Can something be both vital and flawed?
This was the fundamental question of the public debate I had last week with Professor Witold Henisz, the Vice Dean of Wharton. We were invited by The Economist to battle Oxford-style over the following motion: This House believes ESG is vital, and a necessity in the battle against climate change. The debate, energetically moderated by Vijay Vaitheeswaran, The Economist’s Global Energy and Climate Innovation Editor, was billed as one of the highlights of the magazine’s Third Annual Sustainability Week. Dean Henisz argued in favor of the motion. I argued against.
In the end, we found profound areas of both agreement and disagreement. The day before, in another panel, Dean Henisz said, “we have a long way to go before ESG products are fit for purpose.” I latched on to his damning critique, telling the audience that Henisz could not have it both ways: i.e., he cannot claim ESG is both vital and unfit. He shrewdly returned the tactic, quoting excerpts from several of my recent podcasts and new book Sustainable: Moving Beyond ESG to Impact. “We should all want the ethos of ESG to reign,” I have written.
So, which is it? And most importantly, how do we salvage the good of ESG while ridding ourselves of its defects?
Nothing less than a radically honest approach will work. This means first accepting that the ESG movement has valid precepts. Business and finance have crucial roles to play in fashioning optimal environmental, economic, and social outcomes. Current consumption and industrial production patterns are despoiling our air, land, and water in visibly detrimental, perhaps even cataclysmic ways. Moreover, years of rapid economic growth have widened wealth gaps and severely strained social contracts. Correcting these negative effects requires urgent action from all pillars of society – not only individuals, regulators, and civic organizations but also corporations and investors.
We must also remember how ESG was born. ESG investing grew out of the United Nations’ Principles for Responsible Investing. A group of global financial experts assembled by former UN Secretary General Kofi Annan studied how investors could be more mindful about addressing the unique challenges and opportunities of the 21st century and simultaneously more supportive of the UN’s Sustainable Development Goals. In 2004, these experts concluded rightly that all investors should systematically incorporate environmental, social, and governance material-risk considerations into their decision-making.
From these two prompts, multiple initiatives have taken root. Like medieval alchemists, who believed that gold could somehow be derived from base metals, many well-intended financial alchemists like MSCI, Sustainalytics, Morningstar, Bloomberg, and others have endeavored to prove there is some predictive and prescriptive capacity in these three variables, E, S and G. Collectively, they have spent millions of hours and dollars to prove that their unique, analytic ESG processes and investment products could outperform the broader market and/or promote the UN SDGs.
But here’s yet another hard truth: all these efforts have failed. As my research and that of many others has exhaustively shown, ESG investment products are not generating consistent financial performance. Neither are they producing much good – almost none that would have taken place if ESG never been born, that is.
And this is where the debate gets most interesting. Is ESG failing to perform as hoped because we aren’t trying hard enough, haven’t spent enough time or conducted the right tests – or is something more vexing at work? Dean Henisz thinks the former. I believe it’s the latter.
Note, however, what’s not at issue. Neither of us believe that the broad claims of the UN-PRI are wrong. Governance, environmental, and social factors present material risks. This claim is often made most demonstrably by activists who shout, “Climate risk is investment risk!” Yes, it is. But is climate risk, along with other S and G risks, fundamentally mispriced? If so, over what time frame? Moreover, won’t other factors continue to affect asset prices at the same time? What about a corporation’s capacity to innovate and transform? Don’t corporate culture, management quality, and/or financial efficacy also matter? And mightn’t these factors frequently overwhelm ESG considerations?
And while we’re at it, how about other unknowable things, like Putin’s war in the Ukraine, stubborn human dependence upon coal and other fossil fuels, a U.S. debt-ceiling crisis, or the potential invasion of Taiwan by China? There is simply no way that all these factors are less important than environmental and social risks.
Unemotional reflections like these make the obvious more evident. There’s nothing special about E, S, or G that axiomatically elevates them in asset-price determination. This is why Vanguard CEO Tim Buckley recently said that ESG investing provides no advantage over broad index investing. It is also why Professor Alex Edmans of the London Business School has called for the end of ESG. “ESG doesn’t need a specialized term,” Professor Edmans writes. “It’s no better or worse than other intangible assets that drive long-term value and create positive externalities for wider society.”
Value-producing strategies “can deliver financial returns and societal impacts,” Dean Henisz wrote after our debate. I agree. “ESG integration still offers tremendous potential to investors.” Indeed, it does – but it also engenders debilitating obfuscation, widespread confusion, and the potential for multi-trillion-dollar fraud. Green portfolios are likely to underperform brown portfolios, according to research by Professors Robert Stambaugh and Lucian Taylor, colleagues of Henisz at Wharton. Advocating green investments without prominent underperformance disclaimers almost certainly violates common fiduciary standards.
Over the course of his storied life, Sir Isaac Newton wrote more than one million words summarizing hundreds of experiments he conducted in secret, all in a vain search for “the philosopher’s stone,” a miraculous material that could transform iron to gold and wine to the highly coveted “elixir of life.” Over more than four centuries, what he and his fellow alchemists ultimately discovered was multiple chemical compounds could be broken down into elements, and then recombined.
ESG is no different. And just as alchemy eventually evolved into a valuable new field called chemistry, ESG may ultimately evolve into something more promising as well, something that verifiably promotes economic and social value creation simultaneously. What should it be called? Something less misleading and politically explosive than ESG, I hope.
Oh, just in case you were wondering, I was judged the debate winner. When presented with the facts, everyone agrees ESG’s flaws must be fixed.
