Yale Research Shows Woke Investing is Flawed
Written by Wesley George & edited by Oda Larsen
It’s true. The conservative talking point that ESG investing is flawed is inarguable. Woke investing must die.
Not really, of course. But that won’t stop anti-green folks from citing a paper that came out earlier this year that points out some challenges ESG ratings face (whilst completely missing the point, of course). “Counterproductive Sustainable Investing: The Impact Elasticity of Brown and Green Firms” (Hartzmark and Shue, 2023) points out that basing investment decisions solely on ESG ratings is potentially counterproductive.
As most environmental experts will attest, ESG rating systems have pros and cons. That, however, hasn’t stopped investors from using them to inform their sustainable investing decisions. For context, ESG ratings group some companies into Green and Brown categories. Green companies tend to be in low emission industries, like finance, insurance and other services. Brown companies tend to be what you’d guess, O&G, transportation, construction, agriculture, etc.
Currently, there’s about $35 trillion in global assets invested in Sustainable Investing, which is expected to grow to about one-third of all assets by 2025. The premise of green investing, it can be argued, is that ‘it rewards green firms by lowering their cost of capital and punishes brown firms by raising their cost of capital.’ The point of the paper is that the strategy just makes, especially in the short term, ‘brown firms more brown without making green firms more green.’ If Brown firms can’t get cash from borrowing it at a good rate, they’ll likely double down on ‘existing brown projects which deliver relatively more front-loaded cash flows,’1 which is how most firms act when they’re strapped for cash. They expand what’s working now rather than invest in what might work in the future.
Hartzmark and Shue also point out that Brown firms have ‘approximately 260 times as much environmental impact as similarly-sized green firms.’1 I.e., you can’t reduce a lot of emissions from companies that don’t emit much. It’s the Brown firms we want to fix. And furthermore, a huge number of new green patents are coming from these Brown companies. So where does that leave us?
Stephen Dubner, of Freakonomics fame, tackled this topic on his podcast. He spoke with Carine Smith Ihenacho, the Chief Governance and Compliance Officer for Norges Bank Investment Management (aka the Norwegian sovereign wealth fund of around $1.4 trillion). She explained how, after much deliberation, around 2017 they divested pure upstream oil and gas producers, along with coal, tobacco, companies involved with deforestation, certain weapons, etc. However, she explains, ‘Exxon, Chevron, B.P., Shell type of companies, continue to stay because they do much more than just upstream production.’
Both Shue and Dubner highlight the work of Engine №1, an investment firm that made a big impact on ExxonMobil. Just by owning a fraction of 1% of ExxonMobil, Engine №1 was able to win 3 board seats that led to some big changes. As Chris James, the founder and chief investment officer, explains to Dubner:
The biggest change is probably starting the low-carbon-solutions business. Carbon was something to be feared and something that was an existential threat to their business model. And today, it’s one of the three pillars of the organization. This is the effort that they’re doing to mostly decarbonize their own operations, but ultimately sets them up to help decarbonize their customers’ operations. And so, that’s what we felt was a tremendous business opportunity, and why you have seen companies like ExxonMobil come out in favor of the Inflation Reduction Act, because it is a business opportunity for them to provide their customers with a lower carbon footprint for the businesses that they operate.
ESG in practice relies on data sets. According to James, ‘…we’re not advanced enough on the data sets for that to be effective. It is much easier just to say, “Green is good, brown is bad.” I mean, my life would be so much easier if I could just do that, I can tell you.
The takeaway from this research isn’t ‘woke investing must die.’ It’s that making a real impact is more complicated than just Green is good, Brown is bad. As Hartzmark and Shue claim, perhaps “changes in impact are measured in the wrong units…large percentage reductions in emissions rather than large level reductions in emissions. Influential ESG environmental ratings similarly reward percentage reductions in emissions rather than level reductions in emissions.” The point being that reducing the impact of the largest concrete manufacturer by 1% would have an immensely larger impact than a SaaS company reducing their emissions by 100%.
We can’t solve the hardest problems we’re facing by ignoring them. We have to attack them directly with every resource we have available. Invest in solutions that will create the largest impacts, period. It turns out the G might be the most important part of ESG. As Chris James puts it, “the energy transition should move from being thought about as an existential risk to our business to a humongous opportunity for our business.” And that needs to happen on the board level.
