The latest investing fad is environmental, social, and governance funds that invest in "responsible" companies.
But there is no evidence that ESG funds help mitigate climate change.
Investors and the SEC should be wary of thinking these funds help the environment.
Bernard S. Sharfman is a research fellow with the Law & Economics Center at George Mason University's Antonin Scalia Law School.
This is an opinion column. The thoughts expressed are those of the author.
Investing fads are nothing new. For example, in the 1990s the stock market was caught up in the dot-com bubble - a massive speculation spree where investors flocked to any and all stocks related to the internet. Eventually the fad faded, the bubble burst, and investors lost approximately $5 trillion.
The latest fad in investing is environmental, social, and governance (ESG) funds. The purpose of these funds is to invest in "responsible" companies as a way to push for social change - particularly for the purpose of mitigating climate change - while at the same time earning market returns. But the problem with this fad when it comes to climate change is that there is no empirical evidence backing up the idea at their core. In fact it seems fairly clear that an investment strategy of overweighting portfolios with securities of companies that produce a relatively low level of carbon emissions has no impact on mitigating climate change. The world just keeps spewing out emissions in spite of the rapid growth and level of investment in ESG funds.
ESG investing doesn't mitigate climate change
People that understand the data on ESG acknowledge the lack of a connection between the popularity of the products and attaining their supposed goals when it comes to climate change. In a recent LinkedIn post by noted finance professor Alex Edmans of the London Business School, he agreed with my comment "that ESG investing doesn't mitigate climate change."
In another comment, Ashley Hamilton Claxton, the head of Responsible Investment at Royal London Asset Management, wrote, "ESG data is not data, it's opinion. We can't and shouldn't claim direct impact in secondary markets. Investors are one cog in the wheel that turns the global economy. You can't change the world or fix climate change by buying and selling shares and bonds."
The idea behind ESG's impact on climate change is that by moving money away from companies that spew fossil fuels, the funds can effectively make it cheaper for "clean" companies to raise money either through debt or equity offerings and more expensive for "dirty" companies. This sounds good in theory, but does not hold up in reality because the major effects of ESG funds are on the secondary market, where securities are traded but no new money is being raised. As explained by Fancy, investing in ESG funds does not provide new funding for those companies that would help mitigate climate change. "Instead, the money goes to the seller of the shares in the public market." Basically, ESG products are buying stock in companies from other asset managers, not the underlying businesses, so they aren't directly funding these firms at all.
Moreover, there are still plenty of investors out there who are willing to invest in the securities of high carbon emissions companies, allowing those companies to raise new funds at less-than-onerous rates. For example, if ExxonMobil, a company under attack for its policy of refusing to move into low carbon energy production and lobbying against legislation to mitigate climate change, were to make a $2 billion debt offering with a maturity of 30 years, it would probably only have to pay an interest rate of around 3% per year.
So, what's with the ESG fad?
If ESG funds do not mitigate climate change, what is the motivation for marketing these funds to investors? The simple answer is that the investment industry, which includes large investment advisers, rating agencies, index providers, and consultants, makes a lot more money when investors purchase shares in ESG funds versus plain vanilla index funds where the management fees sometimes approach zero.
Of course, investors have a right to invest in anything they want, including the latest investment fad. However, in doing so, it is important for them to understand that investing in ESG funds will not result in the mitigation of climate change. What they are getting for their money are investment funds with higher management fees and potentially higher levels of unsystematic risk - due to a lack of diversification - relative to comparable non-ESG funds.
Finally, the SEC is moving forward on a proposed rule that will require a broad range of mandatory climate change disclosures, facilitating the providing of ESG ratings and the creation of ESG funds. For this to take place, the SEC must not only determine that it has legal authority to do so under the applicable legal statutes, which I discuss in my recent comment letter to the SEC, but also whether it wants to use its discretionary rule-making power in this regard.
In coming to a decision on the use of its discretion, I suspect that at least some of the SEC commissioners will be influenced by the presumption that by requiring mandatory climate change disclosures they are going to somehow help mitigate climate change. The incorporation of this presumption may encourage those commissioners to test the limits of their legal authority.
However, before doing so, I urge each commissioner to take a critical look at the empirical evidence - not just the marketing hype that is coming out of the investment industry. If they can find good empirical evidence demonstrating that investment in ESG funds provides a significant benefit in mitigating climate change, then it may be appropriate, depending on what the law allows, for the SEC to take a broad based approach to its new disclosure rules.
However, I doubt such empirical evidence actually exists, requiring the SEC to take a more restrictive approach in promulgating a new rule on climate change disclosures. In sum, before investors dive into ESG investing and regulators approve new rules that support such investing, I hope all parties take into consideration that such investing will not mitigate climate change.
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