Jeremy Grantham was right (again)
I recently had an exciting lunch meeting with a group of MBA students at the London Business School. While the conversation was supposed to be about wider trends in the investment industry, the topic that created the most interesting debate was the question as to whether ESG investing makes sense and should be part of the investment process of a professional investment manager.
Obviously, I am an advocate for ESG investing and my firm belief is that an investment manager who does not incorporate ESG factors in her investment decision process is probably neglecting her fiduciary duty. But I am clearly more extreme than the mainstream in that respect. I am quite involved in the CFA Institute and thankfully this organisation at least encourages the inclusion of ESG criteria in the investment process as part of the investment managers fiduciary duty. But that stops short of stating that not including ESG criteria in your investment process is a violation of fiduciary standards.
The reasons why a global organisation like the CFA Institute has to stop short of this position are manifold. In emerging and developing markets, integrating ESG criteria in the investment process might simply be impossible due to a lack of data or a business reality that would provide insurmountable obstacles to making any ESG-related assessment of a given investment.
On the other hand, particularly in the US, there still is a widespread resistance to the adoption of ESG investing. In discussion after discussion I have had with friends and colleagues across the pond, the three main arguments against ESG investing mentioned most often were: (i) that fiduciary duty means an investor should maximise returns for a given level of risk, (ii) that ESG investing is a bubble that has lead investments like renewable energy to become overvalued and (iii) that in an efficient market, risks like climate change are priced in already, so there can be no benefit to ESG investing in the long run, only additional costs.
I don’t have the space here to discuss all three of these objections but want to focus on the assumption that markets are efficient and thus price in any potential risks from climate change or other ESG factors. This to me is at the heart of many objections to ESG investing and I could not disagree more.
The belief in the efficiency of free markets is much more ingrained in the US and by extension in the Anglo-Saxon world than in continental Europe and other regions. While I agree that free markets are the best solution to foster economic growth, generate wealth and alleviate poverty in the long run, free markets are also free of morals. In other words, free markets do not care if Exxon uses solar energy to power the pumps for the shale oil production in the Permian Basin - if that is the most cost-effective way to pump the oil, so be it. In my view this is a failure of free markets since it uses a cheaper from of energy to produce a more expensive form of energy. How can this be growth enhancing for the overall economy? It seems to me that this is a case where profits are generated from unproductive or potentially destructive activities. And this failure of free markets has its roots in a mismeasurement of economic growth. I will write about that in a future commentary, but suffice it here to state that bombing a city into oblivion is good for GDP growth because the reconstruction of roads and buildings increases GDP while the destruction of these roads does not create a cost to GDP (only the knock on effects in lost business create a drag on GDP, but not the destruction of the road itself).
Which brings me to the second assumption, namely that free markets are efficient. I think markets are incredibly efficient most of the time, especially on the micro-level where arbitrageurs and other investors make sure that securities are priced correctly relative to each other in the short run. However, on the macro-level, markets are not always efficient. In the presence of meaningful externalities, markets can become severely inefficient. Just think of the tobacco industry. For decades they could sell their products with high profit margins while the costs of their actions were borne by society in the form of higher payments for disability benefits and higher healthcare costs.
Fossil fuel production is another case of such an externality that is ignored by the markets. While the profits of producing and burning fossil fuels are accounted for immediately, the costs to society in the form of health hazards are socialised and distributed to other players like health insurance companies. Second, the long-term costs like climate change are not accounted for until a tipping point is reached, at which point the costs may be catastrophic. In a sense, we have for decades produced and sold fossil fuels too cheaply and not forced oil companies to incorporate all the relevant costs.
And this is where one of my intellectual heroes, Jeremy Grantham of GMO Asset Management, has once again put it better than I ever could. In the face of climate change, he says that investing in climate mitigating technologies like renewable energies is a sure thing. Because if humanity successfully fights climate change in order to save the planet, these technologies will multiply in value many times over, while fossil fuels will probably become almost worthless or their costs of production will skyrocket via the introduction of carbon taxes, or other mechanisms to put a cost on the externalities of these fossil fuels. If humanity, on the other hand, is not able to fight climate change, it will destroy the planet and we will be dead anyway, so it won’t matter if your renewable energy investments will tank.