The Wages of Sin – opportunities in ESG?

More and more investors are considering Environmental, Social and Governance, or ESG, factors when making investment decisions. Some of this is down to moral concerns – some investors don’t want their money invested in arms manufacturers or fossil fuel companies because they object to the businesses on ethical grounds. These investors might be willing to accept lower investment returns in order to align their portfolios with their moral principles, even if their investment decisions have no effect at all on anyone else.

What’s more, lots of investors who consider ethical or ESG factors also want their choices to have a real-world impact. For these investors, it’s not enough for their portfolios to reflect their moral views. They also want their investment decisions to promote positive changes in the wider world.

ESG factors often involve important issues, like climate change, gender equality or arms dealing. It’s therefore important to understand the financial logic behind ESG investing. How do investment decisions impact the real world?

ESG investors also sometimes claim that returns could be higher, or at least no lower, than more traditional strategies. And you can make plausible arguments to support the view that more responsibly run companies will do better financially in the long run. 57% of executives and investment professionals surveyed by McKinsey agreed that ESG programs create shareholder value, and a review by the NYU Stern Centre for Sustainable Business found 59% of studies showed positive or neutral results for ESG investing.

However, it’s also possible that the ESG trend is inadvertently creating opportunities for other investors. If ESG investors shun some companies or sectors, they could leave these companies undervalued. At the same time, ESG favourites could become overvalued, lowering future returns. This isn’t personal advice though. Remember all investments can fall as well as rise, so you could get back less than you put in. If you’re not sure if an investment is right for you, ask for advice.

How is ESG supposed to work?

The link between your investment decisions and the real world isn’t necessarily obvious. So, it’s worth understanding how, for example, an investment in a green energy company instead of an oil and gas major could help fight climate change.

There are two main ways an ethical or ESG investor can have a real-world impact:

More about ESG investing

Activism

Activism is fairly straightforward. It’s where an investor buys shares in a business to try and influence the management team’s decisions. The more shares they buy, the bigger the impact they can have. In some cases, activists might try to get their own supporters elected to the board or replace senior figures like the CEO.

While individual investors can vote at company meetings, and many small investors can sometimes make their voices heard together, activism is usually only a practical strategy for large professional specialists. This is because it often takes a large number of votes to effect meaningful change at a company.

Cost of capital

A company’s cost of capital is a measure of how cheaply it can raise money to invest in new or existing projects.

Let’s say a CEO is looking at a new project that will cost £100m to complete, and which they expect to increase operating profit by £7m each year. That amounts to a 7% return each year. If the business can borrow money at a 5% interest rate, the project makes sense. The CEO can borrow £100m, pay £5m a year in interest and, if all goes to plan, increase operating profits by £7m. In the end total profits after interest costs are increased by £2m.

On the other hand, if the business can only borrow money at a 10% interest rate, the project is no longer worth it. The interest costs of £10m a year will be more than the expected increase in operating profit.

A company’s cost of capital goes down when the prices of its shares and bonds go up. But its cost of capital goes up when its shares and bonds fall in price.

You can see how a bond’s yield (or interest rate) goes up when the price goes down and vice versa in the table below.

Now we can see how an ESG investor could have a real-world impact. If investors choose to buy shares in a company that scores well on ESG metrics, they could push up the prices of its shares and bonds. In theory, this should make it cheaper for the business to invest in new projects, so more of these projects should get funding.

At the same time, by refusing to buy shares in companies they consider unethical or which score poorly on ESG, investors could lower a business’s share and bond prices. This would make it more expensive for the business to invest in new projects, which could even stop them being attempted.

For example, by investing in a green energy firm you could, in theory, make it cheaper for the company to raise money to build a new wind farm. And by avoiding investments in oil and gas companies you could make it more expensive for the company to build a new refinery.

This is only the theory though – in real life there are often many more moving parts and each individual investor’s contribution is likely to be small. But if enough people join in, they could have a real positive impact.

So, what’s the catch?

If they can, investors want to buy low and sell high – the opposite tends not to produce good results. But if ESG investors are pushing up the share prices of the stock market’s ‘good guys’, this should make them less attractive investments from a financial perspective, all else being equal. By the same logic, if ESG investors are shunning others, then these companies’ valuations might not fully reflect their potential.

This presents a potentially awkward challenge to ESG investing. In order to have a real-world impact by lowering company’s cost of capital, ESG investors must raise the company’s share price and should therefore, in theory, expect lower future returns, all else being equal. At the same time, the companies ESG investors might choose to avoid could, in theory, offer higher future returns because of their lower starting share prices.

So called "sin stocks"

Take tobacco stocks as an example. These businesses sell an addictive and dangerous product at massive profit margins. As a result, tobacco producers have tended to generate huge amounts of cash to fund attractive dividends, though there’s no guarantee these will continue.

Remember, dividend yields are variable and not guaranteed. Source: Refinitiv, 11/07/21.

You could argue that tobacco company valuations are lower than they would otherwise be because many large institutional investors won’t buy them on policy grounds.

For example, the largest sovereign wealth fund in the world, the Government Pension Fund Global of Norway, excluded tobacco companies in 2010. It also refuses to invest in many manufacturers of nuclear weapons, coal producers and other companies that “violate fundamental ethical norms or impose substantial costs on society through their operations.”

And it’s not alone. Scottish Widows sold £440m worth of stocks that failed to live up to their ESG standards in 2020, and said this figure “could grow much further”. Blackrock and BNP Paribas have both said they won’t invest in companies that make a large portion of their revenue from coal. The New York pension fund became the first big US city fund to exclude private prison companies in 2017.

By avoiding certain sectors, ESG investors could be creating opportunities in the very stocks they want people to avoid.

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The best reply

The ESG investor could reply that strong ESG credentials should be expected to increase long term profits themselves. From purely a financial perspective, they might argue that tobacco companies are likely to face lower demand from consumers, large fines or punitive tax rates because of their anti-social business models, so lower share prices are in fact justified.

This might in fact be true, but only up to a point. If ESG investors are to have any real-world impact by changing a business’s cost of capital, they must change it by more than is justified by future cash flow projections. If the share price only rises or falls because future cash flow expectations have risen or fallen, then ESG investors aren’t making an impact – at least via the cost of capital mechanism.

While this would mean there’s no opportunity for other investors to profit, it would also mean the expected returns on ESG favourites should be no different than the wider market.

What should investors do?

Ultimately, investors must make up their own minds about what the kind of businesses they’re comfortable owning.

But it’s important to remember that there might not be a free lunch here. To have a real-world impact, ethical or ESG investors might have to accept lower future returns, and other investors could be able to find opportunities by searching in shunned sectors.

We’ve spoken about companies with “anti-social” business models in this article. You can find out why some investors take ESG considerations seriously, and how it impacts us all below.

Why we're all ESG investors now

Investing in individual companies isn't right for everyone – it's higher risk as your investment is dependent on the fate of that company. If a company fails, you risk losing your whole investment. You should make sure you understand the companies you're investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.