ESG investing can do well or well, but don’t expect both

Green bonds, where governments or companies promise to spend at least some of the environmentally friendly income, are having their moment. Last year more were sold than before, and this year the global issuance by BNP Paribas is projected to climb 60% and up to $900 billion. Britain’s first green government issue last summer attracted the highest ever demand for British bonds, and the green color is rapidly spreading from Europe to the rest of the world.

The claim that investors will make more money by investing in green bonds is absolutely absurd. Green bonds typically have slightly lower yields than standard bonds from the same issuer. It locks in guaranteed underperformance to take on the same risk that the government or company will fail to pay back the bond.

Worse, the rapidly increasing sales of sovereign green bonds from developed countries is doing nothing for the environment, and most corporate green bonds achieve nothing.

I’ve discussed many of the problems in previous columns, and will return to more of them in this series, in which I take a critical look at the sustainable investment craze sweeping Wall Street.

The poor performance of green bonds is easy to demonstrate, and is reflected in the “greenium”—the high price for a green bond, and so low yield. In the case of UK green gilts, as British government bonds are known, it showed a return of about 0.02 percentage points lower than normal gilts with the same maturity. In Germany, where comparisons are simplified by matching green and conventional bonds, green bond yields are 0.05 percentage points lower. Holding to maturity these green bonds are guaranteed to perform worse than ordinary bond holders.

Investors who want to stop global warming may be happy to spend a little extra to achieve their goal. The UK government, like all green-bond issuers, has pledged to spend money on green projects, including renewable energy, clean transport and flood control measures.

Investors should not fret: the British government, as with all developed democracies, sets its own spending priorities before deciding to finance them. All these green projects would have been there anyway. In the jargon of green finance, there is no “redundancy” from bonds — and there shouldn’t be. In a democracy, it is the voters, not the global financiers, who decide the priorities of government spending.

In the case of green gilts, the terms allow half of the money spent prior to the year of issue to be spent. Even if an investor could convince himself that the new green-bond-financed projects were somehow extravagant, and could not have happened otherwise, the money spent a year ago certainly happened anyway.

Green bonds hinder spending, as the money cannot – at least in theory – be turned into a shiny new aircraft carrier or, in Britain’s case, a royal yacht. The trouble is, green bonds finance only a small portion of spending, and there are a lot of government spending that qualify. As a result, developed country green government bonds don’t really lock into spending, because if the government decides to cancel a project there are lots of other “green” spending that can be replaced.

Not all green bonds suffer from these problems. A new model of so-called sustainable company bonds links payments to the goal of corporate carbon reductions or reduced water use. If the issuer fails to meet self-imposed targets, coupon payments typically increase by 0.25 to 0.5 percentage points. These create a small but clear financial incentive for the bond issuer to meet green goals. But this low yield ensures that what is better for the environment is worse for the investor.

This trade-off between doing the right thing and trying to make more money in bonds is obvious. But it is fiercely disputed by ESG investors in stocks, even though the same issues apply.

Take one of the most important rules of investing: The starting price matters. This is evident in bonds, because the price you pay determines the return.

In stocks, this should be obvious, but is often overlooked. The stock of a hopeless business that has only a few years of life left can be a great investment, as long as it’s also cheaper than the fundamentals. Equally, a wonderful, rapidly growing company with a rock-solid business model would be a terrible investment at the wrong price.

The company fixing everything on ESG may still be wildly overrated; An all-male, all-white coal-mining-to-tobacco conglomerate run by Dr. Evil could be cheap enough to be a great-if unpleasant-investment. Even if the ESG matters, as their proponents say, price is an important determinant of future returns, even over the long term. Buying only the “good” companies is not the path to better performance.

Danish clean-energy company Orsted shows the problem: Stocks in the poster-child for the zero-carbon transition have fallen 41%, while coal stocks have soared, from its extremely high valuations early last year.

If ranking companies based on ESG scores can really help identify companies that will produce higher or more stable income, then those companies should be priced higher, as everyone wants higher and more stable income. . But once the better profit outlook is priced in, there is no further outperformance.

A matter of doing good by doing good can only be temporary; Despite thousands of asset managers running into trillions of dollars signing ESG pledges, advocates have to believe both that ESG helps earnings, and that it still isn’t worth it.

I sympathize with the idea that the ESG disclosure contains useful information for investors, but that’s just investing. Use that information to find stocks that are cheaper or more expensive than them, and you can profit. But rummaging through the ESG report is not a job for the doers, it is for the capitalists. “Clean” stocks are sometimes overpriced and “dirty” stocks sometimes cheap even after ESG information is included, and to profit you have to be prepared to sell clean stocks and buy dirty – the exact opposite of ESG investors. .

If ESG really does offer rewards to investors, it doesn’t bring any merit. If it is virtuous, expect a low reward.