Environmental, social, and governance (ESG) investing is all the rage these days. Naturally, funds are launching to meet the growing investor demand. However, new company formation cannot keep pace with inflows. Yet, the investible universe is expanding nonetheless. Something funny‘s happening. Nearly every type of company is becoming ESG-compliant without transforming a single operation. While there are certainly some questionable practices at play, this phenomenon is merely exposing a hard truth: a good business is a good business.
History Isn’t Kind
Few people aspire to evil—financiers included. However, history has not been kind to us. We’ve been repeatedly vilified throughout the ages. Jesus expelled merchants and moneychangers from the holy temple in moral disgust. The moneylender Shylock is the principal antagonist in William Shakespeare’s The Merchant of Venice. Greedy bankers are commonly blamed for the Great Financial Crisis in 2008. There are countless other examples of abuse.
This treatment of moneylenders is unjust but not new. For millennia they have been the primary scapegoats for practically every economic problem. They have been derided by philosophers and condemned to hell by religious authorities; their property has been confiscated to compensate their “victims”; they have been humiliated, framed, jailed, and butchered. From Jewish pogroms where the main purpose was to destroy the records of debt, to the vilification of the House of Rothschild, to the jailing of American financiers—moneylenders have been targets of philosophers, theologians, journalists, economists, playwrights, legislators, and the masses.Yaron Brook, The Morality of Moneylending: A Short History
While sympathy is hard to come to by, we’re not bad people. Quite the contrary, finance is vital for our modern economies. However, this virtue is unrecognized by most. ESG investing has become, in part, penance for this unearned shame. The ironic truth, though, is that ESG is an unnecessary and circular path. If only we had the courage to see.
Social or moral considerations are the main drivers of ESG investing. Source
Sizing up the ESG landscape
ESG investing has become more popular, especially over the last three quarters. It’s a morally motivated framework focused on the three pillars of environmental, social, and governance issues. The criteria dominate investment decisions more than traditional, financial factors (like valuation and cash flow). “Doing good” is the primary objective. There are different frameworks, each with its own take on these matters. However, they all seem to prioritize emissions and climate change (for E), gender and race diversity (for S), and an assortment of governance issues (for G).
While ESG frameworks differ, there are similar themes. Source
Investment dollars are flooding into ESG-related funds at record levels. By one account, they have attracted $39 billion of inflows in the first half of 2021 putting the category on track for a record year. Some estimate that ESG funds could account for one-third of all assets under management by 2025!
Investment dollars are flooding into ESG-related funds. Source
All that capital needs to find a home. Not surprisingly, new homes are forming. In the last quarter alone, over 25 funds launched in the US with an ESG focus. However, money flows faster than public companies can be created. Without new options to invest in, these funds joined the herds to buy tech stocks; what else?!
ESG-related funds are mostly investing in tech stocks. Source
ESG trophies for all
To be sure, some industries can satisfy the popular ESG guidelines more easily than others. Oil and gas producers, for example, have a particularly “tough row to hoe” given ESG’s explicit goal to reduce fossil fuel usage. Technology companies have an easier time. However, many companies suddenly became ESG-compliant without changing business practices, as if by magic. This is no surprise, though.
At first, I cynically saw these companies as gaming the system. They were torturing their existing policies to fit the ESG frameworks rather than complying with its spirit. However, I see things differently now. To me, the growth in existing company compliance simply highlights a fact of reality. Most companies are good companies!
Almost all large companies satisfy sustainability reporting requirements now. Source
I’m sure there are companies gaming the ESG system. There’s simply too much to gain for some. However, the essence of ESG—improving the world—is something that every business does. Of course, every company is ESG-compliant. Given the intense market competition, every entity must lower its cost of capital if it can. ESG trophies for all!
Profits are good for humanity
If one’s objective is to better the world through investing, then (nearly) every viable company is worthy. This is because profits are good—not just for lining shareholders’ pockets—but for humanity as a whole. There is no conflict between ethically good companies and financially good companies. They are the same.
There’s a common belief that ethical companies produce poor financial results while offensive ones are among the most profitable. Thus, morally good companies make traditionally poor investments and vice versa. To me, this is backward and unsupported by reality.
Profits are simply what remains from revenues after all costs of production are paid. In other words, they are the value created by a company (or individual). Remember, other people voluntarily purchased the goods and services at prices in excess of what they took to create. Customers accepted those prices as good deals. If they were too high, no transactions would occur; too low and no items would exist to purchase. For buyers to buy and sellers to sell, the price must be attractive to both. (Free) trade is always win-win. Thus, profits represent millions of people improving their lives. Is this not good?
Unfortunately, our economies are not completely free. Distortions exist. Not all trade is voluntary. Hence, not all profits reflect pure value creation. For example, electric energy production is tightly regulated. Consumers have few (if any) choices. Trade is not free making an evaluation of value difficult to assess. The same goes for healthcare, finance, and many other industries that are controlled, to various extents. Nonetheless, these cases do not invalidate their productiveness for customers. Freedom exists on a spectrum and so too does the good that profits represent.
The goal of investing
The goal of investing is to make money from money. Investors seek assets that cash flow (i.e. have yields), have the potential to yield, or will appreciate due to greater demand. In all cases, assets must produce value (and thus cash). This manifests as profits, current or potential. Thus, profitable companies do good for portfolios and humanity alike.
Investors expect ethically good companies to be good financial investments. Source
ESG compliance is counter productive
In my view, a good company produces things that enhance human life. More than basic necessities, they provide health, joy, comfort, and enrich our time on this planet. Furthermore, they do it on the cheap. As a result, they are profitable.
Profits reflect billions’ views of good (if not more). Thus, ESG certifications are superfluous. In fact, they often represent a limited set of values rather than a broad evaluation. For example, the fossil fuel industry is particularly vilified by most ESG frameworks. Yet, a different perspective finds it vital for human life (and hence good). Context matters, and it’s mostly dropped by narrow-minded ESG policies. (Free) markets reflect all opinions and represent every context.
In many ways I find popular ESG guidelines to be unjust and even offensive. In such circumstances—and without getting into specifics since ethical standards are beyond this article’s scope—ESG investing is actually counterproductive. It rewards bad practices!
ESG is coming full circle
Contrary to popular belief, financiers produce an immense amount of value. We enable modern wonders from abundant and diverse food supplies to personal space travel. However, investors are not given a fair evaluation. We are unjustly vilified throughout history. Thus, I see the rise in ESG’s popularity as (partially) motivated by changing this reputation.
However, ESG frameworks are entirely superfluous. Simply follow the profits to find those companies enhancing humanity the most. Profits reflect the moral evaluations of billions of customers around the world voting with their hard-earned money. The good financial performance sought by investors can only result from strong value creation.
The pool of ESG-compliant companies is growing to meet investor demand. While new companies are forming, this mostly reflects existing ones meeting the various guidelines without changing their operations. It’s an implicit recognition of the above more than scamming the system as I previously thought.
ESG designations can even be counterproductive. The freer the market the more purely profits indicate ethically good companies. Deferring to a handful of groups, committees, and organizations is not only inefficient but narrow-minded and potentially morally corrupt. It creates a system ripe for gaming by the biggest, the most connected, and those with the most resources to spare.
Investing is a powerful tool to enact positive change. To truly utilize its potential, fight for economic liberty, champion free trade, and follow the profits. For those are the purest virtue signals of all.