Investing based on Environmental, Social and Governance (ESG) parameters is the rage today. It’s a form of conscious capitalism where the belief is that investment universe for asset managers should be companies that are ethical in dealing with all stakeholders and actively engaged in being sustainable.
It’s definitely a good thought. We want to preserve the environment, have companies that have a positive impact on the community and fair to minority shareholders and other stakeholders.
Issues with Universe
The problem I think lies in what criteria do you use. I read that that ITC, a tobacco company has AA rating by MSCI, which is higher than most companies. One would think the first step in ESG investing would be to exclude ‘sin’ companies such as tobacco and weapon manufacturers, no amount of white washing should outweigh the negative impact of their primary products. So approaches do this.
Also, excluding chemical or coal companies that pollute the environment is easy. But how about diary companies, most companies would rank Nestle as a high ESG rated company but conditions of dairy farming is not an animal friendly easy business. How about fast food? the negative externalities is quite high. Further, an IT services company or Bank which has relatively lesser carbon impact than a metal mining company but majority of its clients might be in Oil and Gas.
This list will end up narrowing down to companies that are engaged in renewable energy, electric vehicles, online travel and some tech companies. But the problem is that they might a dozen companies in India that will end up qualifying.
You have third parties that provide ESG scores that can widen your universe to a broader range of companies that are striving themselves and the world to be better. And in balance have a positive impact. However, that limits you to someone else’s methodology.
Growing Major Trend
Whatever the limitations of ESG investing and our personal views , it’s a fact that there is a major and serious trend underway, when more investors and asset managers are making a demand for ESG investing.
And it goes beyond investing, when countries such as Japan and UK are moving away from gasoline cars in 2030 or Nasdaq is mandating companies to have women directors.
There is no doubt that in the next decade or so, more fund flows and regulation will move towards the direction and quality of data to judge companies based on ESG will improve as well.
Impact
If there is broad movement towards ESG investing - it would mean that companies that rank high on sustainability should of higher valuation multiples relatively.
So far the data does not suggest that but this is still early days.
Source - Factor Research
If ESG companies have higher multiples, they should outperform as well. The data looks slightly favorable
Source - Factor Research
Think about it like this, In India there is already a premium in valuation attached to companies with high corporates governance standards, a similar ESG premium or discount will be added to a company’s flows.
Awareness
It’s important to recognize this trend and to know that companies that might be perceived to be undervalued today actually might persist due to ESG factors and some might be actually facing an existential threat.
Further incorporating a true ESG criteria with a sound methodology that’s proprietary or third party might actually lead to significant factor outperformance in the next decade.
The Friedman doctrine (1970) is a good place to start (https://www.nytimes.com/1970/09/13/archives/a-friedman-doctrine-the-social-responsibility-of-business-is-to.html). As he notes, the corporate executive has no business being the legislature, executive, and jurist when it comes to how shareholders are taxed. It's up to the governments to work on it.
CSR tax in India also gets my goat in the same vein. It seems like the governments have forgotten that it's their job to figure these things out. One could make an argument that the game is rigged, and governments (or people that the government supposedly represents) have no chance in this uneven playing field - that's a different problem, and has to be fixed differently by holding governments accountable elsewhere.