3 June 2021

How ‘socially responsible’ investing could distort markets and harm the planet

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Markets are about psychology. If you can set a trend, then everyone will jump on board. The latest trend to seize institutional market’s attention is for Environmental, Social and Governance investing (ESG), resulting in $2bn per day flowing into sustainable funds this year, according to Morningstar. Corporates are responding in the time-honoured way – peppering annual reports with copious mentions of sustainability, diversity awareness, corporate social responsibility, and how ESG “powers” everything decision they take.

There is a risk the act of being seen to be ESG compliant becomes more important than actually doing anything tangible to improve the planet, better the lives of fellow human beings, or ensure companies are well run.

Last week saw extraordinary events in the oil market, as successful climate change protests shook the industry to its very core. Exxon had to give seats on its board to a tiny activist investor which won support from other holders concerned about the wobbly oil giant’s “strategic direction” in terms of reducing emissions. Chevron submitted to investor demands that it takes climate change seriously. Shell was ordered to slash emissions by cutting production by millions of barrels per day, on the basis of “unlawful endangerment” after being dragged to court by Friends of the Earth’s Dutch chapter. Total faced a similar challenge in France, but scraped by.

On the surface this looks like a victory for the planet, but the unintended consequences could be severe. If oil producers scale back on capacity or production to meet climate activist demands – the potential is to push the price of oil higher until declining demand from oil finds a new equilibrium. That could take decades – meaning severe energy price distortion upwards in the short term, generating inflation and slowing growth. Higher long-term oil price distortions also favour producers with somewhat laxer social compliance values than US oil majors. Tehran will be delighted.

So is ESG a good thing?

It’s significant that these fights weren’t won by tree huggers wailing ‘kumbaya’ outside oil companies’ front doors. The knockout blows came from ESG and Corporate Social Responsibility wielding suits in the boardroom and in court. They won, Big Oil lost, and the world took notice – because if it’s happening in oil, it’s going to happen elsewhere.

Boards being held accountable by investors is nothing new. Courts ensuring companies act honestly and do no harm is fundamental to corporate governance – the ultimate sanction. What changed last week was confirmation that ESG principals are right up there in terms of how companies must act.

I find myself somewhat conflicted here – I get the science, I understand it and, owning a house by the sea, I’m motivated to avoid climate change and rising sea levels.

I also take the view that regulations (and all other varieties of bureaucracy) are distorting – and ultimately spawn a host of ways for corporates to avoid them. I saw it most clearly in financial institution capital – where we dreamt up a million ways to “optimise” bank capital, spawning a host of instruments and behaviours that ultimately triggered the financial crash.

Shareholders taking direct action to discipline recalcitrant boards failing to act on climate change is vastly preferable to companies claiming environmental compliance because they meet pages and pages of greenwashing regulation.

I am developing a strong suspicion that the ESG Industry has become a facilitator for corporates looking to virtue signal by hiding behind environmental gobbledygook. Frankly I don’t understand how a company launching a green bond makes that firm any better or excuses previous years of polluting activity. I am entirely unimpressed by government ministers bragging about the UK’s green Gilts programme – big deal, lots of soundbites, empty gesture.

I’m much more impressed by the tiny activist hedge fund Engine No1 knocking sense into Exxon’s prehistoric board to enforce climate change action by putting two board members in place – it was widely supported by institutional shareholders.

But who is to say the carbon emission reduction policies one set of activists push on a company are better than the alternatives? Many think electric vehicles are the future – but what about long-term carbon costs of producing batteries and cars, or the problems recycling lithium? Successful entrepreneurs like Elon Musk have not so much set a new green agenda as dragged the market down their chosen path.

Who’s next?

The activists are already targeting financial institutions. An Australian coal mine project has stalled because it can’t find insurance because of ESG concerns. The UK government is dithering over a metallurgical coal mine because of the climate signals its approval might send. Banks and funds are being targeted by sophisticated organised protests. “Blackrock – Your assets on fire!” is a campaign that’s working, forcing one the largest investors to pay attention. Philanthropist Chris Hohn’s Children’s Investment Fund Foundation is demanding banks stop funding fossil fuels.

The international Energy Agency is also in on the act – demanding energy companies stop all new oil and gas projects this year. British banks have been described as equivalent to a top 10 carbon polluter based on their financing of fossil fuels. Ahead of the COP26 climate change conference in Glasgow this November, environmental groups intend to target bank boards with demands they cease further fossil funding.

It’s a message banks, regulators and politicians have no alternative but to listen to – and that becomes a distortion. Successful companies are successful because they are well governed and understand what makes them work. Imagine what happens when self-appointed climate tsars take over?

The power of ESG has grown exponentially is recent years. It now sets a ‘climate change trumps the invisible hand of markets’ agenda. It has the potential to become another massive distortion moment. I’d much rather see good corporate governance than companies feeding the ravenous ESG panjandrum of conferences, courses, experts and consultants.

ESG principals are good. The ESG Industry? Perhaps less so. As we all know market distortions trigger multiple unforeseen consequences – not all of them happy.

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Bill Blain is market strategist and head of alternative assets at Shard Capital. He writes a daily market commentary called The Morning Porridge (www.morningporridge.com).

Columns are the author's own opinion and do not necessarily reflect the views of CapX.