Will the rise of ESG investing cause stagflation?
Ethical investing has been around for decades. But its latest incarnation, signified by the acronym “ESG” (investing with consideration of a company’s approach to environmental and social matters, and corporate governance) only really started to gain traction around 2018, based on search engine queries as measured by Google Trends. ESG investing is instead more explicit about the idea that there is no need to compromise between “good” behavior and attractive investment returns. Indeed, ESG investing argues that high quality corporate governance, environmentally responsible practices and good corporate citizenship are essential to the performance of financial assets.
Defining ESG investing is not easy
There is a logic to this and there has even been discussion of the possibility of calculating an ESG ‘factor’ (i.e. a set of characteristics – similar to ‘growth’ or ‘value’ – which tend to lead companies to outperform over the long term). However, these attempts are hampered by a lack of agreement on definitions. Indeed, there is only a weak correlation between the ESG scores of the main rating agencies, indicating the lack of consensus on the standards.
Of the three, “governance” is perhaps the easiest to define: it boils down to strategy, accountability and alignment. The idea that well-run companies with a track record of strong capital deployment and well-established shareholder rights tend to perform better over the long term is neither controversial nor particularly difficult to measure – so there are generally more agreement on what good governance looks like.
The “social” component is the most difficult to quantify. The scope is broad, and while working conditions, workforce diversity, relationships with employees and local communities, and approaches to health and safety, for example, are all important, their impact precise finance is difficult to measure. Finally, “environmental” is pretty easy to understand – it’s about assessing the negative environmental impact of a company’s actions. But in practice, it is difficult to measure this completely or accurately based on the information we have today from companies. It’s a shame, because it’s also the area likely to have the most significant economic impact in the longer term.
The transition could be stagflationary
Indeed, despite all the difficulties of definition, one thing is increasingly clear: achieving higher global ESG standards will be inflationary, and could even turn out to be stagflationary (i.e. slowing growth while driving up prices). This may be the price we have to pay for more sustainable long-term economic growth, but it is something investors need to be aware of when building their portfolios.
Right now, we are in the midst of a generational surge of higher inflation. There are several causes, including monetary policy, the war in Ukraine, and pandemic-related disruptions. A crucial fragility that the price spike has highlighted is the chronic underinvestment in the development of new sources of oil and other essential raw materials in recent years. A key driver of this has been the increase in ESG-related scrutiny, which has made companies reluctant to make the long-term investments needed to exploit new oil resources (for example), for fear to end up with “stranded assets” if the law, sentiment or technology changes.
Not only are we facing higher prices, but we are at a very unusual time in human history in that we are trading technology for a less efficient version as we head towards the goal net-zero carbon emissions. The discovery of fossil fuels and the harnessing of the high levels of energy stored in them has led to accelerated economic growth. Of course, the reverse may be true as we shift to renewables, unless significant new technological advances can be made cost-effectively. There is a close relationship between GDP growth and energy consumed, which in turn means a historically close relationship between GDP growth and carbon emissions (although to be fair, the data suggests that this relationship is not is no longer as narrow as it was before) .
We don’t invest enough
Not everyone agrees with this grim prognosis. The net-zero transition is not inherently stagflationary, argues Brian Davidson, head of climate economics at Fathom Consulting. He notes that the large levels of investment needed to make the transition should spur growth and that renewable electricity is generally cheaper than electricity generated from fossil fuels, which could help ease inflationary pressures.
There is a catch, however – this transition, Davidson says, needs to be well managed by both policymakers and the private sector. Unfortunately, that’s not what we get. Instead, on the one hand, the focus on ESG has meant that investment in fossil fuels has been lower than it otherwise would have been, reducing our energy supply from these traditional sources. . But “at the same time, investments in renewable energy sources and infrastructure have not been what they should have been to replace them”. This in turn contributed to inflationary pressure and reduced economic growth.
ESG investing – or just growth stocks?
A global “net zero” overhaul seems unlikely at this point. So let’s assume that’s the direction of travel – a stagflationary transition away from fossil fuels that implies slightly slower growth and higher prices. How should you position your portfolio for this scenario?
You might assume that ESG investing is the way to go. After all, it has proven very popular in recent years, with an explosion of ESG-labeled products on the market, and for many years this approach has generated superior returns on investment. However, that’s because the low-growth, low-inflation world we’ve been stuck in since the 2008 financial crisis has favored technology and “longer duration” (i.e. assets that don’t will generate the majority of their cash flow later in the future) growth stocks versus more economically sensitive, heavy industrial and commodity names. This favored ESG portfolios simply because they included more of the former and very few of the latter.
More recently, however, soaring inflation and interest rate expectations have led to strong sell-offs in growth stocks and other long-duration assets, which in turn have hurt fund performance. ESG once top flight. Meanwhile, in the same way that one could argue that US Treasuries are too expensive due to excess demand from central banks, the same argument could be made that many non-ESG assets are undervalued due to artificially reduced demand.
It’s hard to choose winners
In the long term, some renewable energy companies and others involved in the energy transition should do very well. But many will not succeed, as was the case during the dotcom bubble. As with many new trends, companies seem to find it easier at first to generate revenue than to create value.
This is one of the reasons some asset managers are taking a broader view of ESG. It’s not just about companies that are already successful, it’s also about engaging with companies that are improving. For example, Waverton Investment Management takes what it describes as “a pragmatic approach”, aiming to “identify companies that allocate capital responsibly, ensuring the resilience of their business model and their long-term financial viability”.
Importantly, the approach “not only includes companies that already operate to high ESG standards, but also those that are on an improvement trajectory and/or part of the transition solution. These are often enhancers and enablers that offer the most value to investors and the prospect of superior returns over time”.
Buy food, fuel and defense supplies
Disruption to supply chains will also interact with ESG investment goals aimed at pushing more investment into certain sectors. As economist Peter Warburton of Economic Perspectives notes: “The ‘health and security’ aspect of social investment has undergone a significant reinterpretation, to encompass physical, food and energy security”. Ensuring a reliable supply of food and fuel in a world where the old certainties of globalization can no longer be taken for granted involves “a massive reallocation of resources to food agricultural production and global transportation. Higher food prices will be needed to create incentive to grow additional crops and address structural damage to global food supply chains. Investments in farmland, food production and transportation should be amply rewarded,” says Warburton. “Go with the grain!”
Perhaps ironically, some of the companies that seem best positioned to benefit from an ESG-focused stagflationary transition to renewables are oil and gas companies, where supply constraints after years of underinvestment in production capacities were worsened by the situation in Ukraine. The recent spike in energy prices has made these companies very profitable investments, but in the longer term, ones that are well managed, with strong governance standards and plans in place to manage the transition to environmental standards higher ones (including navigating the policy of such a transition) are likely to be the best investments.
Defense stocks have also performed well in recent months, but have often been omitted from ESG portfolios in the past. For many people, well-managed defense stock is an acceptable investment, and the war in Ukraine has led to something of an ethical reassessment of the defense industry (which again shows how difficult it is to define exactly what is an ESG investment and what is not). ‘t).
Despite the many criticisms, ESG investing, in whatever form it takes in the future, looks set to stay. But for now, investing in companies that participate in the energy transition seems like a better course of action than blindly buying companies based on nothing more than a strong ESG rating. Likewise, companies with inflation-indexed earnings or real assets (like farmland, for example) appear worthy of exposure if we are to see a prolonged period of stagflation.