Are you an ESG investor?

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“YES!”, you may say proudly. Well, read on.

If you are an investment manager, and you believe that climate change is real and bad and caused by fossil fuels, one thing that you might do is avoid investing in fossil-fuel companies. Here are two ways you might explain that choice, to yourself or your clients or anyone else who asks:

  1. I think fossil-fuel companies are bad for the world, so I do not want to fund them. This will raise the cost of capital of fossil-fuel extraction, which will lead to less fossil-fuel extraction and less climate change.
  2. I think that climate change is real and caused by fossil fuels, and I think that the world will increasingly realize that, and consumers and regulators will respond by, for instance, taxing or banning fossil-fuel extraction, or shifting away from gasoline-powered cars, or whatever. So fossil-fuel companies have a lot of risk of falling demand or onerous regulation, and the market underprices that risk.

Those two views might lead to different investment decisions. Approach 1 might tell you to avoid investing in a big oil company that also does a lot of innovative renewable-energy work, because you think it is morally bad, even though you think it is financially well positioned for a climate transition. Approach 2 might tell you to avoid investing in a hotel company with lots of beachfront properties, because it is at risk from climate change, even though it did nothing wrong. But there are a lot of simple overlapping cases. Pure-play thermal coal companies might be out under either approach.

Both of these approaches can be loosely described as “ESG,” environmental, social and governance investing. Technically they are  both “E,” but you could have analogous approaches for social and governance issues: Are these things goals that you want to achieve alongside your financial goals, or are they risk factors that affect your financial analysis? Purists might say that only Approach 2 is ESG investing, that ESG investing is about considering environmental, social and governance risks in making financial decisions, while Approach 1 is something else (“socially responsible investing”).

However most discussions of ESG are not done by purists, and much of the time there is no need to draw this distinction. Either approach excludes coal companies, fine. If you are a big asset manager, you can tell people that you are focused on ESG issues to improve returns, and you can tell people that you are addressing major global problems through your ESG investing, and nobody worries much that those two things are different.

I admit that the concept of ESG is not clearly define and can sometimes be very confusing. I personally don’t have a preference in those 2 approaches, but big asset management institutes do. So investors, keep an eye out when choosing which ESG funds to put your money in.