ESG is Nonsense

The debate surrounding ESG (Environmental, Social, and Governance) and CSR (Corporate Social Responsibility) often begins with the assumption that we can distinctly categorize companies as "good" or "bad." However, this is not clearly the case.

In contrast to profitability and returns, which have standardized measures and supporting data, social responsibility is more subjective and varies based on individual perspectives. Consequently, it's no surprise that Greenpeace’s rankings of companies differ significantly from those of organizations focused on labor rights.

Given the ambiguity in interpreting the impact of ESG ratings on portfolio performance, it is essential to approach such results with particular caution.

First problem

...that arises when attempting to assess the impact of ESG information on investment performance is defining what is meant by “ESG information.” It turns out there are a large number of organizations attempting to answer that question. Criterias are - biased/ unclear/ undefined/ unreasoned.

In some cases, the criteria are so numerous that it is difficult to separate those that are germane from those that are not.

For instance, Bloomberg’s ESG data covers 120 environmental, social, and governance indicators. Nonetheless, virtually all the raters include the most highly publicized indicators in their ratings.

Pertinent problem

... is why governance, a measure that has historically been defined in research in terms of responsiveness of managers at publicly traded companies to their shareholders, is bundled with environmental responsiveness and social consciousness, two concepts that often require managers to put the interests of other stakeholder groups ahead of shareholders.

It may be that the governance that is incorporated in the ESG concept is different from the conventional governance measures, but if it is, any references to the payoff to good corporate governance should be not be part of the ESG sales pitch, because it represents a mindset diametrically opposed to the stakeholder value mindset that underlies ESG!

Pricing

If being socially good creates a payoff for firms either as higher cash flows or a lower discount rate, their values should increase.

But will markets have the foresight to look past what may be near-term lower earnings and reward them with higher pricing?

This question holds importance not only from the broader perspective of efficient markets but also due to its more immediate consequences.

If markets are shortsighted and overlook the value of being socially responsible, managers whose compensation and job security depend on stock price performance and current financial results might hesitate to adopt socially responsible practices.

Research on this topic is limited due to two primary challenges. First, it requires an ESG measure that can be correlated with current pricing, measured by multiples such as PE, price to book, or EV to EBITDA. Second, even if a correlation is found, establishing causation is challenging. In other words, do companies with high ESG scores receive higher market pricing, or are companies with higher market pricing simply viewed more favorably by society?

One straightforward proxy to explore the link between ESG and pricing is to compare the pricing multiples of stocks held by ESG funds to those of the broader market. A snapshot from early 2020, for example, provides the following data:

The chart suggests that ESG stocks are priced more like growth stocks than value stocks. However, without accounting for differences in growth, it is challenging to conclude definitively whether this reflects a market that is forward-looking and incorporating ESG considerations.

To avoid the complexities that make it difficult to isolate the effects of ESG on pricing, one effective approach is to focus on ESG events—specific occurrences that prompt the market to reassess a firm's ESG standing.

Finally, there is a pressing need for an open, honest, and detailed national dialogue concerning ESG-related public policies, especially those pertaining to climate change. Ideally, this discussion will lead to the development of sound policies that establish the legal and regulatory framework within which corporations operate. With the right framework in place, corporations can return to their primary goal of maximizing shareholder wealth.