G.R. Krahmer
Sustainable investing is becoming increasingly popular
Private individuals and large institutions are increasingly investing money in strategies that meet certain criteria in the field of Environmental, Social en Governance (ESG). This method of alternative investing is also often used Socially Responsible Investing (SRI), called sustainable or green investing. In this article I will always use the term sustainable investing for this. But how sustainable is sustainable investing actually, and perhaps not unimportantly, does it also yield results?
Building a sustainable portfolio
Building wealth with a sustainable portfolio sounds like a really good idea, and it probably feels better than it sounds. However, it would be wise to consider the following two points before implementing a sustainable strategy.
- Impact on your expected returns
- Degree to which the investment is in line with your norms/viewpoints and values
These considerations must be examined together:
If a sustainable portfolio has slightly lower expected returns, but is perfectly in line with your standards and values. You are probably quite willing to make the trade-off.
But… If a sustainable portfolio not only has lower expected returns, but is also not in line with your standards and values. Then it sounds a lot less attractive.
The underlying idea behind sustainable investing is as follows:
“ESG is based on the idea that companies are likely to achieve higher returns when they create value for their stakeholders – employees, customers, suppliers and society at large, including the environment – and not just for the company’s owners ”
What does ESG stand for?
ESG stands for Environmental, Social and Governance and represents the three factors used to measure the sustainability of an investment. ESG Criteria are a set of standards and values that help an investor to select companies that are in line with his own standards and values.
ESG Criteria
The environmental criteria examine how a company contributes to and performs on environmental challenges (e.g. waste, pollution, greenhouse gases, deforestation and climate change). The Social Criteria look at how a company treats its people (e.g. human capital management, diversity and equal opportunities, working conditions, health and safety and mis-selling) and the Governance Criteria look at how a company is run (e.g. remuneration of its executives, tax practices and strategy, corruption and bribery and broad diversity and structure). Below is a list where you can see what is taken into account.
| Environmental | Social | Governance |
| Energy consumption | Human rights | Quality of management |
| Pollution | Child and forced labor | Board independence |
| Climate change | Community engagement | Conflicts of interest |
| Waste production | Health and safety | Executive compensation |
| Natural resource preservation | Stakeholder relations | Transparency & disclosure |
| Animal welfare | Employee relations | Shareholder rights |
The problem with ESG ratings.
The heart of the problem lies in the fact that ESG ratings are often given by impartial rating companies such as MSCI. And because the rules are not clear, there is a chance that some companies may wrongly receive a high ESG score. Contrary to what many investors think, the ratings have nothing to do with companies’ responsibilities regarding the ESG factors themselves. What happens is: what they measure is the extent to which a company’s economic value is at risk due to ESG factors.
1. Potential benefit for larger companies.
ESG ratings often appear to give larger companies higher average ESG ratings. That does not mean that they are better for the environment or better for society. The fact is that larger companies simply have more resources to work on their ESG policy and then report on it.
2. Sector neutrality can influence outcomes.
Most ESG scoring methodologies have some kind of sector neutrality. This means that each sector includes all ESG scores. Even in sectors that are known to be bad for the environment – such as the oil and gas sector – some companies score high on ESG criteria. For example, a gas company can receive a high ESG score based on their policy, for example because they emit little CO2, while a gas company is clearly in conflict with sustainability.
3. Correlation between ESG rating agencies is low.
The correlation between ESG scores from different rating agencies is often limited. Research shows that the correlation between ESG scores from different rating agencies can be as low as 0.3, which clearly shows that everyone scores differently. For example, Shell can receive an average high ESG score from one rating agency, while the average score from another can be much lower. It is also possible that one ESG criterion can receive ratings in different ways.
4. Ratings are often no longer up to date.
ESG scores from traditional rating agencies may lose their relevance. A company’s current ESG score is often comparable to the score three years ago. This may be partly due to the delay in reassessments and the fact that specific ESG data points often no longer change. There is therefore a risk that it will take some time before changes in underlying ESG trends become visible in the ESG ratings. There are therefore new ESG rating agencies that focus more on timely, news-driven ESG information using new technologies. This ensures ratings that are more current.
5. There are no guidelines on how scores are determined.
Collecting high-quality, comprehensive data remains difficult. An important reason is that companies are not required to report on most types of ESG data. While companies can voluntarily provide ESG information, they are not required to do so and often do not. Extensive reporting is not required for ESG data to do, as is the case for financial information.
Not a sustainable company, but still a high ESG score?
For example, a company can emit an incredible amount of CO2, but still a reasonable amount ESG-score to get. So this is possible if the ratingfirma’s see that the polluting behavior is well managed or if this does not pose a major risk to the value of the company. It would explain why Exxon and BP, which you know are a threat to the planet, still get away with a nice average (“BBB”) score from MSCI. MSCI is one of the largest rating companies. It could also be one of the reasons why Phillip Morris (the largest cigarette and tobacco manufacturer) managed to get itself on the Dow-Jones Sustainability Index. They have launched a campaign where they are working towards a “smoke-free” future, this is possible rating agencies view as reducing risk. Even knowing that their next generation products will still be harmful and addictive.
The two ways of sustainable investing
The two most common ways of sustainable investing are:Negative screening en ESG integration.” Negative screening means that you avoid certain companies or sectors, for example because they emit too much CO2 or because they invest in the arms trade. ESG integration is more of a kind of reassessment. Instead of excluding certain sectors completely, the weight is increased for companies with higher ESG scores and for companies with lower
ESG scores the weight is reduced. There are numerous index funds and ETFs to invest in for both strategies, and there are funds that apply both strategies.
Impact of sustainable investing on expected returns
Let’s first look at the impact of sustainable investing on expected returns. The effect of ESG scores on stock returns was examined in this publication from 2019. They examined a global sample of 5972 companies in the period 2004 to 2018. They arrived at the conclusion that companies with higher ESG scores achieved lower returns on average than companies with lower ESG scores. They found that a one standard deviation decrease in the ESG score was approximately equivalent to a 0.13% increase in monthly expected returns.
But lower expected returns are not the only thing sustainable investors face. A sustainable portfolio is by definition less widely spread than the market. And a decrease in spread reduces the reliability of the expected outcome. If companies with higher ESG scores also had higher expected returns, less diversification and a less reliable outcome might still be worth it. But companies with a higher ESG score have lower expected returns. You then get a less diversified/reliable portfolio and a lower expected return. So not really a good deal.
Costs of sustainable investment funds.
Finally, we also consider the costs of investment funds. A globally diversified stock portfolio with ESG ETFs in it comes with average costs of around 0.30% per year. If we compare this with a similar portfolio to which we do not apply ESG criteria, we arrive at approximately 0.14% annual costs for the investment funds. Suppose you were to passively grow your assets with ESG ETFs, and with the same return, based on costs, you would often end up lower than if you maintained a non-sustainable portfolio.
Conclusion
So make sure that if you invest sustainably, you make the following considerations:
- Is a lower expected return worth it?
- Are you willing to pay higher costs?
- Are your norms and values actually respected by the companies in which you invest?
Are you curious about how you can passively grow your wealth by building a sustainable portfolio? Learn as an investor, among other things Avoid ESG pitfalls and get to know all the ins and outs about the possibilities of index investing.
When ESG puts profits at risk, it doesn’t provide any clear way to measure success and is just a mediocre investment. How can it be that we are all being pushed in this direction?
There are two big reasons for this:
First, ESG gives people like Larry Fink, the CEO of BlackRock, the world’s largest investment institution, a way to feel good about themselves. It’s a Get Out of Jail Free card for guilty billionaires. They take the credit in the New York Times and the rest of us are left with the bill.
Secondly, ESG ensures that a small group ‘elite people‘ has the power to tell other people how to run their business. If you don’t comply with ESG rules, it will be difficult to get that loan or investment, whether it is good or not for your company and its shareholders. This is the way to bring companies and entire economies to the &*^*! to help. Including your pension. Time to do something about it and ensure that your pension is properly arranged and protected against this ESG trend.
