Tom Bailey: the two theories driving ethical ETF demand

Both theories behind ESG investing entail assuming an element of market inefficiency. 

The summer’s news has been dominated by climate change and extreme weather events, from the floods in Germany to the wildfires in Greece and Turkey. There is a growing sense of urgency around climate change. At the same time, this year so far has seen a record amount of assets pour into environmental assets, notably ESG ETFs – those that track an index of shares after applying an environmental, social and governance criteria.

ETF investors, therefore, are increasingly looking to commit their capital to tackling climate change. But what exactly are investors looking for when they invest in ESG-focused ETFs? The ESG umbrella is broad and so too are the motivations of investors who by such funds.

There seems to be two theories behind ESG investing.

The first can broadly be described as “reward good companies and punish the bad.” Basically, the idea is to invest in ETFs using an ESG screen, giving more weighting to environmentally sound companies and less weighting to the bad ones i.e. polluters and other companies damaging the environment.

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For some investors the reason for doing this is simply one of moral conscience. Screening out, or reducing exposure to, bad companies allows them to sleep better at night. However, for other investors it is about trying to make a difference. It is about ensuring that their capital is going to support good, environmentally-sound companies, and denying capital to the bad ones.

This, it is hoped, has a real-world consequence. If ‘good companies’ see more investors buying their shares, they will have a lower cost of capital. This means it will be easier and cheaper for them to raise money and fund new projects. In contrast, the ‘bad companies’ will see their share price decline. As a result, they will face a higher cost of capital, meaning they can’t fund projects so easily or raise money. Either the bad companies will go bust or they will pivot away from polluting activities or try to improve in some other way.

Whether this works out in practice remains to be seen. But the awkward part of this is that it suggests investors in good companies will see lower returns than those that invest in bad companies – at least in the short to medium term. Very simply put, cost of capital is the return investors expect from a company. So, a higher cost of capital means a higher return for investors. A lower cost of capital means a lower return (in theory!). Or think of it another way. If a bad company's share price declines, its share price will be cheaper relative to its earnings. You pay less for every pound of earnings. A good company will be more expensive relative to its earnings. You pay more for every pound of earnings.

Of course, investors are free to invest in this way if they wish. It is, after all, their money. If they wish to potentially sacrifice returns to make the world a better place, that is their right. Although it must sit uncomfortably to think that “immoral” investors buying ETFs with more weighting towards bad companies might end up being rewarded.

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However, this is not the only theory of ESG investing that is likely motivating the inflows into ESG ETFs. The other theory goes something like this: we are on the cusp of a huge societal and economic change, away from fossil fuels and other pollutants. Climate change, and a desire to combat it, will render certain industries redundant. Either governments will ban or curtail their operations, tax their products to the hilt, or socially conscious consumers will simply decline to buy.

Meanwhile, to slow climate change, governments will devote ever more resources to decarbonisation. Under this theory, governments and consumer will favour companies that are able to reduce their pollution or environmental damage. As a result, such companies will perform better. So this theory says that investors can buy good companies but also produce above average returns at the same time.

Readers will notice that the two theories are in contradiction of one another. Which one is the best framework to understand ESG demand, I am not sure.

The second theory is of course most appealing and therefore likely more popular - but appealing is not always correct. But as this is a column that looks at the whole ideas around active versus passive investing, it is perhaps worth considering where these two theories fit in with ideas of Efficient Market Hypothesis (EMH). This hypothesis states that asset prices reflect all available information.

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Both theories involve assuming an element of market inefficiency. The first theory – that ESG investing is about changing the cost of capital for companies – is premised on the idea that not all investors are the rational return seekers EMH assumes them to be. Investors are investing their money with non-economic considerations. Asset prices are being determined by values. As I noted, this is up to investors.

The other theory – that better returns can be had through investing in good companies – suggests that the market right now is inefficient. It is based on the idea that the market, on the whole, is being irrationally short-sighted about the long-term risk of climate change. Or the market is underappreciating the reality of governments and social shifts set to come to combat climate change. But eventually the market will catch up to the reality, raising asset prices.

So, according to this theory, if you are able to see through this short-sighted bias and buy ESG or clean energy ETFs, you will benefit. Perhaps it’s true. But as we have seen, clean energy and other such stocks are a very crowded trade. The inflows into iShares Global Clean Energy ETF USD Dist GBP (LSE:INRG) caused the ETF’s index to be revised. This idea of markets underappreciating the climate-related changes happening may have been true a few years ago. Unless of course we still don’t know the extent of radical and drastic climate change policies to come.