Is ESG investing counterproductive? | Professor Kelly Shue from Yale School of Management

Bryce: [00:00:15] Welcome back to another episode of Equity Mates, or should I say welcome young Padawan to FinancialForce, Awakening your guide through the galaxies of finance and investing. We're on a hyperspace journey to decipher the most searched money and investing mysteries, all thanks to you, our esteemed Starfleet of listeners. Our mission to shape you into a Jedi Master of investing. My name is Bryce, and as always, I'm joined by my equity buddy, Ren. How are you?

Alec: [00:00:46] I was wondering what you were doing before we got started. And you said, Don't worry. And I thought you were just chatting to someone on WhatsApp. But now I know you're doing that. So is it my job to guess the theme? 

Bryce: [00:00:59] Guess it. 

Alec: [00:00:59] Star Wars. The intro doesn't really gel with the seriousness of the interview that we've.

Bryce: [00:01:06] That's fine. We're elaxed people here. 

Alec: [00:01:08] Fair enough. It's good. It's good that you're bringing that back. We actually got a few comments about how much people loved the pirate intro, actually. So we've got Pirates. We've got Star Wars. I can't wait to hear. 

Bryce: [00:01:21] Well, as I said, as I said before, before we went away, I was going to commit to it. Yeah. Over some X then the final part of the year to see how we go. So right at the moment I'm committing to the opening. Maybe by the end of the year I'll commit to the voices as well, but will say. 

Alec: [00:01:37] Oh, like the accent. Yeah, well, actually when we did it for. 

Bryce: [00:01:40] Star Wars, I don't know. 

Alec: [00:01:42] Well, anyway, look to today we are talking ESG investing and climate change. So that's a hard pivot right there. But when we speak to Kelly Shue, who's a professor of finance at the Yale School of Management, together with Samuel Hartzmark, they have written a paper, Counterproductive, Sustainable Investing, the Impact Elasticity of Brown and Green Firms. Really, it's all about ESG investing and perhaps some of the counterintuitive or counterproductive outcomes that ESG investing might be driving. It actually might be driving more emissions, Bryce. 

Bryce: [00:02:20] Yeah, I found this. I found this fascinating by nature of, I guess, taking money away from what we classify as, you know, firms that are contributing to a high carbon footprint, we could actually be pushing them further and further down the other end.

Alec: [00:02:37] Yeah, Yeah. Now we'll let Kelly explain the thesis. So we went to put it in the introduction. But I think the important thing to just establish from the outset is these days there's like what, $40 trillion in impact or ESG or sustainable investing funds. And with that amount of money and that amount of people in the space, there's a number of different ESG strategies. What we're talking about here in this interview and the paper that Kelly and Samuel wrote really focuses on the traditional divestment style of ESG investment, which is where if you don't invest in a company, that doesn't satisfy your criteria. So when we're talking about environmental outcomes, if it's a high polluting firm, you don't invest in that firm. That's the standard ESG investing and that's what we're talking about here. 

Bryce: [00:03:25] Now, shout out to equity mates community member Robert Matthews. He was actually the inspiration for this episode as he'd come across Kelly's research paper and asked the equity markets community in our Facebook discussion group for their thoughts on her research. So join the conversation. We'll put a link to this episode in the Facebook group. And if you have thoughts on it, we'd love to hear it, as would Kelly, because, you know, she would love to hear feedback from the equity markets community as well. So we hope you enjoy the episode. It's definitely a different way of thinking about ESG investing and your approach to things. 

Alec: [00:04:00] Before we get to Kelly, first of all, a reminder that while we are licensed, none of this should be taken as personal advice. We're not aware of your personal financial circumstances. This episode is for education and entertainment purposes only. And secondly, one piece of housekeeping. Our new book, Don't Stress, Just Invest, has hit bookshelves. So if you want to continue your investing journey, if you have ever thought about what is enough when it comes to investing, pick up the book. I hope it helps. But Bryce, let's get to it.

Bryce: [00:04:32] Let's do it. Well, Kelly, welcome to Equity Mates. 

Kelly: [00:04:36] Thank you. 

Bryce: [00:04:36] It's a very interesting research paper, as we kind of said in the intro, A lot to discuss. And we've got to start with the big question, which is just is ESG a scam?

Kelly: [00:04:45] Well, I don't think ESG is at all a scam. I think the people behind ESG have very good intentions, which is that they want to improve from impact on the environment as well as on other social and governance metrics. They've committed a lot of money to this movement, but it is still in its infancy. And I'm working on research showing that a large part of how this money is spent could result in actually counterproductive outcomes in which firms actually end up harming the environment. But I don't think it's a scam because there was no intention to defraud investors. So it's not a scam in that sense.

Alec: [00:05:28] I think this is a really important part of the conversation and it sort of builds on a conversation that we're having in the equity markets community and I guess across the broader investing landscape here in Australia and around the world. The last few years we've seen a massive explosion in ESG investing funds and the conversation around sustainable investing. And then in the last perhaps 12, 18 months in Australia, there's been a big conversation around greenwashing and, you know, the sort of marketing tactics that some firms use. But I feel like your research takes it a step further and actually talks about the perhaps counterintuitive or unintended impacts of ESG investing. So I think it's a really important research paper to unpack. But if we take a step back and talk about what led you to this paper, can you talk about the work you're doing at Yale and sort of what inspired you and the conversations that inspired you to actually do this work? 

Kelly: [00:06:22] So a big part of my job is I teach introductory corporate finance to MBA students and executive MBAs. And part of what I study is how firms make choices of which projects to invest in when they're in financial distress or when they're in bankruptcy. And what I've observed, I think this is no surprise to anyone, is that when firms are distressed so they find it difficult to raise financing or it's expensive to get investor money, that they become more short term as they're worried about their short term survival. They tend to focus on existing modes of production, which is how they generate cash. Right now, they tend to steer away from more speculative or long term projects that require a lot of investment upfront and, you know, could be very profitable, but it would take years for those profits to arrive. So I was thinking about that and mapping that over to sustainable investing or ESG investing, because a big part of, you know, sustainable investing as it's currently implemented is this idea that by divesting away from firms that are currently high polluting or brown or low ESG, we're going to punish them, and somehow that is going to cause them to become more green. But from a corporate finance perspective, if we push our firm a little bit closer to bankruptcy, I've seen that all the empirical evidence points toward them being actually a bit more short termist, and therefore they're going to steer away from expensive projects upfront that transition into greener production. 

Bryce: [00:07:55] Hmm. So I guess the follow on from that then, Kelly, is, you know, a lot of the community and people who are investing with an SJ lens do it with the assumption that it is going to eventually or, you know, make the world a better place and green. So based on your research, does ESG investing mean that the world is going to be greener?

Kelly: [00:08:16] I think the current dominant strategy within ESG ideally should be heavily modified. The current strategy, and again, there's a lot of heterogeneity out there. There's a lot of thoughtful strategies already in existence. But I would say the bulk of the 35 or $40 trillion globally that is invested in ESG or sustainable investing, it follows a very simple and I would argue, somewhat naive strategy, which is divesting away or screening out firms that are currently brown or high polluting and investing in or overinvesting in a bunch of services firms that are low polluting. So services firms tend to be insurance firms, financial services firms, or health care. And the problem with this type of methodology is sustainable. Investors are essentially directing their money toward encouraging a set of firms that would never harm the environment in any way by the nature of their business. So if we give that set of firms essentially subsidised financing by giving our money to them, right, they can grow a bit bigger, but they're not going to further improve their environmental impact because they already have zero or close to zero greenhouse gas emissions. To begin with, it's not in their business model to do green technology R&D because, you know, they're an insurance firm. And meanwhile, if we really punish the set of firms that by the nature of their business, they're high polluting. You know, we actually interrupt the kind of natural technology dynamics that have favoured green production anyway, because if you have a long run perspective, coal mining is not that profitable anymore for most developed countries. So they were on a natural path toward greener production that I think we would want to accelerate. But it's not clear that pushing these energy firms toward bankruptcy is the way to do that. 

Alec: [00:10:11] Yeah, so if we just summarise where we're at and sort of the the state of ESG investing and we should be clear that we're talking about the divestment strain of ESG investing these days, there are a number of different sort of ESG funds that take a number of different strategies. But when we're talking about divestment, as you explained, you don't invest or you don't lend to the brown polluting firms that increases their cost of capital. It makes them more short term, it makes them sweat their existing assets and their existing operations rather than investing in greener forms of operation or technology. And then I guess the logical conclusion is that some of these firms start going out of business and they don't invest in change. And we heard another interview you did and you made the point that when you say that, when you say they'll go out of business the instant you think coal companies are these brown firms, that will go out of business. But the Brown firms are actually talking about a little bit more varied than that and quite integral to the economy. So can you just talk about some of the firms that we're talking about here when we talk about these quote unquote, brown firms? 

Kelly: [00:11:24] Yeah, I think, Alex, you bring up a very good point, which is that if we raise the cost of capital to infinity, let's say, for for these brown firms, you will succeed in wiping them out and they're not going to pollute anymore. So in that sense, you know, if that's your only metric, that that will be a success. However, a lot of brown firms are not in or they're in industries that don't have readily available substitutes and that are critical for society. So take agriculture, transportation, and building materials. What I found in my research is that sustainable investors tend to underweight all of agriculture, and they overweight greener industries such as insurance. And it's not possible to eat less food and substitute for it by consuming more insurance. It seems like a better strategy would be to say sustainable investors should not underweight agriculture as a whole. What they could instead do is they still invest in agriculture, but they could invest in the greener firms within agriculture, or they could invest in firms that are actually maybe still high polluting in terms of levels of their greenhouse gas emissions, but have had meaningful improvements in terms of reducing their emissions over the past several years.

Alec: [00:12:42] We'll just take a quick break there and then we'll be back to continue unpacking this topic after the break. Welcome back to this episode of Equity Mates. We're speaking to Kelly Shu, a professor of finance at the Yale School of Management. And we're unpacking perhaps the counterproductive nature of ESG investing. 

Bryce: [00:13:07] So, Kelly, what's the incentive then for brown firms to become green if under this sort of current structure of ESG investing? 

Kelly: [00:13:16] I think what sustainable investor should try to do is to dial up this incentive channel. There's nothing wrong with this theoretical channel, which is let's take a firm that is currently high polluting. It knows that if it becomes green, it can access cheap financing from these ESG investors. So that's a good incentive for it to transition toward becoming more green. What I've shown in my data is that so far, sustainable investors primarily only reward firms that are already green and that have had large percentage reductions in their emissions. This focus on percentage reductions in emissions is absolutely the wrong unit to be considering. And it's because brown firms and green firms start with vastly different levels of pollution to begin with. So the typical brown firm has about 260 times the amount of greenhouse gas emissions as a similarly sized green firm. So that means even if a green firm reduces its emissions by 100%, that is actually less meaningful for the environment than the same sized brown firm, reducing its emissions by only 1%. So to a rough approximation, what firms are doing if they're already green just does not matter. We don't have to worry about them. It's really the brown firms and getting their incentives right that would help the environment. 

Alec: [00:14:44] So on that point, have you seen any models around the world of a better way to invest sustainably and to really, I guess, create an incentive structure for brown firms that is actually driving the outcomes that we want to see? 

Kelly: [00:15:00] So there are certain niche strategies that can be very effective, such as investing in brown firms but engaging with their management or essentially voting your shares. There's also direct impact investing, which is targeted investments at either green R&D or project specific green financing. So while I think all of this is promising, I do kind of want to recognise that in reality what we have is a large pot of money from investors who want something similar to a diversified equities portfolio, but they just want it tilted toward ESG. So they're looking for a risk and return profile that is similar to a diversified equities portfolio. And I think realistically, it's too much to ask of them to put that same giant pile of money into a highly specialised and risky impact green R&D fund. So I think there is hope then for some kind of smaller corrections, which is let's dial up that incentive channel and reward companies that have reduced their emissions meaningfully in levels rather than in percentage terms. And let's also do a better industry adjustment focussed on transition. So instead of avoiding high polluting industries altogether, think about how to invest in brown industries but reward the green firms within those industries or award the improvers within that industry. 

Alec: [00:16:30] Yeah, and there are some examples of sort of the biggest investors in the world, I guess are taking the approach they are advocating here and not just divesting, but rather I guess, engaging. The classic example is the Norwegian Sovereign Wealth Fund, which I think is $1.4 trillion or something these days. And they reviewed their operations and divested from upstream oil and gas producers because they're the oil and gas producers that are trying to explore and find new sources of oil and gas. But they maintain their investments in the big downstream producers, the Shell, the Exxon, the BP and the like. Because everything you're saying, you know, they are engaging, trying to change operations, reducing the cost of capital and allowing them to invest is going to drive better outcomes than just increasing the cost of capital and walking away. So I guess for the big institutions, they can have that impact. But Kelly, unfortunately for people like Bryce and I, we can't have that impact. We can't have that $1.4 trillion impact, at least not yet. So for small dollar, everyday investors, for people, maybe students in your class who are just starting their investing journey, what do you tell them when they're trying to get their heads around this topic and then trying to, I guess, invest in line with the findings from your research? 

Kelly: [00:17:56] I would advise them to do their research on the specific funds that they're considering to make sure that it has more of a perhaps a transition focus without underway hitting entire Brown industries. The other idea that I hope investors will consider is I think many investors very rationally want to avoid holding brown firms, not necessarily because they will even want to improve the environment. They're worried about carbon transition risk and I can't fault that reasoning. So the idea here is that firms that emit a lot of carbon may be exposed to heavy taxation and regulatory risk in the future that's not currently priced. So it's just kind of a possibly a bad investment to invest in these types of firms. And I think that's a very legitimate concern. But I hope people will think through the consequences of what it means to start pricing carbon transition risk. It actually leads to the same outcome, which is if we avoid investing in brown companies because we think they have high carbon transition risk and we don't want that in our portfolio, then it means then that these brown companies have a very high cost of capital, which pushes them a bit closer toward bankruptcy. Leading them also to become more short term is impossibly preferred. 

Bryce: [00:19:19] Well, Kelly, will we leave it there. Thank you so much for your time. We certainly appreciate you coming on and leaving us with a different way to sort of think about how we can, you know, approach ESG as an investment. And we'll include a link into the podcast episode that we talk about and your research paper as well for our audience to have a deeper look if they're interested. But thank you so much.

Kelly: [00:19:41] Thank you very much for letting me talk with this audience.