In Defence of ESG: Why the 'Dean of Valuation' Might Be Missing the Mark

In Defense of ESG: A Balanced Perspective on Aswath Damodran's FT Article

Our favourite Aswath Damodaran , a prominent finance professor at New York University Stern School of Business and holds Kerschner Family Chair in Finance Education is of Indian origin, recently shared his thoughts on why ESG (Environmental, Social, and Governance) factor investing should come to an end in the Financial Times. You can read his article here: ESG is beyond redemption: may it RIP.

In this article, I aim to summarize his key arguments and provide a counterpoint for those who ardently support long-term value creation. Damodran contends that ESG is beyond redemption and should be abandoned, primarily based on three main points:

1. ESG's Lack of a Concrete Definition

Damodran rightly highlights the evolving nature of ESG goals and their sometimes vague definitions. He points out that ESG scores attempt to measure everything, and as a result, may end up measuring nothing effectively. He supports this argument by noting that ESG scores are used to evaluate companies across diverse industries, from fossil fuels to technology. This suggests that ESG scores might not provide a comprehensive assessment of a company's overall performance.

2. ESG Investing and Financial Returns

The author's second argument revolves around the notion that ESG investing doesn't necessarily lead to higher returns and might even lead to lower returns. He asserts that ESG investing can encourage companies to make decisions that don't align with the best interests of their shareholders. There is evidence indicating that ESG investing has shown a negative impact on stock returns, challenging its role in maximizing profits.

3. Uneven Application of ESG Pressures and Unintended Consequences

Damodran's third point is that ESG pressures are not evenly applied and have resulted in unintended consequences, such as an increased reliance on fossil fuels. He raises concerns about the impact of ESG on society, particularly its role in companies divesting from fossil fuels, which, he claims, has paradoxically increased our dependence on them. He supports this by highlighting the continuing rise in global carbon emissions despite significant investments in ESG funds.

Although these arguments are evidence-based, we cannot disregard other critical facts that could lead to divergent interpretations.

Now, let's explore the other side of this story, which offers a perspective that complements Damodran's argument to establish whether ESG factor investment remains a challenging yet favorable choice for stakeholders seeking to create long-term value.

1. ESG's Evolving Definition and Goals

While Damodran expresses concerns about the lack of a clear-cut ESG definition and the continually shifting goals, it's important to understand that adaptation is a natural response to the ever-changing world. Just as democracy replaced monarchy and digital technology surpassed typewriters, ESG is adapting to address the challenges of the 21st century. For those advocating long-term value creation, the need for a longer time horizon when evaluating ESG's impact is essential.

2. ESG Investing and Financial Returns

Damodran's argument that ESG investing doesn't guarantee higher returns, especially for smaller companies with reporting limitations, can be compared to the claim that indices comprising larger companies don't accurately reflect market sentiment. Large companies set examples for smaller ones to follow, and all companies, regardless of their size, play a role in building a sustainable world.

3. ESG's Impact on Society

While Damodran suggests that ESG has inadvertently increased reliance on fossil fuels, it's essential to acknowledge the investments it has spurred in renewable energy sources. Additionally, statistics and reports from these companies suggest a different narrative. Around 45% of assets under management (AUMs) are committed to achieving zero emissions by 2030 to 2045, closely aligned with ESG investing. While it's true that these AUMs haven't yet made a significant impact at a macro level, this is the initial phase. We should anticipate real action after germination.

Bonus Argument: The Importance of the Social Factor in ESG

In some of his recent interviews, Damodran dismisses the social factor in ESG as the "most useless part" of this investment approach. However, the social factor is underdeveloped and holds significant potential to generate value in the future. When ESG's social impact is fully realized, it will be a game-changer for businesses and society, as it has the most to gain from its resurrection.

In Conclusion

ESG is not without its flaws, but it remains a powerful tool for creating a more sustainable and equitable world. As ESG continues to evolve, its impact will only grow stronger. While ESG investing is still in its infancy, abandoning it now is like prematurely giving up on a child's potential. In due time, ESG will evolve into an art form. Rather than bidding farewell to a substantial portion of the world's invested wealth, let's give it a chance to thrive. Thank you.

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