carbon emissions.

Financial Stability, as measured by the Piotroski F-Score Test. That’s a respectable test if you’re constructing a risk-averse portfolio. I devote a small portion of my portfolio to investing based on a slightly modified version of that. But penalizing companies with a low F-Score amounts to taking a stand against disruptive (but not very stable) companies such as Moderna, Lyft, Canadian Solar, Beyond Meat, etc., which seems to conflict with the common perception of responsible investing.

Innovation, measured by “R&D expenses / revenue”. So Aurora Innovation (self-driving truck software), which had no revenues in 2020, would have scored as infinitely innovative? Maybe Newsweek isn’t being as transparent as I’d want about their methods. But that’s an odd conclusion to reach about a report which, on the same page, describes evaluating companies on their disclosure and transparency. Twitter appears to score higher than Moderna on this innovation measure, even though I suspect that Twitter’s innovation typically increases harm to society. But I suspect this measure is pretty good on average, both at increasing investors’ returns and at doing social good. It certainly offsets some of the downsides of promoting financial stability.

Average volunteer hours per employee. It’s easy to imagine situations where increasing that is bad for society. Would I want a Moderna employee to volunteer at a soup kitchen in 2020? Absolutely not! Delaying vaccine availability by a day would cause deaths that won’t be outweighed by volunteer activity.

Is volunteering at a botanical garden better for society than putting an extra hour of high quality work at an ordinary job? I’m guessing yes, but by such as tiny amount that I’m unwilling to sacrifice any of my investment returns for it.

Volunteers don’t have a great track record at figuring out whether they’re being helpful. I expect this becomes a bigger problem if an employer pressures people to “volunteer”.

This indicator looks like a classic example of ineffective altruism.

Average training hours per employee. What does this tell me? Is more training time evidence that the employer is improving employees more? That the training is less efficient? That the job is unnecessarily complex? That a large fraction of employees were hired recently? Or that the employer hires applicants who need more training than average?

Effects on Investment Returns

If ESG investing were purely altruistic, then there would be money to be made by investing in non-ESG stocks.

But some of what ESG investing does is inform investors of political risks. Maybe some of the diversity stuff corrects hiring patterns that were hurting profits (I see conflicting evidence; maybe sexual discrimination used to hurt profits, but stopped doing so in the past decade?). These effects ought to cause ESG stocks to outperform.

Neither of these two opposing forces seems strong enough to tempt me to make any simple bets on how ESG index funds will perform.

I suspect there’s good money to be made by buying companies that are unfairly treated by ESG scores.

But it looks hard. I can see signs that Tesla’s been kicked out of an ESG index for mediocre reasons, but only because it got a lot of publicity. Highly publicized news is generally evaluated efficiently enough by markets that my time is better spent elsewhere. The best investments are ones that are being neglected. Whereas Tesla looks like it was inflated 6 months ago due to non-ESG hype about Tesla’s environmental worthiness.

I’ve already been investing in the solar and lithium stocks that may have been inadequately supported by ESG scores, so I see nothing new here to do in response to ESG scores.

I plan to try giving a slight preference to companies that don’t have any ESG rating. That’s likely to be almost equivalent to investing based on the small minus big factor, so I expect it to make little difference.

The social component of the ESG score looks like it has a little potential to be something worth betting against, but it’s likely mostly noise. Most likely I’ll make a few cautious bets of this kind, and then decide it’s not worth the effort.

Regulation?

Could SEC regulations make ESG ratings more aligned with the public good, by preventing investors from being misled by greenwashing?

The SEC has a track record of stopping some types of misinformation, at the cost of reducing the availability of valuable information. So the value of regulating ESG ratings depends heavily on guesses about whether ESG is valuable or a scam.

I’m mildly optimistic that the SEC can provide some benefits by preventing misleading claims about greenhouse gas emissions, verifying that carbon offsets don’t count changes that would have happened anyway, and verifying that companies use the politically correct definitions of “women” and “minorities” in quantifying their board’s diversity.

For measuring how companies treat employees, it’s unclear how regulation could make an ESG rating as valuable as a Glassdoor rating. And SEC regulation of what should count as “volunteer hours” seems guaranteed to generate more costs than benefits.

What about this scenario: a money manager makes vague claims about using ESG ratings to construct a portfolio, leading clients to imagine that the portfolio has stocks with high ESG ratings. The actual algorithm that’s used selects stocks with low ESG ratings, in hopes of profiting from a contrarian strategy. It seems like the SEC ought to be able to handle this risk at little cost. But I wouldn’t be shocked if rules about this generated a side-effect of locking in one narrowly defined approach for how to translate ESG ratings to stock picks.

There are lots of minor issues that would benefit from SEC standardization, e.g. if a board member changes their identity from cis-woman to trans-man, how promptly does the change need to be reported? (I think some rating systems would report that as a decrease in diversity if the person was already classified as a minority).

Should the SEC ask ESG rating agencies to measure how well ratings protect money managers from clients who want better performance, or from Twitter mobs? Doing so would likely defeat those manager’s goals in using ESG ratings. That might be a good result.

I presume the SEC shouldn’t require anyone to report how well ESG ratings generate warm fuzzies (I ignored warm fuzzies so far in the post because they don’t seem to affect how ESG is implemented).

Conclusion

There’s little reason to expect either large benefits or large harm from ESG investing. The most likely result is mediocre bureaucracy.

The goals that it serves will be a complex mix of money manager interests, the public good, and interests of big companies.

Investors who can devote a fair amount of thought to altruistic investing are likely to be more effective than ESG investors.

I suspect there’s a bit of low-hanging fruit in reviewing the available ESG rating systems, to shift a bit of influence away from the worst and toward the best. I’m unsure whether I’ll get around to writing such a review.