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ESG criteria: vectors of a real revolution or mere window dressing? (Reader)

This is the first reader article on the blog. To submit an article, you can send it by email to (not all articles will be published).

My comment:

I am particularly interested in ESG criteria, as I use them to construct my portfolio at BlackBoar Capital (student Investment fund). My view on ESG criteria is similar to W. Churchill's view on democracy: "democracy is the worst form of government – except for all the others that have been tried". In other words, ESG criteria have many flaws, but no better tools exist today.

I agree with Alessandro's point that ESG criteria are very broad and not that constraining. I also agree that today's climate emergency requires more drastic tools, tools scarifying short-term returns for greater environmental and social benefits.

Before a more efficient tool is created and accepted by most corporations, we should use ESG criteria as efficiently as possible. For example, the "ESG gain investing strategy", which prioritises investments in companies with recent ESG gains, has some positive impacts as it encourages companies to reduce a part of their CO2 emissions and to enhance their social impact.

Now, I will let you enjoy Alessandro Bozzi's article.

The article: by Alessandro Bozzi

Alessandro Bozzi is 20 years old and a third-year student at McGill in Economics and Finance.

Our planet is coming out of a summer that has been punctuated by climate disasters of unprecedented intensity. From the mega-fires that ravaged Europe to the exceptional heat waves experienced in North America, these extreme weather phenomena will, according to a unanimous scientific community, be increasingly recurrent and violent in the next three decades. According to UNEP (United Nations Environment Programme), if we hope to keep global warming below 1.5°C in 2050, global fossil fuel production must decrease by 6% per year until 2030. As coal is the main source of greenhouse gas (GHG) emissions, it is essential to stop its expansion today and to start a real exit from it. As majority shareholders of most fossil fuel companies, asset managers have exceptional power to accelerate the energy transition. Good news! In recent years, the number of asset managers committing to being "carbon neutral" by 2050 has been growing steadily. ESG (environment, society, and governance) criteria, which assess the environmental and social impact of companies, are now a real craze in the financial markets. Compliance with these criteria has become a requirement for many asset managers. According to the IMF, investment in these ESG assets has doubled in the last four years to US$3.6 trillion. With the growing influence of asset managers, it is essential to ensure that all these fine ESG promises are not empty.

In a survey released last September, Util - a company that specializes in analyzing the environmental impact of companies - used the 17 Sustainable Development Goals defined by the United Nations to measure the environmental impact of the 281 ESG-labeled U.S. investment funds, relative to the rest of the U.S. funds. The survey reveals that while ESG asset portfolios are slightly less harmful to the environment, their overall net impact is still negative.

This ineffectiveness of ESG criteria stems from a major flaw: they are very vague and therefore not very binding. While in traditional accounting, companies obey standards that set common principles of method and reliability (IFRS standards in Europe, IAS standards in the United States), there is no framework of standards that allow the environmental impact of companies to be quantified. For the moment, companies are free to define their own metrics. As Util's survey shows, ESG criteria are sometimes defined differently depending on the sector of activity, leading to very generous ESG criteria and making comparative analysis from one sector to another impossible. In addition, companies reserve the right to publish or not their environmental data, and can therefore disguise them as they wish without any real external control.

In the absence of a standard defining the conditions necessary to obtain the ESG label, these criteria remain "a selection that does not really select", in the words of Julien Lefournier, former trader-arbitrageur and author of the book "L'Illusion de la Finance verte" ("The illusion of green finance"). Indeed, the ESG rating of a portfolio of assets currently corresponds to the average of the ratings of each asset in the portfolio. With such a calculation method, obtaining a good ESG score is more often the mark of a simple weighting phenomenon than of a positive environmental impact. If we start with a classic portfolio, we simply remove the lowest-rated assets, and mathematically we obtain an ESG average that is higher than the classic portfolios, yet the absolute impact of the new portfolio remains negative.

If this example is simplified, we can see that most ESG portfolios are content to do "a little better" than their peers without having a positive impact. This explains why ESG portfolios are almost the same as conventional asset portfolios. Util's survey perfectly illustrates this similarity: the first sector in which both groups of funds invest most often is technology (18% of traditional fund assets and 16% of ESG fund assets). In the United States, the giants Microsoft, Amazon, Apple, and Alphabet are the four companies to which the most investments are directed in both groups of funds. Ironically, Amazon is the fourth most invested company in the US ESG funds. With no obligation to divest fossil assets associated with the ESG label, it is not surprising that many asset managers promising carbon neutrality by 2050 have yet to adopt a policy of excluding coal. The hypocrisy is all the greater given that some of them are even involved in financing new coal-fired power plants.

For all these reasons, it is clear that in terms of environmental impact, companies and investment funds are judged more by their words than by their actions. In this context, where ESG criteria are only a façade, the question arises: is the development of effective criteria possible? As things stand, the answer is no. For an investment to be truly "sustainable", it must be based on non-financial criteria that are independent of short- and medium-term profitability objectives. However, financial products are today structurally trapped in a valuation method that is in total contradiction with a real ecological transition. Indeed, the current valuation methods of financial assets do not take into account negative externalities (such as GHG emissions). "The investment world has progressively restricted itself to the profit and loss account as the only measure of risk-return," said Jennifer Grancio, CEO of the ESG Engine No.1 fund.

In this context, where investments are rewarded solely on the basis of their short-term return, the omission of negative externalities in the valuation of polluting assets de facto penalizes investments with a positive environmental impact, which are often more expensive. Let's take the example of meat production: the production of a vegetable steak costs on average US$1.97 more than a beefsteak. However, the production of the latter emits very large quantities of methane that are not taken into account in its price. This cost difference between the green solution and its polluting alternative is called the "green premium". In a system where a company's performance is not judged as such but constantly compared to its competitors, imposing environmental rules on itself that others do not respect is to inflict a competitive handicap on itself. And as in any game, if only one participant imposes constraints on itself that the others do not respect, it necessarily loses!

Today, ESG investments are sold as a short-term profit opportunity. Such a discourse is the antithesis of the long-term industrial transformation that must be achieved to face the climate challenge. As long as investors do not accept lower returns on green assets, green assets will never be attractive. Without binding legislation that would, for example, massively exclude polluting assets or make managers of polluting assets pay a share of the green premium to compensate for the structural underperformance of sustainable investments, the offer of "green" finance will remain a mere announcement effect that will not generate any structural change.

Alessandro Bozzi


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