After the Bell: The sad and untimely death of ESG investing

Someone had a dream that the way to change the world was to convince investors to invest in companies that are concerned about the environment, society and governance (ESG). Follow the money, they said. Hold investment companies accountable, they said. If you can change money flows, rather than begging people to change their behaviour, you are effectively creating an incentive for them to do so from their pockets.

How did such a sensible idea go so wrong, so fast? Bloomberg reports that for the first time, ESG funds suffered net global outflows over the past quarter. And the money involved is pretty chunky. 

Bloomberg cites fund management monitoring company Morningstar as recording that clients withdrew a net $5.1-billion in the final three months of 2023 from US ESG funds. There were $1.2-billion of outflows in Japan, and although Europe did record $3.3-billion of net inflows, that wasn’t sufficient to ameliorate net global outflows. 

What’s happening here and is there a solution?

First, the most obvious problem is that ESG funds just aren’t doing very well. The S&P Global Clean Energy Index was down by more than 20% last year, compared with a 24% increase in the S&P 500. More than that, the trend towards index funds remains strong and works against ESG funds. In Europe, for example, which is by far the world’s biggest market for ESG investment products, passive funds saw inflows of about $21.3-billion, while active strategies lost almost $18-billion. 

Second, fund managers have been frustrated by the lack of clarity about what is and what is not investable if you are an ESG fund. The British website Financial News (FN) recently initiated a survey among its readers and found that 60% of respondents considered criticisms against ESG investing to be justified. 

“Those respondents to FN’s survey who said the anti-ESG backlash has merit echoed these points, describing the green investment movement as ‘smoke and mirrors’, ‘meaningless metrics and not proactive change’ and a ‘scam’ that has ‘become too politicised’.” Heady stuff.

To take just one example, respondents were asked if it was okay for an ESG fund to hold shares in arms companies; 40% said it was, and 43% said it was not. Respondents also blamed unclear rules and “a lack of uniform, regulated and enforced metrics” for ESG’s recent reputational woes. You don’t say. 

Third — and this one is pretty complex — the world is discovering some unintended consequences in ESG investing, oddly enough. If investment flows exclude, say, coal companies, then new coal companies are not established, which will affect the overall coal supply. The result will be that the price of coal will increase unless, of course, the transition to environmentally sustainable energy sources increases so that coal demand declines. But in the short term, that’s unlikely to happen — these transitions take years.

This has been very visible in SA, with Anglo’s decision to spin out its coal producer Thungela. Thungela’s share price has been weak this year because supply chain issues around the world have eased. Consequently, the price of coal has declined on the back of a reduction of supply fears. But even though they have come down very sharply, coal prices are still around 50% higher than they were in the decade before 2021. 

The result is that despite Thungela’s share price declining sharply, its dividend yield — the ratio between the value of the stock compared with the dividend payout — is still just nuts. I mean, really nuts, like 45% nuts. In other words, if you close your eyes, hold your nose, and invest in Thungela today, in two years you could easily earn back your entire investment just on dividends alone — and you would still own your shares. Incredible. 

This is very bad news for ESG funds, because investors look at the movement of the overall market and ask why they are getting such poor returns while the market as a whole is rising strongly. In a sense, the backlash against ESG is as much a bread-and-butter issue for investment companies as it is an issue of uniform metrics.

I think there is one other problem, and that’s tossing E, S and G together in a single bundle. You can understand that there may be special issues around standards and metrics for environmental investment. But surely, governance issues are much more obvious. 

Corporate governance is essentially about making sure that a company has structures in place to ensure that, as far as possible, nobody does anything ape. For example, the CEO doesn’t try to extort free shares from the company (hello Elon Musk) and board members do their jobs (hello Tesla). This goes beyond the law, of course. But the point is that you want all companies, whether they are environmentally responsible or not, to have good governance.  Just because the company makes guns doesn’t mean it can’t be run sensibly. Putting the G in the same bucket as the E, or even the S tends to dilute the picture.

There is one last problem with ESG investing, and it’s that all the business service organisations, from accountancy firms to brokers to advisory organisations, have  jumped on to this idea. The result is that qualifying as an ESG-compliant company has become a wonderful money spinner for the McKinseys of the world, but kinda expensive for the rest of us. 

Is there a way to fix all of this? I think there is; it will take a bit of time, but fundamentally the idea is sound. What we are seeing are wrinkles in the application. Those wrinkles will be ironed out in time.

But then again, maybe I’m just dreaming. DM