Does ESG Investing Have the Impact We Think It Has?

Sam Ngooi Life with Money

I’d like to divest from oil and gas,” I said firmly. My request felt urgent. The world itself was at stake.

It was 2015, and my answer wasn’t what the financial advisor was expecting when he asked how he could help. Todd, who worked at a large investment firm, was assigned to work with me.

This was his introduction. Basically, “Hi, my name is Corenna, and can you help me pull my money out of anything environmentally problematic?”

I had recently earned my master’s degree through a program focused on conservation, and I had spent a fair amount of time thinking about climate change.

As a result, I tried to be intentional in my daily decision-making, including being cognizant of where my dollars were going and what they were supporting. I was far from living a carbon-free life, but I felt good about trying to reduce my footprint when I could.

But one day, a guilty realization struck me. Are any of my efforts worth anything at all if I’m simultaneously investing in the oil and gas industries? I’m literally profiting every time they are.
cognitive dissonance
Like many people, I didn’t really know much about the stock market. I had no idea what I was invested in, or – to be honest – how investing in the stock market really works. So, when I declared that I wanted to divest from oil and gas, I thought it would be as easy as simply declaring my wishes and then someone – in this case, Todd – making it happen.

I don’t remember exactly how our conversation went, but I do remember Todd gently explaining that it wasn’t as straightforward as picking a few companies to avoid. Which companies don’t rely on oil and gas to do business? Hmm. I admitted I didn’t know, but wasn’t it someone’s job to figure it out?

Perhaps even more interestingly, he said that as a fiduciary, he wouldn’t – couldn’t! – let me divest from oil and gas. It was just too early for that. The world still depended too heavily on both.

I remember hanging up the phone feeling exasperated, disappointed, even angry. How would the world avoid climate crisis if investor – myself included – continued to pour money into oil and gas?

I tried not to think about the gap between my values and my investments. It didn’t feel good.

Years later I started working at Park Piedmont, and I thought, “Here’s my chance!” But through ongoing learning from PPA advisors, I’ve come to realize that it still isn’t that straightforward.

PPA Financial Advisor Sam Ngooi explains why.

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Like Corenna, others may also struggle with how best to express one’s values through money. Why can it feel so challenging to achieve? For one, money is emotional. Feeling powerless or overwhelmed by how we use money can be uncomfortable and can cause us to question our identities and how we move about the world.
How do we express values through our money?
Luckily, things have progressed since 2015, and there are an increasing number of options for expressing values within one’s portfolio. For one, ESG investing focuses on environmental, social, and governance data about a company.

Company metrics around carbon emissions, worker safety, leadership diversity, and the like are rolled into a comprehensive score to help guide investors on whether a company is a sound investment. Climate-conscious investors like Corenna might seek out “green” companies that scored high on environmental measures, reallocating their funds away from “brown” companies with high greenhouse gas emissions and low environmental scores.

Alignment between money and sustainability values achieved, right?

Not necessarily. There are more than 600 rating agencies and systems, each with their own methodology that can lead to a single company earning a range of scores. A single numerical score, while easy to digest, combines a range of variables at the expense of nuance.

According to The Atlantic, “A company that has high carbon emissions and an ordinary record on diversity, but excellent corporate governance, can end up with a very high overall ESG score.” For someone who supports diversity and inclusion efforts but prioritizes sound environmental practices above all, a flattened ESG score can obscure the very details that help discern how a company’s values measure up next to their own.
ESG Investing imperfectly aligns portfolios with values
It’s also easy to assume that a high ESG score means a company is proactively progressing towards better practices with a net positive impact. The Atlantic writes, “MSCI, one of the most influential ESG-rating firms, describes itself as ‘enabling the investment community to make better decisions for a better world’ and declares, ‘We are powered by the belief that [return on investment] also means return on community, sustainability and the future that we all share.’”

In actuality, an MSCI ESG rating measures a company’s exposure and resilience to financially material environmental, societal, and governance risks. This means a company might be a big carbon emitter, but if climate change doesn’t pose a big danger to its operations, it might have a higher ESG score.

Some academics and analysts have also questioned whether the E in ESG is useful as it’s currently defined. Recently, Yale Professor of Finance Kelly Shue and Boston College Finance Professor Samuel Hartzmark launched a research project to measure the impact of sustainable investing on “brown” and “green” firms’ environmental impact. Shue and Hartzmark found that green firms with increased investment capital don’t see a huge change in their environmental impact.

As Shue notes in a recent Freakonomics episode, “[Green firms are] mostly services firms that already don’t pollute. So, when they get more money, they continue not polluting. And they’re also not the best candidates for developing green technology because it’s not part of their business model.”

In contrast, brown firms tend to respond to reduced investment capital by becoming more brown, either by cutting back on pollution-abatement efforts or by reducing spending on green initiatives and investments.

Thus, although it’s counterintuitive, divesting from brown firms might be counter-productive. It raises the cost of capital and forces short-term decisions focused on survival, rather than allowing for longer-term decisions focused (we would hope) on more sustainable innovation. This often leads to more pollution rather than less.

It’s important that brown firms have enough capital to innovate. Shue says, “The brown firm typically pollutes 260 times as much as a similarly sized green firm. So, if that brown firm were able to cut its emissions by just a mere one percent, that is actually way better for the environment than the green firm cutting its emissions by 100 percent.”

Shue also points out that brown firms exist in sectors critical to a well-functioning society (e.g., energy, transportation, agriculture, and building materials). “Punishing” these companies through financial failure is not only counterproductive to their progress but also might have unintended negative consequences on society as a whole.

This realization has given rise to investment options and initiatives that engage with brown firms to make them greener, such as by using ESG data and shareholder voting to encourage more sustainable policies.

So, avoiding companies with low-ESG scores might not have the impact we expected. Maybe you’re surprised by that too.

Does that mean ESG investing is pointless, or that it won’t continue to improve? Should we give up altogether?

Not at all.

The key is to shift our thinking and expectations. We can recognize that relying on an ESG ranking or score to guide investment/divestment choices is certainly a convenient option, but not a perfect solution for clear conscience investing either.

That said, a significant benefit of ESG data is the increased transparency and detail it provides about a company. More than ever before, investors have information at their fingertips to guide their decision-making.
Aligning finances with values
And if the journey feels overwhelming – as it did for Corenna in 2015 and, as she’d admit, it still sometimes does – remember, you don’t have to travel it alone.

Our job as advisors is to walk alongside you, to share new information as it becomes available, and to help you align your finances with your values and goals – whether you’re focused on the short-term, the long-term, or generations into the future.