Can an investing model created to supply certain companies with easy money work when there isn’t a bubble in the market? That’s the suggestion of James Mackintosh in The Wall Street Journal, who says that in a bubble-less world, ESG investing won’t make the difference it intends to. He writes:
A full-blown ESG bubble would surely encourage investment in things that count as “good” ESG, especially low-carbon energy. Every other bubble in history has been accompanied by a corporate spending boom, whether on canals, railways, the internet or mines, as existing companies take advantage of cheap capital and new players try to supply investors with what they want.
History has another lesson: Bubbles give investors too much of what they want. The price then collapses. Investors who don’t flee in time lose big.
Another problem for ESG adherents is that without a bubble, the investing strategy doesn’t in fact encourage companies to do much more of what the investors want.
Here’s how ESG investing is meant to change companies: I sell my traditional fund and pour the money into a sustainable fund, which buys stocks with high ESG scores. Repeat with $3.9 trillion—as estimated by Morningstar to be following ESG approaches world-wide—and the price of the higher-scoring stocks should be pushed up and the lower-scoring stocks down.
A higher stock valuation means a company can raise money through new share issues at a lower notional cost, important when executives decide whether to go ahead with an investment. Marginal dirty projects (coal mines) should become unprofitable, and so be canceled, while marginal clean projects (wind farms) should get a lower cost of capital, become profitable, and so get a green light.
How it actually works is a bit different. ESG investing is failing to change the cost of capital by much, even as vast amounts of money claim to be managed in a sustainable way.
The companies that score best on ESG tend to have higher valuations for other reasons anyway. Big companies do better on ESG, and so do stocks that have the stable earnings and low debt that investors value more highly.
MSCI’s popular USA ESG Leaders ended 2021 with a forward price-to-earnings ratio about 6% higher than the broad index, a premium that rose rapidly during the year. It is higher than usual, but only in line with the average premium from 2012 to 2015, in spite of the gusher of ESG funds since then.
Such small changes in the cost of capital have only a minor influence on corporate investment.
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