Environmental, social and governance investing has come under fire after a rise in fossil-fuel prices and a drop in low-carbon technology companies dented the performance of some ESG funds while Russia’s war in Ukraine highlighted the risk of social issues.
One vocal critic of ESG is Aswath Damodaran, who teaches corporate finance and valuation at the Stern School of Business at New York University. At its core, ESG investing is about putting money into companies that aim to create a better world.
But in a recent blog post, he called ESG “a feel-good scam that is enriching consultants, measurement services and fund managers while doing close to nothing for the businesses and investors it claims to help, and even less for society.”
In 2020, NYU Stern School of Business published a paper Damodaran wrote with Bradford Cornell of the Anderson Graduate School of Management, UCLA, “Valuing ESG: Doing Good or Sounding Good?” The two wrote that ESG investing doesn’t lead to higher returns. Other studies, such as research by Morningstar and the CFA Institute, offer different views on using ESG criteria for investing.
In a phone interview with MarketWatch, Damodaran explained his criticism of ESG and how he looks at valuation in an era of climate change and values-based investing. This conversation has been condensed and edited for clarity.
MarketWatch: What spurred your interest in ESG?
Damodaran: It seemed to be accepted as conventional wisdom, that companies could be good and be more valuable, that you could be good and earn higher returns. But that’s a lie. In business, everything is a tradeoff. The ESG market is also all over the place. If you ask Morningstar, they’ll say it’s a measure of risk, not goodness. People on the goodness front say ESG is to make companies behave better, to be good corporate citizens. The problem with goodness is how the heck do you come up with a consensus on the measure of goodness? If you don’t have consensus, then this just becomes one group saying we’ll tell you what good is and trying to impose it on the other group. Now it seems to be a gravy train; lots of people are making money on this idea. It started on the idea of wanting to make the world a better place, but you lost the script when (BlackRock CEO) Larry Fink became your spokesman.
MarketWatch: Your expertise is in valuation. A number of investors and analysts see climate change as affecting companies’ equity valuations. How should we value companies in the 21st century?
Damodaran: The way we value companies has been the same for hundreds of years: cash flows, growth and risk. The techniques we use to value companies might have become more refined because we have more data. (Climate change) shows up in companies in two ways. If companies are creating climate change, the EU and the U.S. have significantly more regulations on emissions and an oil company now pays far more on costs than it did before. Natural disasters can be potentially catastrophic, so companies buy insurance against this. With climate change, you don’t need ESG; it’s going to show up in your cash flows, it’s going to show up in your value. The problem is even if all of that showed up (in cash flows) without government action, and without all of us acting appropriately … climate is going to continue. Twelve years ago, we got 84% of our energy from fossil fuels. Now we get 82%. We seem to be doing nothing to reduce our reliance on fossil fuels [despite ESG investing].
MarketWatch: ESG ratings spurred companies to release much more data than ever before. What data should companies disclose to improve valuation analysis?
Damodaran: I would like oil companies to reveal their carbon footprint, but I wouldn’t require Google
to do it. The disclosure I would require from Facebook would be about privacy and data sharing. What we have now is disclosure diarrhea. It’s like when you see meat labeled gluten-free. Why do they do that? You get labelling by companies to create a false sense of “look how good we are.”
MarketWatch: You say “good” can’t be measured, and you say ESG raters label some companies as “good” or “bad.” When do ethics affect business operations? For example, where would a company like Purdue Pharma fall?
Damodaran: The Sackler family is a perfect example of a bad company. The advice to companies throughout history has been “don’t be bad.” It (affects) valuation. As a business, when you talk about cash flows, growth and risk, it’s the value of the business over its lifetime. If you think about your business in terms of long-term cash flows, if you walk too close to the bad line, you run a greater risk of catastrophe or crisis, which puts the rest of your cash flow at risk. The only research in ESG that has any resonance is that bad companies are more exposed to these catastrophic risks.
MarketWatch: For decades actively managed socially responsible or religious-based mutual funds have used fundamental research to invest in high-quality companies, engaged in shareholder advocacy or used their values to avoid certain sectors. So what is your concern about ESG?
Damodaran: The notion of investing for virtue has always been there; ESG didn’t invent that. Those funds aren’t rating other funds or companies on how they were doing, based on their definition of goodness. That’s what ESG is doing. It’s thrust down on people. But investing based on virtue is every person’s right; I think we all need to invest based on our consciousness. We all need to sleep at night.
MarketWatch: Some sustainable investors have criticized third-party ESG ratings as boiling down a company to a single number that can be packaged into an investable product like an ESG exchange traded fund. Their critique is these funds focus only on metrics, not necessarily values. That seems to be your critique as well.
Damodaran: You can’t have ESG funds without the ratings. You need the ratings because who has the time to look at 2,000 companies and build [an index fund] from scratch. The measurement services come in, the funds use the service to design portfolios and go to wealth managers to talk to their clients who want to do good, they offer them a high-ESG-scoring fund. It’s relieving each of us of a responsibility we need to be taking (when investing). ESG is offering us this cheap and easy way out. At the core, if you think of ESG as goodness, you’re trying to standardize something that by definition can’t be standardized. Goodness is defined by each of us individually. The notion that [ESG raters] can come to a consensus and measure that goodness strikes me as just about impossible.
MarketWatch: So to approach values-based investing, using Tesla
as an example, if I’m an advocate of clean energy, I like Tesla, but if I’m concerned about labor and unions, I wouldn’t buy Tesla.
Damodaran: Exactly. Embedded in there is the question: Where do they get the raw materials? You may trace that supply chain to the Congo and you may think that creates more human damage than General Motors
It’s not a carbon footprint I worry about; it’s a human footprint.
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