Greenwashing Your Investments

Collapse 2050 readers are already aware we're getting lied to by governments and corporations. Not just about the extent of biosphere destruction, but also about the "solutions" we're supposed to embrace.

Corporate greenwashing is rampant. Plastics recycling is probably the biggest offender, with industry propaganda dating back decades. Unfortunately, most plastics that go in the blue box end up burned or in a landfill.

More recently, many products and companies claim to be "carbon neutral". While this makes a great soundbite for a commercial, unfortunately most businesses define "carbon neutral" using twisted accounting that excludes parts of their businesses or includes dubious carbon offsets.

The general public finds comfort in these platitudes, but the skeptic knows there's almost always a catch.

One form of greenwashing that is less well-understood is Environmental, Social, Governance (ESG) investing (sometimes referred to as "responsible investing" or "sustainable investing"). The complexities of capital markets overlaid on top of the intricacies of corporate incentives and investing jargon can cause confusion. Indeed, I believe some investment fund managers count on this confusion to mislead investors.

Investment fund marketers are careful not to explicitly make false statements, but they know that their audience will fill any messaging gaps using their own assumptions. When investors hear some of the feel-good language related to ESG investing they make associations and imagine outcomes that don't actually exist.

Most ESG fund investors want to make a difference, but most ESG funds don't make any difference at all.

The biggest assumption investors make is that "ESG" is a catch-all for "doing good". Investors see brochures with pretty pictures of trees, windmills and solar panels and assume that their investment in ESG investment products will help save the planet.

This is a big mistake.

What is an ESG fund?

ESG funds are investment products (like mutual funds or exchange traded funds) that are constructed to feature environmental, social and corporates governance factors into their investment process.

Many ESG investment funds attempt to do this by excluding certain categories of sin stocks: guns, tobacco, porn, and so on. With growing concern about climate change, fossil fuel companies are increasingly at the top of the sin list.

The first problem with fossil fuel company exclusion is it's limited in scope. Energy companies don't operate in a vacuum and are highly integrated with all sectors of the economy. They are financed by banks. They supply petroleum to chemicals and plastics manufacturers. Plastics are used in the production of millions of products. If excluding oil companies, why not also their best customers and financiers?

It's true that fossil fuel companies are at the heart of CO2 emissions and shutting down oil companies would stop the flow of petroleum based products throughout the economy. But this is where investors are mistaken. Excluding fossil fuel companies from ESG portfolios fails to shut anything down.

Companies have always had to work with various strata of investors that exclude certain investments based on a variety of characteristics. Value investors shun momentum stocks. Tobacco and gun stocks have been excluded from many large portfolios for decades. Yet, tobacco and gun stocks have continued to perform as expected. Investors may come and go, but long run stock performance tends to align with a company's business prospects and intrinsic value.

The exclusion of companies or sectors doesn't affect performance. Research from South Africa's period of Apartheid has shown that boycotting certain companies, sectors or countries is ineffective at altering share price performance.

Companies simply don't need 100% of investors to be interested in their stock. There will always be a class of investors who don't care about what they invest in as long as the returns are good.

In fact, if ESG exclusion did impact share prices it would make the stock more attractive to non-ESG investors. For example, if a class of investors shunned Altria (the cigarette company), causing its share price to decline, Altria's expected future return would rise attracting other investors who would then drive the share price back up. A smaller pool of potential investors doesn't change a company's business prospects, and thus its intrinsic value. There will always be investors willing to capitalize on this. Moreover, without the burden of ESG-related business expenses, Altria's intrinsic value may actually rise relative to other ESG-friendly companies making it an even more attractive investment to investors that don't prioritize ESG factors.

As conscientious investors abandon a company, the remaining class of financiers care less-and-less about the company's practices. All things equal, this leaves the offending company to continue as it pleases, perhaps even creating a disadvantage for the 'good' companies that must operate under greater constraints.

Many argue that if a large enough cohort of investors avoids an ESG-offending company its cost of capital could rise, prompting company executives to alter business practices. However, avoiding prime offenders like oil producers might only create a market where energy companies trade at a discount, but with no fundamental change to the underlying business. After all, an oil producer exists to produce oil. As long as it has access to funding - via retained earnings or outside capital - business will go on with little change.

When evaluating whether ESG investing actually creates change, it is important to understand cause and effect. Cigarette smoking has declined significantly over the decades, but not because Altria's cost of capital has risen. Altria hasn't changed its primary business model despite many investors avoiding tobacco stocks since the 1990s. Rather, it was regulation, taxation, education and litigation that forced dramatic change to both supply and demand, reducing smoking rates in the developed world.

So what do ESG funds actually accomplish?

Most ESG investment funds use a set of values-based screens to filter out sin stocks. Some use a sweeping approach that removes entire sectors. Others look at revenue sources for individual companies to determine exposure. Regardless of the stringency of the filter, the general idea is to eliminate exposure to companies and industries that don't align with an investor's values.

These strategies were originally created to service religions endowments and foundations with strict values-based rules. The purpose is to avoid values conflicts and the effects are largely superficial. The purpose is NOT to create change.

Risk-Based ESG Funds

Similar to values-based ESG funds, risk-based ESG funds exclude certain companies or industries based on a set of pre-determined factors. The types of companies or sectors that are excluded might closely resemble those of values-based ESG funds. The main difference is the intent of the fund. While values-based funds seek to align with a set of morals, risk-based ESG funds seek to reduce exposure to risk.

Companies with poor ESG practices may theoretically be exposed to greater regulation, litigation or reputation risk. These potential challenges could affect the ongoing profitability and financial position of a company, negatively changing its risk-return profile. A devastating announcement, for example, could push a the stock of one of these companies down 5, 10, 20% or more. Many ESG funds seek to avoid exposure to these risks.

Conceptually, this is something all fund managers do regardless of whether or not their funds are labeled "ESG". Risk management is part of the investing DNA and ESG risks are simply one of many that are evaluated. Given this, drawing particular attention to ESG risks is more-or-less a outward manifestation of what was already taking place, but perhaps to a more explicit degree for marketing purposes.

Activist-Style Impact Funds

The vast majority of ESG funds provide some combination of values-based and risk-based filtering. However, what many ESG investors mistakenly believe they are actually getting are Impact Funds.

Contrary to popular belief, investment funds that seek to make change must actually own shares of ESG offenders. Investors looking to force change would do better by adopting methods used by activist investors, like Carl Icahn. Activist investors take large stakes in companies they want to change. Shareholders, as company owners, have a right to board representation. The board hires company executives who then run the company.

Research by the European Corporate Governance Institute suggests that shareholder activism can create real change:

We study the nature of and outcomes from coordinated engagements by a prominent international network of long-term shareholders cooperating to influence firms on environmental and social issues. A two-tier engagement strategy, combining lead investors with supporting investors, is effective in successfully achieving the stated engagement goals and is followed by improved target performance. An investor is more likely to lead the collaborative dialogue when the investor’s stake in and exposure to the target firm are higher, and when the target is domestic. Success rates are elevated when lead investors are domestic, and when the investor coalition is capable and influential.

Abstract, "Coordinated Engagements". January 2021

The 2021 proxy challenge started by activist investor Engine No. 1 is a perfect example of an investment manager attempting change. Via an activist approach, Engine No. 1 was able to secure 3 seats on Exxon's board. This could only be done because Engine No. 1 owned Exxon shares, made a shareholder proposal and rallied other shareholders around its cause.

Of course, in reality nothing much has changed at Exxon. The outcome of shareholder activism tends to be limited to profitable changes (e.g. divestments, capital restructuring, etc.). It's simply too much to expect a company to cannibalize itself for the benefit of society. Realistically, positive ESG changes forced by activist shareholders are incremental and mostly performative.

It is unlikely that impact funds alter the course of humanity's self destruction, but these funds are at least attempting to deliver the changes investors think they're buying.

Bottom Line

If you have investments, let's be real. You need to make sure you're not buying (and paying for via fees) something you're not getting.

Even if your portfolio is invested in products that claim to be beneficial to the environment, they're probably not. Even if your money is invested in impact funds that advocate for change or invest in green energy, the accomplishments are probably minimal. After all, no matter how many Exxon board seats an asset manager gets Exxon is still in business to extract and deliver fossil fuels.

Humans have failed at self-regulation. Investors are part of the capitalist system and it is unrealistic to expect change from the inside. Corporations exist to make a profit. Investing exists to earn a positive return. It is unlikely, therefore, that either will put themselves at a disadvantage to benefit society.

Instead, real change - if it ever comes - must be forced from the outside via government regulation, taxation and incentives.