Investments have consequences. Capital can be used to pursue technological breakthroughs, targeted rates of returns, or nonfinancial goals such as lower carbon emissions. Environmental, social and governance strategies have captured the imagination of many who want to do well and good—that is, to generate above-market rates of return and improve social and environmental outcomes. But to date ESG equity strategies have been broadly disappointing, underperforming common indexes while failing to generate meaningful progress against climate change. Many ESG strategies have been lose-lose.
“Temperature-aligned” funds illustrate how and why disappointment has been so common. These funds restrict investments to companies that have credibly committed to the Paris Agreement goal of net-zero carbon emissions by 2050. Depending on the verification process used, 175 to 225 companies in the S&P 500 fail to meet this requirement.
In practice, this means these funds overweight sectors such as tech and finance while underweighting sectors such as oil and gas. But holding less-diversified collections of shares has neither improved risk-adjusted returns nor helped decarbonize industries. Temperature-aligned funds have financially underperformed and failed to promote a more temperature-aligned globe.
Yet there is incontestable value in having more sustainable business practices.
George Serafeim
of Harvard Business School estimates that sustainable companies carry a 300-basis-point equity-valuation premium over nonsustainable companies. His research has two important implications. The first is that less-sustainable companies generally carry higher dividends. All else being equal, higher equity dividends will generate higher financial returns over time.
The second is that value can be created by turning “brown” companies “green.” Investors who want to do well and good should target dirtier industries and companies that have the greatest transformation potential, the opposite of temperature-aligned strategies. Capital providers must invest to achieve net-zero emissions, not divest.
Lower carbon emissions aren’t the only nonfinancial goals that ESG investors seek. Diversity, equity and inclusion practices are also common, as are economic-mobility and social-justice objectives such as better primary education and healthcare for underserved communities….
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