Man screaming after losing his train.
Regardless of whether you are of the red or blue political stripe, public opinion, private capital, human capital, government capital and consumer interest are all trending towards “green” or “sustainable” products and investments in the long run.
The political heat associated with ESG keeps escalating. Texas, leading a coalition of 24 states, for instance, just sued the Biden administration to stop a new Department of Labor rule that is said to prioritize ESG concepts into ERISA regulations.
I am going to go out on a limb here and claim that the current political pushback is unlikely to stop the ESG movement in the long run. Why? Because public opinion, private capital, government capital, and human capital are all heading in the other direction towards “green” or “sustainable” investing. Let me explain.
Public opinion related to climate change
I have come across surveys conducted by many leading academic institutions (e.g., Yale, Stanford, and Harvard) and research organizations (e.g., the Pew Research Center) which show that a majority of Americans care about climate change and global warming. Even if you are a skeptic of surveys, you would have to argue that all of these reputable organizations somehow got it wrong through faulty survey techniques. It may not surprise you to learn that 72% of Democrats relative to 22% of Republicans feel that human activity contributes to climate change as per the Pew Center poll.
An under-reported observation, though, is that younger Republicans far outnumber the average Republican in worrying about climate. Millennial and younger Republicans are at least 10 points more likely than Baby Boomer and older Republicans to say the federal government is doing too little to address climate change as per the Pew survey. For example, 53% of Millennial and younger Republicans say the federal government is doing too little to protect air quality, compared with just 30% of Baby Boomer and older Republicans.
Clearly, the red states have a lot of Millennials and younger Republicans. One has to wonder whether the politicians of the red states fully reflect the views of their own electorate, especially the younger segment which will become the electorate of the future.
Inter-generational wealth transfers
Studies claim that a massive $73 trillion of wealth is expected to pass on to the next generation in the next 20 odd years. We, in the university, see the next generation before the asset management industry or even corporate America does. Most of the students I meet are deeply interested in investing vehicles that reflect their values. And I’m a business school professor, not a liberal arts professor!
Many do not even want a massive alpha (i.e., beating average market returns) if the funds they invest in at least make a best-efforts pitch for being authentic and rigorous in following through on their stated sustainability mission. Yes, the sustainable investing market today is tainted by greenwashing, dubious rating agencies that push pseudo-precision at the cost of accuracy and relevance, and daily op-eds claiming that the ESG investing is responsible for most, if not, all of what is wrong with America.
The cynic could say that investing in ESG funds is a convenient way for the younger generation to feel like they are doing something about climate. That is, I don’t want to stop consuming oil and fast fashion, two big contributors to emissions, but I own an ESG fund and that makes me feel a little less guilty about my consumption. We will come back to the investor-consumer dissonance raised here later.
And, how does owning the ESG fund help? Students think that their ESG funds vote in favor of ESG proposals. I then point to research which suggests that this is not the case. On top of that, ESG funds tend have to higher expense ratios than a standard market tracking fund. Hence, I advise our students to hold a low cost market tracking fund such as the Vanguard Total Stock Market Index Fund in addition to an ESG fund to translate their values into investment vehicles.
Students understand these criticisms and hope that the market will eventually become better at detecting and penalizing greenwashing. Rating agencies will hopefully improve over time. They also hope to see more transparent discussions related to why ESG funds do not vote in favor of ESG proxy proposals. New frameworks for sustainable investing that can identify stocks that can do good and do well at the same time are emerging, as discussed later in this article.
Climate related investments
Around one fourth of all new venture capital, some $50 billion, went to climate startups in 2022. One could argue that stock markets are always looking for the next growth sector. Now that technology’s status as the next big thing is wobbly, capital will perhaps continue to flow into climate ventures because that is where perceived potential growth might lie. Of course, there’s some exuberance in climate startup valuations and things can and do get overheated but fundamental economic prospects in the long run matter as well.
Government capital
The Inflation Reduction Act (IRA) is arguably the most important attempt at climate policy in the last three to four decades. The textbook answer to the emissions problem is a carbon tax. But such a tax is a political non-starter in the U.S. Richer but politically polarized societies such as the U.S. will probably attempt to subsidize, not tax, their way to decarbonization. The IRA provides around $369 billion of subsidies and incentives for “green” projects. In a tit-for-tat move, the EU is planning to invest around €170 billion euros in green ventures.
What is the likely economic impact of the IRA? The White House states that the climate provisions of the IRA will save social costs of $1.9 trillion on account of climate change by 2050, especially on items such as coastal disaster relief, flood insurance, crop insurance, healthcare insurance, wildland fire suppression, and flooding at Federal facilities.
What’s more, POLITOCO reports that two-thirds of the green-energy projects funded by the IRA have gone to Republican states, although Republicans voted en masse against the IRA. Perhaps we will not have red states or blue states, just green ones! I wonder whether the red state politicians will have a hard time reconciling their anti-ESG stance with the benefits of IRA-induced activity in their constituencies.
Digging deeper into the data reveals other multi-layered insights. The top three states that rely on wind and solar power the most for their power needs are Kansas (54%), Iowa (53%), and North Dakota (51%)—which all happen to be red states. Texas alone has added 58,000 GWH of wind power in the decade ended in 2019.
Ironically, Kansas, Iowa and North Dakota and of course Texas are a part of the 25-state coalition that filed a lawsuit against the Department of Labor’s new rule allowing asset managers to direct their clients’ retirement money to ESG Investments. Texas has also introduced a bill to ban asset managers accused of boycotting fossil fuels while simultaneously being a superpower in wind energy!
Concrete new investing frameworks focused on doing well and doing good are emerging
Why have we not seen attempts to improve conceptual frameworks associated with finding investments that both do well and do good? In my class on “financial sustainability,” I routinely share a list of questions that investors should ask to identify good companies in a shareholder value maximizing sense. Of course, many of those questions overlap with ESG considerations.
For instance, what is the future addressable market of a company, especially if the company is looking at “green” and “sustainable” product lines that are expected to grow rapidly in the future? What should oil and gas production and investment in new wells look like, given the advent of cheaper renewables? What does the company do to manage its talent, or its top performers? What are the company’s labor costs, a data item that is only disclosed by around 15% of firms? Who are the firm’s suppliers and how efficient are they at using materials and inputs (sometimes proxied by their greenhouse gas emissions)? Does the valuation of the firm include a potential discount or a premium for expected product demand on account of inevitable global push towards decarbonization? What are the “known unknowns” affecting the company such as the possibility of paying a carbon tax, either in the U.S. or in the E.U.?
Why have we not seen attempts to construct a similar set of questions and associated KPIs (key performance indicators) or metrics to identify firms that focus on shareholder value and societal impact? Convergence between shareholder value maximization and societal impact is probably the easiest point of common departure for both sides of the political aisle. However, ESG investing has expended too much energy arguing about the efficacy, or lack thereof, of ESG ratings and negative industry screening (the practice of excluding “sinful” industries such as tobacco, oil or guns from portfolios).
Apart from not being very effective, as shown in my joint work with Bob Eccles and Jing Xie, negative industry screening raises two thorny investing questions. First, with negative screening, the investor runs the risk of missing out on investing in some highly innovative company in the screened-out sector. Ironically, a number of green initiatives are currently funded by oil companies. Second and even more complicated, is the investor a consumer of the products of a company that her investment vehicle does not hold, such as say ExxonMobil?
When I asked around for investors working on new frameworks to identify innovative companies that do well and do good, I was given the names of two individuals and one institution: (i) Thomas Kamei at Counterpoint and Morgan Stanley; (ii) Katherine Collins at Putnam and (iii) Generation Investment Management.
For obvious reasons, their frameworks are not entirely public. I hope to dig more and write about these frameworks in future columns. Having said that, I am encouraged that someone is thinking hard about a constructive rubric instead of defaulting to ratings and mechanical screening.
One of the challenges that active management frameworks such as ESG investing will have to grapple with is that deviating from the broad index, over the long run, tends to lead to underperformance for two reasons. First, active management sometimes runs the risk of excluding blow out winners such as a Tesla or an Amazon. Second, active management is almost always more expensive in terms of expense ratios and tax liabilities for the investor that get triggered by frequent buying and selling of stocks.
For an example of this tension, consider the performance of Shares MSCI USA ESG Select ETF (ticker SUSA) which happens to be one of the oldest ESG funds. I have chosen an older ESG fund because true under or over performance attributable to an active strategy like ESG is only apparent over long periods of time. It turns out that SUSA has underperformed the S&P 500 index (SPY), but not by much. The 10-year return on SUSA was 221% relative to 230% on the S&P 500. Why did SUSA underperform?
It turns out that, among other things, SUSA did not hold Amazon, for instance. Circling back to my earlier point about the investor-customer dissonance, I wonder whether the owners of SUSA never shopped at Amazon? It seems reasonable to expect an investor to profit from her purchases of product from the company held in her portfolio. On top of that, can the same company be labeled as sustainable when you take consumption decisions and not so when you invest?
Moreover, SUSA’s higher annual expense ratio of 0.25% compounded over the 10 years also eats into returns relative to holding a very cheap S&P 500 index fund such as the one marketed by Vanguard which happens to only charge 0.04% per annum. To be fair, that difference over 10 years is probably 2.5%, a discount that some of my students will be happy to live with.
After reading the SUSA case, you might legitimately counterargue that I am confounding active investing with ESG. One can have active investing without ESG (depending, of course, on how you define ESG), and passive investing using ESG (like an index that just screens out the bottom 10% based on ESG ratings).
Let me reiterate that the investing frameworks I am referring to have to be active. Passive ESG, almost by definition, relies on money run by computers. Computer algorithms need scores (ESG ratings) or lists (indexes). Many indexes are usually created using ESG ratings or via negative screening, both of which are somewhat irreparably flawed in my opinion.
Human capital in corporate America
If you have wondered why the CEO of Disney felt obligated to comment on Florida’s “Don’t Say Gay” campaign or why the CEOs of Delta and Coca Cola took a stand on Georgia’s voting laws, consider the pressure placed on these CEOs by their employees. Silence is increasingly not an option because the highly educated workforce demands that leadership speak out on social issues even if CEOs have no real comparative advantage compared to diplomats or political commentators.
Anti-woke funds are going nowhere
Notwithstanding the inherent conceptual inconsistencies in the anti-woke funds that I have written about in the past related to DRLL and MAGA, the top anti-woke funds that I know of do not have seem to have gotten much traction from investors.
At market close, on February 6, 2023, ACFV, or the American Conservative Values ETF, had assets under management (AUM) of $34 million. DRLL is perhaps among the biggest with $387 million in AUM. Both ACFV and DRLL have high expense ratios of 0.75% and 0.41% respectively. As I pointed out in my earlier piece, an investor can buy an ETF almost identical to DRLL from State Street called XLE at a third of the expense ratio.
The Vivek Ramaswamy company, Strive Asset Management, has listed eight ETFs in total, including DRLL. These eight funds have a cumulative AUM of $644 million. Five of them (Strive U.S. Semiconductor ETF or SHOC with an AUM of $13.76M, Strive 1000 Growth ETF or STXG with an AUM of $2.51M, Strive 1000 Value ETF or STXV with an AUM of $2.49M, Strive Small-Cap ETF or STXK with an AUM of $2.45M, and Strive 1000 Dividend Growth ETF or STXD with an AUM of $2.55M) arguably barely exist.
MAGA’s AUM is around $19 million. The Second amendment ETF, EGIS, has an AUM of $25 million. The Right to Life ETF, LYFE, has an AUM of $18 million. Remarkably, all these red state efforts at banning funds interfere with their political beliefs that we should provide choices of all kinds to the investor.
In sum, regardless of one’s political views, the ESG train has left the station. The capital market, the product market, and the labor market have perhaps already decided that ESG investing is here to stay in the long run.
