The Naked Emperor: How ESG is Failing Its Mission on Climate

Co-Authored By Garvin Jabusch, Chief Investment Officer- Green Alpha Advisors

Occam’s Razor approaches to solutions: There is an objectively right and an objectively wrong way to invest to address the climate crisis

Those of us in the Save-the-World industry spend a lot of time thinking about the right questions to ask to get the right solutions.?We agonize over the way to run complex projects and to build impactful possibilities to slow or halt the current trajectory we are on that is leading to almost certain catastrophe for the planet and ourselves. In the process, we have as a whole tended towards focusing on the gray areas of myriad stakeholder perspectives in order to engage bad actors so as to influence their negative contributions to the current global environmental fiasco we are living in.?

And so, for the past 30 years we have been circling the proverbial drain, talking about ways to engage in the most meaningful way, analyzing the effects of different strategies, allowing for “C-students” to have their names on the honor roll. As a result, the “graduating class” appears to have participants that all deserve a spot at the top Ivy League school. It appears as if we have a socially, environmentally responsible set of stakeholders that are performing at the top of their class. They are emperors parading down the globally focused path to climate solutions, wearing their mantles of approval for their social responsibility. But our metrics, expectations and evaluations are tragically off. And so those garments of supposed innovation and progress are vacant of substance. Indeed, they are quite exposed to the future collapse of ecosystems as we know them.

Within the environmental-social-governance (ESG) universe we have a system of assessing the environmental responsibility and performance of corporations and institutions that has a sliding scale, a bell-curve, a grading and evaluation approach that allows for confusing and misleading labeling and an acknowledgement system where the mediocre or even lousy “students” are all lauded as valedictorians. That system is going to kill any chance we have to actually transition away from environmentally devastating economic value-propositions because the “audience” is insisting that our global economy is dressed in finery and is on the right path, when in fact it is wearing no clothes. Grading on a sliding scale is leading to us being frogs in the pot of boiling water, where we do not recognize our imminent death until it is too late.

So, the time for this conciliatory, incremental, malleable strategy of engagement and acknowledgement has, frankly, long past. The time for a much simpler and more powerful assessment is here. We need to move aggressively and expediently to just a “pass/fail” approach to acknowledging (or condemning) the entities that are impacting our ability to transition to a global economy that is not only environmentally sustainable, but regenerative as well. Employing the principle of Occam’s Razor: A passing grade means you are actively creating and executing value propositions that lead to a regenerative economy. A failing grade means you are still engaged in economic activity that bolsters the existing suicidal infrastructure of extraction and ecosystem annihilation. End of story. In terms of ESG asset management, this means that if a company is not doing more, on an ongoing basis, to stabilize the world than it is to destabilize it, we should not own it. Bluntly, we need to focus more on the output of ESG than on the confusing and distracting methodologies.

Are we really trying?

For all the talk and all the hype, the cold reality is that on climate change, we are headed for catastrophe and no one, including ESG managers, is doing enough to avert it. Some ESG strategies are enabling it. Despite ESG (and socially responsible investing/SRI before it) having been popular investment themes for decades, capital has continued to flow into the causes of our biggest problems, and the world continues to see record high atmospheric carbon concentrations year in and year out. This isn’t because ESG hasn’t yet become sufficiently popular to be effective. It is because ESG, overall, isn’t doing its job.

The economy and economic growth are direct functions of what sectors and industries receive investment capital. Today, most investments, including many invested via ESG-themed products, are still flowing into traditional business-as-usual (BAU), with all the risks that brings. BAU masquerading as ESG is not just accepted but sometimes trumpeted. One of the authors heard the CEO of a well-known ESG firm exclaim from the conference stage, ‘Ford is the most innovative company in the world!’ Except that, no. Ford is responsible for its share of the climate crisis, and also for health degradation worldwide. ESG doesn’t seem to understand that all of Exxon’s oil didn’t burn itself.

This wrong approach to ESG is enabled and justified by one thing: ESG rankings that give asset managers cover to buy whatever they want, and not worry about the true climate emergency, tipping points or social justice impacts their decisions are causing. Third party vendors are happy to provide scores (for a fee) that enable business-as-usual investing under the ESG banner. Consider one of the most widely used scoring systems, the MSCI ESG ratings. Under that schema, clear, direct corporate causes of the climate crisis like Chevron Corp and Exxon Mobil are given perfectly acceptable ESG ratings of BBB, or ‘high average’ in MSCI’s parlance. This is grading on a curve in a situation where only absolute performance can matter.

We think the reasons for this live on a two-way street. Asset managers and executives appreciate having the cover to buy whatever they want, so organizations like MSCI are happy to provide that. Conversely, MSCI wants to sell as many ratings subscriptions as they can, so they make sure the ratings fit comfortably within the requirements of justifying a business-as-usual portfolio (for asset management wonks, read ‘low tracking error portfolio’).

MSCI does this by incorporating not dozens but hundreds of unique data points per company, feeding them into an algorithm that prioritizes those in various ways, to arrive at a weighted average that can then be converted into a letter grade ranking. This highly granular (we might say tortured) approach gives sufficient cover to push back on any naysayers who object to the system’s outputs. But if we measure the quality of the process by the results, we can observe it's limitations. Firms causing the climate crisis should not qualify as ESG. Focus on process over output is itself a form of greenwashing.

Critique of greenwashing/graywashing

In January 2020, Larry Fink declared that the climate crisis would be central to investment decisions at BlackRock, and that the firm would avoid shares of companies that “present a high sustainability-related risk”; yet in September 2020, BlackRock launched a new ESG branded ETF that featured holdings in fossil fuels, including Marathon Petroleum Corp and Schlumberger. In January of 2021, Fink wrote that solutions to the climate crisis are the future of investing, and that they need to be a central part of any growth strategy; in February 2021, Fink told a group of asset management professionals that divesting from fossil fuels is the same as greenwashing. On April 8th of this year, BlackRock launched two new climate-themed ETFs, the BlackRock U.S. Carbon Transition Readiness ETF (LCTU) and the BlackRock World ex U.S. Carbon Transition Readiness ETF (LCTD). Together, the ETFs hold Royal Dutch Shell, Total SA, Exxon Mobil Corp, Chevron Corp, and a number of other fossil fuels companies. To Fink, it turns out, owning the primary cause of the climate crisis is the same as being a climate impact investor.

BlackRock isn’t the only one. Most ESG portfolios, even those that hold themselves out as fossil fuels free, still today have no problem holding all kinds of dangers to the world, including a primary demand driver for fossil fuels, internal combustion engine (ICE) makers. Toyota is an ESG darling, for example, never mind that they have been notoriously resistant to making electric vehicles, and instead prefer to build and sell 10,000,000 ICE vehicles every year, damaging human health and directly causing the climate crisis. One could say that owning the causes of the climate crisis like ICE cars and fossil-fired utilities is the furthest thing from what ESG should be, that it is in reality the act of investing in collapse. Toyota is not a serious ESG portfolio holding.

It’s not that ESG can’t have impact, it’s that it usually doesn’t

All this is important because where we invest matters. How the economy works can only emerge from where our investment money flows. Anything that doesn't receive investment can't endure; if you starve a beast, it will die. So, pouring money into fossil fuels and other toxins will result in those parts of the economy enduring and growing, at least until those risks do result in irreversible planetary decline. This is also important because investors have been sold ESG portfolios with the promise they will have their hard-earned investment dollars invested into positive impact companies, and these investors deserve better than they are generally getting today.

Again we want to be clear: there is an objectively right and an objectively wrong way to invest to address the climate crisis. The right way is to do your best to determine if the company's overall activities are stabilizing the world or destabilizing the world. ESG scores are not a reliable way to assess that. So, we believe it is time to use the much simpler heuristic of ‘stabilizing vs. destabilizing’ as reflected by sources of revenues, simply analyzing what it is that a company gets paid to do. Relocating the conversation to that straightforward evaluation could finally bring impact investing to a place where it is sending real market signals that the fixes to our problems have value, but the causes of our problems do not.

In conclusion

Relying on exponential innovation and cooperation for creation of value and economic health - as opposed to relying on dirty fossils and linear business models - is a scalable and sustainable approach to replace our current race to the bottom. Systems that mimic healthy ecosystem exchanges are the only way to replace our current suicide strategies. We have deployed these models successfully in a very limited capacity. We need to send signals to the market that we are ready to overhaul our destructive infrastructure immediately and at scale by replicating what we know works with monumental commitment and financing.

Traditional asset management assumptions have left investors far too exposed to the causes of the world’s looming threats. ESG, in failing to recognize the dangers of these investments, is also largely failing in its mission. In this failing, we are not only jeopardizing our planet’s health but we are risking the relevance and existence of ESG itself.?

History shows that civilizations that successfully navigated major technological and environmental disruptions also managed to have and to create political, institutional and financial changes to match their risks and new means of production. Our current time of exponentially escalating risks and destructive technologies requires the evolution of asset management to meet the new era. And that is the naked truth.

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