ESG Investing: Can You Have Your Cake And Eat It Too?

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ESG or Environmental, Social and Governance has become the hottest topic in investing today. Academic papers reported that that sustainable assets under management worldwide were approximately $30 trillion by 2019. Blackrock CEO Larry Fink has said that “We will be increasingly disposed to vote against management and board of directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices underlying them.” In addition, investors are being told that they can have their cake and eat it too. By investing in socially responsible, green companies they can they help improve society, feel good about their personal contributions, and also expect to earn higher investment returns. Is this too good to be true? Unfortunately, it is.

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How Investors’ Preferences Affect Expected Returns

Nobel Prize winner Eugene Fama, along with Kenneth French, developed a simple framework that can be applied to determine how investors’ preferences for socially responsible green companies are likely to affect expected returns.  They show that when investors prefer highly rated ESG companies the expected return from investing in those companies will be lower, with the magnitude of the effect depending on how much money those with green oriented investors have available to invest. The greater the hunger of highly rated ESG companies, the lower the expected return. Turning the matter on its head, the Fama-French theory implies that out of favor low rated ESG companies, such as oil and gas producers, offer higher the expected returns.

Does the Fama and French theory work in practice? Although the ESG boom is too new for there to be sufficient data to study how investor preferences for green companies affects expected returns, work has been done using previous “sin” stocks such as companies involved in businesses such as alcohol, tobacco, firearms and casino gaming.

Studies by Hong and Kacperczyk and Dimson, Marsh and Staunton find that sin stocks have indeed provide higher average returns than as the Fama-French theory predicts. In today’s world the new sin stocks would be shares of low rated ESG companies such as producers of fossil fuels. The studies imply that investors must be compensated in terms of greater expected return for the reputational costs associated with holding sin stocks. As a result, in today’s market a renewable energy company like NextEra is likely to provide investors with lower future returns than a fossil fuel company like Exxon.

Adjustment Effect On ESG Stocks

This prediction seems to fly in the face of recent experience. In the last several years, the stocks of green companies like NextEra have skyrocketed while those of old-line energy companies like Exxon have languished. The explanation for the apparent paradox is understanding the difference between a market in transition and one in equilibrium. Concern over ESG is a relatively new phenomenon coming to the fore during the past 10 years or so.

During the last decade, market prices have been adjusting to a new equilibrium that reflects ESG considerations.  As the market adjusts to incorporate ESG information, the prices of highly rated ESG stocks will tend to increase and the prices of low ESG stocks will fall.  Consequently, during the adjustment period highly rated ESG stocks will outperform the low ESG stocks, but that is a one-time adjustment effect. Once the adjustment is over and prices reach equilibrium, the value of high ESG stocks will be greater, but the expected returns they offer will be less.

The bottom line is that there are a lot of reasons for investing in socially responsible green companies. Unfortunately, the prospect of higher future monetary returns is not one of them. If you would like to know about this subject, a video is available on the Cornell Capital Group website.