‘SUSTAINABILITY’ NEEDS CONTEXT, AND ESG ISN’T HELPING

On March 16, Tariq Fancy, the former Chief Investment Officer of Sustainable Investing at BlackRock, published a widely read Op-Ed in USA Today and made the rounds to various financial media outlets, decrying the greenwashing he believes is occurring on Wall Street.

The thrust of his argument is that ESG investing "boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community."

On the surface, we could not agree more.

A report we published last year entitled Failure to Impact argued ESG ETFs and mutual funds mainly invest in businesses that neither do harm nor good. Instead, they sell investors on the idea that they are doing good.

In shining a light on the investment industry, Mr. Fancy fails at elucidating the changes necessary such that the investment community can have an impact, and in doing so, dumps the burden of addressing climate change on the government.

The government undoubtedly plays a role in addressing the monumental challenge of climate change, but it is not alone, nor should it be. We all have a role to play.

As Mr. Fancy rightly pointed out in a CNBC interview, investors are capital allocators, a position that, if taken seriously, has great potential to create impact. This impact can be accelerated by or accelerate government action.

What Mr. Fancy identifies as a shortcoming implicit in ESG is instead a shortcoming implicit in the market's broader understanding of value, and therein lies the opportunity for investors to have an impact. ESG ETFs cannot be mission effective; they are a price agnostic instrument that provides investors with certain types of exposure; such a device cannot have an impact because few strategic choices about sustainability are being made in the process through which the instrument allocates capital. As such, ESG ETFs will always be little more than greenwashed financial instruments. The same cannot be said of active management.

If we begin with the premise that all investment managers pursue the ideal portfolio, and the perfect portfolio is one in which wealth is protected and compounds at a better than average rate forever, we can begin to uncover the sources of environmental and social value that capital allocators can have for society and their investors. A position in the theoretical ideal equity portfolio is, first and foremost, going to depend on a businesses' sustainability and the potential for that sustainable activity to produce returns for shareholders.

What does it mean for a business to be sustainable? This is the unanswered question that the financial world must be focused on. It is a question no ESG score or shortcut analysis can answer. ESG investing has identified some of the virtues a sustainable business might have, but a holistic conception still eludes investors. A holistic conception of sustainability is more than identifying isolated virtues and will certainly not arise from the simplistic measurement of those virtues.

Understanding a business as sustainable necessitates an understanding of a business in its details. For a business to be sustainable, it must have sustainable economics; in short, it must be a business that can continue to do what they do within the constraints of their balance sheet flexibility. To be sustainable, a business must be environmentally sustainable, not in the simplistic sense of carbon emissions, but a holistic understanding: in terms of atmospheric emissions, resource utilization, efficiency, water use, etc.

There was a time when a business could be economically sustainable but not environmentally sustainable. The window in which that is possible is quickly closing because there is a genuine economic risk of acting in an environmentally unsustainable way. Understanding a business's environmental and economic sustainability is contextual though, with its ultimate sustainability depending on achieving the right balance between environmental and economic sustainability. They are two sides of the same coin.

Investors must also search for businesses that engage with customers, suppliers, the communities they sell to and operate in, not because companies should prioritize stakeholders over shareholders, but because companies cannot deliver on their responsibilities to shareholders if they do not. You cannot sustainably produce shareholder returns if you ignore stakeholders, as stakeholders are the sources of a business's employees, its customers, and much more. The debate between the shareholder theory and stakeholder theory is a red herring. For a business to be sustainable, it must increase its profitability for the benefit of a firm's owners. A firm can only do that if it considers the needs of its stakeholders. These are not mutually exclusive ideas but rather complementary ideas.

If investors are capital allocators (and very few are in reality), their impact is felt throughout society via the corporate behavior of the businesses they choose to allocate capital to. ESG, as conceived, is a failure. In that, Mr. Fancy and I agree. His op-ed fails to advance the necessary conversation we in the financial community must be having. The shortcomings of ESG investing do not mean that thoughtful investing cannot help governments, society, and businesses address the many problems the world is faced with; it only means that ESG investing cannot.