On ESG, Let’s Get The Incentives Right First

ESG inflows - not greenwashing - are still the real story in 2021

“Show me the incentive and I’ll show you the outcome.” - Charlie Munger 

Despite all the hype, is ESG investing still underrated? 

Very possibly. There are impressive numbers to support the case. In 2020, ESG funds recorded their 5th straight year of record inflows according to Morningstar. That means over $51 billion was newly invested in “sustainable” strategies in US markets alone. That is certainly not small. 

It isn’t puny in aggregate either. Those new inflows represented around one fourth of the total sum invested in US equity and bond mutual funds that year. For context, the percentage for ESG funds was around 1% of invested funds as recently as 2014. It seems clear that things have changed and arguably changed for the better when it comes to “sustainable” investing.

If that is the “glass half full” take on ESG investing in 2021 then there is sadly a very real “glass half empty” perspective as well. Namely, the disappointing “greenwashing” issue that has received considerable and deserved negative attention in the media recently. Greenwashing is the practice of making it appear that a company or an investment qualifies for an ESG fund or score but in reality is doing as little as possible to improve its conduct. It is a classic case of the reality not matching the rhetoric and in a terribly corrosive and cynical fashion.

One particularly destructive maneuver is companies with poor environmental track records successfully gaming the metrics for inclusion in ESG funds and thereby attracting capital inflows from inclusion in ESG or sustainable funds. It is difficult to know how widespread this practice extends. Even former Bank of England boss, Mark Carney, a leader in advocating for a greener capitalism has been charged with greenwashing for his new employer, the Canadian property giant Brookfield. 

Whether the financial industry and regulators deal with this critical challenge is an important development to monitor. We have to get this right. If companies can cheat the system then enough will and it will be tough for others to actually make the necessary tradeoffs and be rewarded. The incentives, in other words, are wrong. If we are not careful then soon enough having an ESG rating will be the financial equivalent of taking your shoes off at the airport TSA checkpoint: something everyone does but no one pays any attention to and not something that accomplishes anything related to its stated purpose. 

This authenticity issue is doubly problematic because neither Wall Street nor the environment can long afford any sort of purely performative ESG theater. The former has precious little credibility to waste and the latter does not have the time. 

More positively, while greenwashing is both a serious issue and one that is getting a lot of (deserved) criticism it could also be a sign of the ESG industry finally maturing. 

Here the signs could be looking up: in short, as data and regulation improve - which they will as Europe’s new regulations come into force this spring and the SEC desperately tries to catch up this summer - so will the signal to noise ratio about which companies are doing well on various ESG metrics. It is entirely possible that this press attention is a long overdue development that will keep the spotlight on the financial industry and regulators as they try to sort out the under-developed data and reporting structure involved in qualifying for these fund

That would be very welcome news. There will also slowly but surely be greater depth and greater sophistication around what qualifies as an ESG metric. The arms race between different ESG data companies and regulatory agencies and international oversight bodies, will ensure that steady improvements occur and, as things improve on the margin, investors’ confidence should follow.

That interest from investors of all stripes - retail and institutional, large and small, long term buy and hold and high frequency, professional and amateur - will in mean that capital flows into the space. This is equally critical as it sets up the incentives for the companies to do their utmost to qualify for the - enhanced - standards of ESG investment funds. 

And, as funds flow into this space there is the very real possibility that these two incentives - greater trust in the ESG industry and greater interest from companies to qualify for that industry’s products - could effect real, profound change. Both within the confines of the sluggish financial industry and beyond it in the broader economy and corporate sector. It would do so principally by picking winners and losers in the effort to be “green.” No one will want to be tarred as being resolutely in the “brown” part of the market. No one likes brown.

So, the flywheel of companies being rewarded for tough choices and big sacrifices and innovation attracting more capital could begin and rapidly go in a positive direction and create the necessary incentives to make meaningful changes. 

Charlie Munger is, as ever, correct. Get the incentives right and everything can flow towards the desired outcome(s). The combination of better data and analytics combined with better regulation and enforcement is therefore critical to get right.That is why we here at Pebble hope to be at the center of the former and also why our next blog post will address the absolutely vital and also under-discussed SEC push into this space. Check out our product here and sign up for our wait list.

It might be late but it hopefully isn’t too little too late. At least not yet.