The contradictions and complications of ESG investing

Whatever your preferred word of choice is for describing a process that’s far from straightforward, environmental, social and governance (ESG) investing fits the bill. We don’t say this lightly, either, given that the bar for complexity around most investment matters is typically quite high. But when it comes to incorporating ESG factors into an investment process, the complexities involved can rise to a new level.

To understand why this is so often the case, let’s walk through a few examples.

Example #1: Oil

The environmental element of ESG investing looms large for many investors today. As the world continues to warm at an unprecedented pace, more and more investors are clamouring for increased exposure to alternative energy sources in their portfolios—whether it’s solar, wind or water—and trimming back exposure to fossil fuels, including oil and gas (O&G) behemoths.

Despite momentum toward a clean-energy transition, the cost of oil remains cheap in comparison to the price of most alternative fuels, such as hydrogen, biodiesel, electric batteries or fuel cells. This can present quite the dilemma for ESG investors, because in order to encourage the widespread use of alternative fuels, oil prices may need to climb higher for these options to become more attractive—on a cost basis—to businesses and consumers. Yet rising oil prices would be beneficial for oil companies. In other words, logic suggests that higher oil prices, while helpful for reducing demand for fossil fuels, may be associated with an outcome exactly opposite of that desired by an ESG investor—increased profits for the O&G industry.

However, such a scenario is not the only way to make alternatives more cost-competitive. Consider a case where rising prices are driven by carbon taxes. In this scenario, higher prices don’t mean more revenue for oil companies, but rather companies and individuals are charged a tax for goods or services based on greenhouse gases emitted.

The potential for a carbon tax, which has been floated, and in some cases implemented, by governments around the world is one rationale behind reducing an investor’s exposure to carbon-intensive companies. Here, the basic idea is that because the largest carbon emitters would have to pay the most in taxes, their profits would take the biggest hit.

This now sounds like a win-win for the ESG-conscious investor. Prices are higher, thereby reducing demand, and companies are not directly profiting from the price increase.

Not so fast. It’s unclear who, precisely, will bear the burden of the tax: the company or the consumer. This will depend on the elasticity of carbon—that is, the degree to which the demand for carbon goes down as costs increase. If demand for carbon-intensive products is inelastic, meaning demand is relatively unchanged by rising prices, an energy company would likely be able to pass on the increase in costs to consumers. However, if the price of carbon is relatively elastic (i.e., an increase in prices cause demand for oil to fall), the energy company likely won’t be able to pass on the full cost to consumers, and instead will have to eat into its bottom line to cover the tax.

To be clear, both scenarios could have the desired impact on climate outcomes—reducing carbon emitted by making it more expensive. But what if we extend beyond “E”? Things start to get more complicated. Governments are increasingly recognising that the transition to clean energy needs to be a just transition—in other words, a shift away from the world’s reliance on fossil fuels cannot disproportionally impact lower-income parts of the population, who are the least able to afford the tax.

This situation is a classic example of the various challenges inherent in ESG investing. At first glance, from a strictly environmental perspective, it seems relatively straightforward to invest more in alternative fuels and support policies that make those fuels cost-competitive. But, if carbon taxes are instituted to accelerate the transition toward cleaner energy, what are the social impacts (the “S” element of ESG investing) that could result? In other words, greenhouse gas emissions may be lowered, but at what social cost?

There are no clear takeaways from this conundrum, except to point out how complicated ESG investing can become when you start probing further under the surface. And problems like these aren’t just limited to investors looking to only reduce portfolio exposure to high-carbon emitters. Next, let’s take a look at the types of dilemmas that often confront ESG investors seeking to increase exposure to alternative energy sources.

Example #2: Alternative fuels

Consider the case of an institutional investor seeking to reduce the carbon footprint of their portfolio by moving capital from a fossil-fuel company to an electric-vehicle (EV) company. While the latter undoubtedly will have a much cleaner reputation due to its lower carbon emissions, there are other environmental impacts that should be considered as well, such as how the minerals used to make the lithium-ion batteries in EVs are acquired. In this case, the mining operations required to extract these minerals are fraught with a range of other environmental concerns including deforestation, soil erosion, water scarcity and biodiversity impacts.

Similar to the carbon-tax example from above, investments in EVs may also come with unintended social risks. For instance, cobalt—a key component of lithium-ion batteries—is concentrated in the Democratic Republic of the Congo, where the practice of modern slavery is estimated to be among the highest in the world. The same holds true for lithium, where the largest deposits are located in Chile—a country with comparatively weak human-rights standards. Ultimately, for ESG investors, human-rights concerns like these in the supply-chain of EV batteries constitute a whole new set of risks—in an area that’s less transparent than the regulated space most fossil-fuel companies operate in.

Example #3: The contradictions of transparency

Transparency is also another key complicating factor for ESG investors, and unlike in the example above, it’s the increasing degree of transparency (rather than a lack thereof) that can make investing with an ESG lens so tricky—not to mention rife with contradictions.

Why? It’s primarily because as the idea of increasing investments in new energy and renewables takes hold, calls for greater clarity within the industry on what actually constitutes a sustainable investment are increasing as well. On the one hand this has been a positive outcome as it’s reduced the risk of greenwashing in the financial industry, with standard taxonomies being developed for defining sustainable investments. This, in turn, makes it simpler to determine what it means for an investment to be sustainable, with the European Union’s taxonomy system serving as a great example of this.

But, as with all things pertaining to ESG investing, with greater transparency comes a new set of complications. In this case, the definitions that have been developed are very narrow in scope, resulting in few assets actually being classified as sustainable investments. One reason is that in order to identify companies meeting the definitions, we often have to rely on revenue data—meaning that a company’s level of sustainability is determined by how much of its revenue comes from sustainable activities (for example, revenue from a wind farm).

With massive amounts of capital needed to flow into renewables and greener technologies in order to satisfy goals such as the nationally determined contributions (NDCs) spelt out in the Paris Agreement, it is not just current revenues that matter, but also identifying companies investing in new technologies that are not yet generating revenue. Unfortunately, data on investment, or capital expenditures, is harder to find and attribute to sustainable activities as precisely as revenue data. As a result, adhering to strict taxonomy standards tends to rely on the few companies already generating significant revenues from sustainable activities that meet the strict definitions of the taxonomy. Aligning to these frameworks could mean funnelling capital into a very few number of securities. This, in turn, could generate an asset pricing bubble, which could either discourage investments due to high prices or have detrimental consequences for ESG investors when that bubble inevitably bursts.

Needless to say, this makes for yet another tricky path for ESG investors to navigate. In essence, employing a broader definition of sustainability means running the risk of being tagged with a greenwashing label, while using a narrower definition could mean increased risk of losing money.

So, what can be done? One potential solution may be to classify some investments as partially aligned with the definition of sustainable or fitting some but not all requirements—but the jury is still out on this. Lastly, it may also make sense to examine a company’s power-generation mix—in other words, determine what percentage of its energy comes from wind, solar and other renewables, versus coal, or natural gas.

These are just a few of the many options on the table being mulled industry-wide. As we say, with ESG investing, it’s complicated.

Example #4: The full lifecycle and real-world impacts

We believe it’s also prudent to point out that in many cases, the full lifecycle impacts of alternative technologies on factors like the environment are not well understood. For example, what happens when an EV battery dies? Can it be recycled safely? Will it be recycled? As the economy experiences greater electrification, the environmental impact of millions of end-of-life batteries could be severe if not well-managed.

The same concerns exist when investing in other types of clean energy as well. While there’s fortunately been a heightened focus on measuring greenhouse gas emissions, similar accountability frameworks are generally lacking when it comes to other potential environmental impacts, such as deforestation.

Consider the case, for instance, of a company that reduced its carbon emissions by building a new, energy-efficient manufacturing facility. This means there’s now less pollutants coming out of the facility’s smokestack. This reduction in emissions is measured by government regulators and investors, and ultimately logged as progress in the transition toward cleaner energy. Yet the same company also cleared land to build its new manufacturing facility, cutting down numerous trees in the process. The full lifecycle impacts, which we can characterise as real-world impacts—including biodiversity loss and desertification, to name a few—simply aren’t being accounted for, as there is far less consensus around how to measure these impacts. The same holds true for social risks as well, particularly in the supply chain, where human-rights violations may be occurring. Clearly, factors like these are critical for an ESG investor to be aware of.

The bottom line: Consider partnering with an investment solutions provider who understands the complexity

As the world moves toward a cleaner future, it’s clear that the inherent risks and opportunities for ESG investors are expanding as well. As interest in renewable and clean-energy investments grow, we believe that investors need a comprehensive picture of the potential ESG risks—positive and negative, intended and unintended. A deeper understanding of this transition will create the best chance at achieving their desired outcomes.

Ultimately, when it comes to ESG investing, there’s far more than meets the eye. It’s not easy. But we believe that by partnering with a skilled global investment solutions provider that offers a time-tested, holistic, ESG-integrated approach, it can be done quite well.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.

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