By Shaw Mabuto, Partner, SPEAR Capital

Over the past few years, environmental, social, and governance (ESG)-led investing has grown exponentially. In fact, the value of ESG-driven assets almost doubled over four years, and more than tripled over eight years, to hit US$40.5 trillion in 2020.

Driving that growth has been the belief among investors that ESG investments provide a win-win scenario where they can help save the planet while netting positive returns. And, to a large extent, that’s held true. A 2020 study found that 60% of sustainable funds outperformed the market over 10 years.

Despite such results, there are some who believe that the win-win scenario offered by ESG is a fallacy. Financial Times’ US Editor Robert Armstrong, for instance, argues that “win-win arguments promoting both bigger profits and better social returns are illogical”.

Just how valid is this counter-argument? And should it impact the decision-making of anyone wanting to take an ESG-led approach to investing?

The case against win-win

According to Armstrong, the illogic of the win-win argument can be explained by the fact that the argument rests on two fallacies. The first is that the time horizon which individual investors operate over doesn’t match that at which social good and financial interests must converge. Nor, he argues, is this convergence within the scope of any corporation’s planning horizon.

The second is that “a wicked or ‘anti-ESG’ portfolio perfectly well might offer the best available return”. Even as ESG portfolios become more de rigueur, Armstrong suggests, an ‘anti-ESG’ portfolio might provide better value because the assets in it can be bought cheaper.

Others have pointed out that there may be an ESG bubble forming. That’s because many ESG companies, particularly those in the environmental space, are loss-making and yet their share prices keep rising.

The problem with the logic behind the first fallacy is that it presumes that the point at which social good and financial interests must converge is some point in the future. It’s not. Despite considerable reductions in local and international travel thanks to COVID-19, 2020 was still the hottest year in history. A 2020 report by Greenpeace Southeast Asia and the Centre for Research on Energy and Clean Air, meanwhile, found that globally, air pollution has a $2.9 trillion economic cost, equating to 3.3% of the world’s GDP. How much more money should be left on the table before social good and financial interests converge?

The trouble with the second argument is that it ignores the societal pressure and consumer shifts could force companies that are “anti-ESG” now to change their policies or even pressure them out of existence. Of course, certain “anti-ESG” companies could thrive and outperform in this scenario, but as a whole, the risk could warrant the discount.

The arguments for a bubble can be similarly disproven. Those suggesting that we’re in the midst of an ESG bubble ignore the fact that ESG-focused companies are likely to lead the post-COVID recovery. In the wake of the pandemic (and the clean skies that accompanied cities locking down), people have realised that business cannot carry on as usual.

As people, corporations, and countries look to improve their environmental and sustainability credentials, they will flock to the companies that allow them to do so. The last of these entities is particularly important. Can it really be a bubble if governments are pushing companies to become more ESG-compliant because doing so is the best hope for the planet?

The right companies under the right guidance

None of that, of course, is to say that every ESG-focused company is guaranteed to succeed. Even with all the right policies in place, a company can still make products that don’t resonate with changing consumer wants and needs.

It’s therefore imperative that investors choose funds with experience and a strong record when it comes to backing fundamentally strong ESG companies. Additionally, they should steer clear of only relying on ESG funds that invest in listed companies.

Private Equity (PE) funds, for example, are often capable of identifying companies which have a potentially strong proposition and are more focused on taking a hands-on approach to their success. Without the vagaries of the stock market to deal with, they can take a long-term approach which benefits both the companies in its portfolio and its investors.

Embracing ESG’s reality

The growth of ESG over the past few years, therefore, isn’t a sign of misguided investors taken in by a fallacy. Nor is it, as some have suggested, the early signs of a bubble. The most investor-friendly companies going forward will be the ones that lead the way when it comes to ESG.

And that’s not because they’re simply giving the investors what they want. It’s because, fundamentally, ESG principles are what makes a good company. By serving the environment, looking after the social good, and exercising good governance, they’re setting themselves up for long-term success (so long as they’re producing products that consumers genuinely want).

Sceptics who think that the ESG win-win scenario is a fallacy would do well to remember that.