Week 52: The Frontier of ESG & Outcome Investing 2030

Dear all,

The most significant failure we have witnessed is not that current ESG & Impact investing has not yet delivered; it is that mainstream investing, for 100 years, ignored and still ignores negative externalities generated via their investment decisions. And gets paid for it.

Much has been said and written during 2023 about ESG investing, its shortcomings, weaknesses, as well as misinterpreted intentions of this investment philosophy. The core was and will continue to be the underlying premise this investment philosophy builds upon. Companies that manage relevant and material environmental, social, and governance aspects of their business operation, as well as how they manage what they produce, provide, and sell, will have a significant impact on their long-term valuation.

As such, it will also impact their long-term financial performance, given that valuation is mirrored in that performance over time. All of this is naturally connected to the pricing of material and relevant positive and negative externalities, which, at least in Europe (EU Taxonomy), has helped create an initial price and cost framework that can be used, at least to some extent, to understand implications on companies and sectors subject to these investments.

At the same time, the ESG & Impact investment philosophy that implies price and cost ratios of properly managed ESG aspects of business to be fully integrated into the valuation models used in the markets today relies on market sentiment, regulation, and changing consumer purchasing patterns.

Investment Philosophy

An investment philosophy is one's approach to markets based on a set of principles, beliefs, or experiences that drive trading and portfolio decisions. Value and growth investing are two widely used, as well as contrasting, investment philosophies.

The major investment styles can be broken down into three dimensions: active vs. passive management, growth vs. value investing, and small cap vs. large cap companies. ESG and Impact investing are investment philosophies rather than an additional approach to mainstream investing as such.

Here lies the ultimate difference. Mainstream investing across the world does not care, or has no intent to do so, or is not mandated by fiduciary requirements, to address any negative externalities generated through the investments they make.

If the Tesla company, by not allowing unionization of the workforce, keeps the costs down and increases working hours for the same buck, mainstream investors are jolly happy. Why? Because mainstream investing operates in a form of 'market failure' and does what it can to maintain that failure. In fact, it is incentivized to do so.

What determines the difference between mainstream investment philosophy and ESG & Impact investment philosophy is the definition of 'return' or outcome on your investments. Return and outcome are certainly interpreted in a different way depending on the investment philosophy deployed.

Managing Externalities, Not ESG Scores

As we know, the negative impact of externalities is not priced today in the way they should be. Negative externality, in economics, is the imposition of a cost on a party as an indirect effect of the actions of another party. Negative externalities arise when one party, such as a business, makes another party worse off, yet does not bear the costs from doing so.

Externalities, which can be either positive or negative, occur when a transaction has a cost that neither the buyer nor the seller is forced to pay. For example, a factory may release air pollution into the environment, incurring large social costs that neither the factory owners nor the consumers purchasing their product pay. Because the factory does not pay the costs of this negative production externality, the factory will produce a higher quantity of goods than would be socially optimal, leading to higher social costs, parents paying for asthma treatment, farmers experiencing crop damage from acid rain, global warming, and so on.

The indirect costs include decreased quality of life, say in the case of a homeowner near a smokestack; higher health care costs; and forgone production opportunities, for example, when pollution harms activities such as tourism. Since the indirect costs are not borne by the producer and therefore not passed on to the end user of the goods produced by the polluter, the social or total costs of production are larger than the private costs. Neoclassical economists long ago recognized that the inefficiencies associated with externalities constitute a form of 'market failure.'

Climate change is the outcome of a fully functioning capital-accumulating economy. Thus, is it completely true that externalities constitute a form of 'market failure'? Markets are politically regulated institutional processes far removed from idealized, perfect competition, and prices are negotiated between small numbers of powerful brokers, involving hidden subsidies, e.g., for infrastructure and military technologies. Governments provide safety nets and corporate bailouts in times of crisis, offering a form of public insurance to facilitate private profit.

Let me give you one example; airlines have been able to expand massively as providers of jobs and economic growth. At the same time, their kerosene fuel is typically tax exempt, and public road and rail connections to airports are cross-subsidized. A primary reason for the ongoing failure to respond to climate change is that markets are predominantly oligopolistic in nature (i.e., dominated by a small number of suppliers). In addition, competition in markets incentivizes pushing costs onto others.

In this sense, climate change is not the result of a market failure but rather the outcome of a fully functioning capital-accumulating economy working hard to shift costs onto others, especially those who lack voice or power (such as the poor, future generations, children, and nonhumans).

Orthodox schools of thought and research traditions (including highly constrained forms of modeling), particularly in the fields of economics, energy, and climate, need to be challenged and replaced with, or complemented by, more heterodox approaches.

Transformations toward more sustainable and just futures require a radical reconfiguration of longstanding sociocultural and political-economic norms and institutions currently reproducing the very problems driving climate change.

Evidence is Not Enough

Researchers have provided theoretical evidence that climate risk should have a large effect on financial markets and may be mispriced (e.g., Bansal et al. 2016; Daniel et al. 2016); empirical evidence that equity markets underprice climate risk and underreact to it (Hong et al. 2019); and empirical evidence that extreme weather uncertainty affects financial markets (e.g., Kruttli et al. 2021). Further, Pankratz et al. (2021) show that firms with increased exposure to high temperatures face reductions in revenues and operating income.

With regard to firm value, evidence shows that increased climate risk disclosure affects firm value (Krueger 2018); that firms’ exposure to climate risk predicts their stock returns (Kumar et al. 2019); that investors demand greater compensation from firms with higher carbon emissions (Bolton and Kacperczyk 2021); and that exposure to regulatory climate shocks negatively correlates with firm valuations in recent years (Sautner et al. 2021).

ESG & Outcome Centre of Gravity 2030

Now, all of this leads us to the frontier of ESG & Impact investing in 2030. Why not 2024, or 2025? The semi-long-term view, although 10 years would be even more appropriate, is far more important than a short-term, incremental, two-steps-back-one-step-forward view, which I believe will be the play in the next couple of years. But let’s start with some questions ESG & Outcome investors should ask themselves.

• How could geopolitical competition over energy resources and ideologies of control that frame dominant responses to climate change be challenged and overcome? We have already seen this at the latest COP in the UAE—what does this mean for sectors, markets, and people that will be affected by this competition?

• How have mainstream economics and neoliberal responses to climate change (e.g., carbon markets and a broader financialization of the environment) become so pervasive, and what opportunities are there for alternative or complementary approaches? Both in terms of the definition of returns, outcomes, and the current valuation of companies and their impact on their value going forward?

• How could approaches that rapidly reduce energy-related emissions be realized (e.g., actively displacing and disassembling fossil fuel–based energy systems, and energy demand management practices)? What is the impact on sectors and markets given their different maturity as well as capabilities to reduce this? Where are the breaking points?

• How can fossil fuel–based, high-carbon lifestyles, practices, and visions of incremental mitigation be rapidly replaced by sustainable alternatives and profound system change? What sectors, subsectors, markets, products, and services will be impacted, and what are potential systemic solutions available?

Real Economy, Not Disclosure

For all the articles and all the conferences and all debate on what needs to be done or not, one thing is certain. The very center of gravity of all ESG & Outcome investments is companies these investments are made in. It is not disclosure, it is not Scope 3 slicing and dicing; it is not ESG ratings, and it certainly is not SFDR classification (although this one is related to disclosure only).

Regulators can regulate disclosure as much as they want if the real economy does not shift, disclosure becomes a theoretical exercise. We can clearly see that the shift away from fossil dependency is slow and inconsistent. The Sustainable Finance Disclosure Regulation, which steers about $11 trillion in total investment holdings, may be rewritten to encourage funds to hold so-called transition assets, namely those that are currently brown but have the potential to become greener.

The message is clear. For all the pledges on this planet, we need to see reality for what it is. The underlying business models are not fundamentally changing, and those that do change, a limited number, tend to be smaller and less influential companies.

Growth is still generally not decoupled from CO2 emissions; growth projections of companies are still not aligned with their strategic Sustainability goals. Disclosure becomes a safe haven for endless pages of numbers and stories that mean nothing since these are not linked to the core business of companies, their products, and services.

There are three core elements that will shape ESG & Impact investments until 2030 and beyond: energy, geopolitics, and inequality. And in relation to the angle, Governance will become, as it should have been long before, a core measurement used by investors to understand and analyze the true performance of companies in relation to “externalities management”.

The Core Drivers & Shifting Time Horizons

The energy transformation will be one of the major elements that reshape geopolitics in the 21st century, alongside demography, inequality, urbanization, technology, military capability, and domestic politics in major states. I will touch upon two of them in this context: Energy transition and inequality will have diverse impacts on different parts of the world and will require different focuses and offer different opportunities for ESG & Impact investors.

The shift will most likely be more tangible on the energy transition side, especially focusing on emerging markets or giants in the East and South. Notably China, India, Brazil, and Africa. We will see far more regional ESG & Impact and Outcome-driven investments as well as far more advanced, targeted-to-the-bone impact investing vehicles.

The current Anglo-Saxon dominance of mostly ESG investment space through enormous ETFs will become challenged and, in many cases, also questioned. This, since they, in essence, do not address core challenges but rather rely on obsolete ESG ratings. Fundamental changes are taking place in the global energy system that will affect almost all countries and will have wide-ranging geopolitical consequences.

Renewables have moved to the center of the global energy landscape. Technological advances and falling costs have made renewables grow faster than any other energy source. Many renewable technologies are now cost-competitive with fossil fuels in the power sector, even before considering their contributions to the battles against air pollution and climate change.

Energy lies at the heart of human development. It is a critical factor in economic activity and essential for the provision of human needs, including adequate food, shelter, and healthcare. Energy also fuels productive activities in the wider economy, including agriculture, industry, and commerce. In the last twenty years, millions of people have gained access to electricity. Developing countries in Asia, led by China and India, have made significant progress. Yet to achieve universal energy access by 2030, as agreed in the SDGs, these efforts will need to accelerate. On current trends, about 674 million people, mainly in Africa, could still be without power in 2030.

The global energy transformation will have a particularly pronounced impact on geopolitics. It is one of the undercurrents of change that will help to redraw the geopolitical map of the 21st century. It will have and already has a significant impact on the investment landscape around the world. The new geopolitical reality that is taking shape will be fundamentally different from the conventional map of energy geopolitics that has been dominant for more than one hundred years.

Fossil fuels have been the foundation of the global energy system, economic growth, and modern lifestyles. The exploitation of fossil fuels lifted global energy use fifty-fold in the last two centuries, shaping the geopolitical environment of the modern world and had a significant impact on the wealth and security of nations.

An energy transformation driven by renewables could bring changes just as radical in their scope and impact. The majority of countries can hope to increase their energy independence significantly, and fewer economies will be at risk from vulnerable energy supply lines and volatile prices. Some countries that are heavily dependent on exports of oil, gas or coal will need to adapt to avoid serious economic consequences.

Many developing economies will have the possibility to leapfrog fossil fuel-based systems and centralized grids. Renewables will also be a powerful vehicle of democratization because they make it possible to decentralize the energy supply, empowering citizens, local communities, and cities.

Renewable energy resources are available in one form or another in most countries, unlike fossil fuels which are concentrated in specific geographic locations. This reduces the importance of current energy choke points, such as the narrow channels on widely used sea routes that are critical to the global supply of oil.

Most renewables take the form of flows, whilst fossil fuels are stocks.  Energy stocks can be stored, which is useful; but they can be used only once.  In contrast, energy flows do not exhaust themselves and are harder to disrupt. And renewable energy sources can be deployed at almost any scale and lend themselves better to decentralized forms of energy production and consumption.

This adds to the democratizing effects of renewable energy. Cost side is important as we know renewable energy sources have nearly zero marginal costs, and some of them, like solar and wind, enjoy cost reductions of nearly 20% for every doubling of capacity. This enhances their ability to drive change but requires regulatory solutions to ensure stability and profitability in the power sector. If global demand for fossil fuels declines, alliances built on fossil fuels are likely to weaken. Alliances may be maintained for various other reasons, but the energy pillar will become relatively less important.

Economic Stability

Inequality is all about the distribution of power and resources, the rights people can exercise, and the opportunities they can access. Some amount of inequality is inevitable, but it becomes problematic when it prevents people from living decent lives and fulfilling their rights.

Since the Covid-19 pandemic, wealth inequality has escalated, further distorting power dynamics and impeding progress on reducing poverty in all its forms. Economic inequality is closely linked to political inequalities, creating a self-perpetuating cycle that reinforces division in society as the poorest people have less influence over political decision-making than the wealthiest. There is no single measure that can capture all aspects of inequality, nor a single dataset that provides comprehensive and timely data to underpin all inequality measures.

The world is vastly unequal, where extreme wealth coexists with extreme poverty. The poorest 50% of the global population share just 8% of total income. Meanwhile, the richest 10% of the global population earns over 50% of total income. Capital gains, not income, play a central role in this context.

Inequality Climate Angle

Carbon emission data finds that the highest emitters, and those most responsible for climate change, are people with the highest incomes. According to the World Inequality Report, the 3.8 billion people that make up the poorest 50% of people contribute to just 12% of total carbon emissions. Meanwhile, the richest 10% of people on the planet, 771 million people, are responsible for 47.6% of global carbon emissions. Historically, global carbon inequality was mostly due to differences between countries, whereby the average citizen in a richer country emitted more carbon than the average citizen in a poorer country.

Since 1990, the emissions of the richest 1% of individuals around the world grew by 21%, and the emissions of the top 0.01% grew by 168%. This has and will have a significant impact on energy transition and the willingness and ability of large groups of underprivileged people around the world to transform, to buy an EV, or install a solar panel.

In the poorest economies, a large part of the population depends directly on activities that may be most affected by climate change, notably, the agricultural, forestry, and fisheries sectors. People with the lowest incomes are the most likely to depend for their survival on resources provided by nature, which are increasingly being commoditized.

Rising temperatures are exacerbating preexisting disparities in access to clean water and affordable food. Most of the time, the poorest populations do not benefit from insurance mechanisms or have access to basic health services, making them particularly vulnerable to any shock hitting their assets and income streams.

The climate dimension of inequality has been around and is well known. Addressing that in the investment context has mainly been focused on making investments in solutions that take down overall CO2 emissions, not so much in relation to the inequality context of these very emissions. I have not seen any Climate Inequality investment vehicles on the market, but maybe that will be something that we will see going forward.

Real Inequality Investment Issues

I have mentioned Governance earlier as one of the most prominent angles of ESG & Outcome investing in 2030. There are several reasons why this will become the focus for many ESG & Outcome investors going forward.

For nearly 20 years, the SEC in the US has required that institutional investors disclose how they vote the shares of the companies which they own, including their votes on corporate pay packages known as “say-on-pay” votes, which are advisory votes on a company’s most highly compensated executives that shareholders must periodically cast.

Unfortunately, these voting records leave much to be desired. The non-profit shareholder advocacy organization As You Sow has for several years published a comprehensive and highly insightful report on this topic, whose title in its trenchant brevity says it all: “The 100 Most Overpaid CEOs: Are Fund Managers Asleep at the Wheel?” The latest As You Sow report from February of 2023 seeks to explain it thusly: “The most overpaid CEO pay packages are approved by boards, elected by you – the investor – and the asset managers who hold their stocks in mutual funds and ETFs.”

Among other items, this latest As You Sow report highlights the voting practices of “The Big Three” index fund managers in terms of say-on-pay, namely BlackRock, Vanguard, and State Street, whose funds are believed to hold, when aggregated, more than 20% of the shares of S&P 500 companies.

According to As You Sow, the largest U.S.-based fund manager, BlackRock, voted against only 5.7% of S&P 500 CEO pay packages submitted for approval by shareholders in 2022; Vanguard, the next largest U.S.-based fund manager, voted against only 4.8% of CEO pay packages at S&P 500 companies in 2022; and State Street abstained or voted against 9.6% of S&P 500 CEO pay packages in 2022. Or, to put it another way, some of the very largest institutional investors in the United States voted to approve well over 90% of the pay packages granted to the CEOs of S&P 500 companies in 2022.

Contrast this general posture of acquiescence with that of many shareholder activist funds, who often strenuously (and usually rightfully) rail against excessive compensation awarded to the senior executives of public companies.

More broadly, a report from the independent consulting firm Semler Brossy dated 1/12/23 and entitled “2022 Say on Pay & Proxy Results” noted that in 2022, the number of S&P 500 companies that “failed” their say-on-pay vote (meaning less than 50% of shareholders voted to approve a company’s executive compensation plan) was a mere 4.7%, and that the compensation plans at S&P 500 companies received overall support from 87.2% of shareholders on average.

The above serves to illustrate that, with all of the investment dollars allocated to professionally managed mutual funds and ETFs, an overwhelming percentage of these funds voted to approve pay policies ultimately resulting in S&P 500 CEOs making an average of 272 times that made by the median worker in 2022.

This seems to be quite at odds with the public, ESG-conscious image cultivated by many institutional investment organizations, particularly when considering the risks that income inequality can pose to economic stability. Governance KPI for ESG & Outcome managers around the world than qualitative stories about how to improve the number of educational hours for the workforce in a particular company.

What is the Outcome?

If the focus of ESG & Impact philosophy is material, measurable, and result-oriented outcomes in relation to aspects it believes will create performance in relation to companies (that are subject to these investments), it is on the right track.

The very core question of this approach is “How do companies make money on ESG?” If they cannot answer that question, and many are struggling despite 200-people large CSR/ESG/Sustainability departments, best-in-class integrated reports, and quarterly updates to markets with three bullets named “Our Sustainability approach” (IR usually gets them as nice-to-haves, filling in the space, in the presentations).

It is about the systemic view of the company, not silos. Now, of course, if they know how they make money on ESG, they also know or understand the value of externalities, which addresses the other dimension intended with this investment.

New ESG & Outcome Vehicles

The landscape of ESG and Outcome investing is expanding with the introduction of various thematic vehicles. These encompass mining outcome vehicles, rare-material outcome vehicles, oceans, gender, security, battery-storage, protein funds, democracy, equality education, immigration, and more.

The possibilities are vast since investments can be deployed to support and develop systemic improvements in specific companies, sectors, and geographies. While outcomes refer to specific and measurable short-term effects, impacts adopt a broader and long-term perspective.

Given the precarious situation we are in, outcome-driven investments with a clear short-term improvement focus need to take center stage. An outcome is a finite and often measurable change, while impact can be conceptualized as the longer-term effect of an outcome.

Outcome-based investing revolves around placing goals at the center of the investment process, constructing portfolios around unique goals, maximizing the probability of achieving those goals, and ensuring flexibility, adaptability, and diversification.

The frontier for ESG & Outcome investments likely lies in the small and midcap space in 2030, outside developed markets. Emerging markets present both the biggest gap in funding a transition and significant opportunities. These markets are where the impacts of climate change can be most acute, attracting both global and domestic institutional capital to allow their financial markets to broaden and mature.

Outcome Datasets

ESG & Outcome investors need to focus more on understanding and finding data that connects expected growth projections of businesses with their ability to transform their business models.

This requires analysis on product and service lines, market segments companies operate in, and a multidimensional approach. Traditional ESG ratings are considered obsolete, incomplete, and, in many cases, dangerous. True materiality, mirroring the externality impact a company has, will become the common denominator for evaluating real, tangible improvements. Evaluations of companies will have 20-30 different externality dimensions, addressing specific markets, regions, and contexts.

That’s all for now and best wishes for the holiday season!

Best regards,

Sasja