Recent geopolitical events have some Americans blaming environmental, social and governance investing for everything from the high price of oil to the invasion of Ukraine. This is a legitimate concern, as it appears the very essence of what’s good for the world is changing before our very eyes. It is, after all, oil the world now covets, and it’s the high demand for it that is fueling Russia’s invasion (put aside the sky-high prices we’re paying at the pump).

Are ESG investors wrong to demand cleaner energy practices from public companies? Are they wrong to demand tighter gun controls in the United States when we’re sending lethal weapons to Ukraine? Like most things in life, the answers are nuanced.

I’m the author of a book dedicated to ESG investing and a partner of a wealth management firm that recently launched an ESG platform—one that’s seen inflows of nearly $50 million in 18 months. So these questions of course pique my interest. More importantly, I find myself wondering if ESG investing is really helping society or if it’s simply a giant marketing scam that has been “weaponized by phony social justice warriors” (or behemoth financial institutions charging higher fees). That’s what Elon Musk said about the space when his electric car manufacturer, Tesla, was kicked out of the S&P 500 ESG index.

To answer these questions, I looked to Larry Swedroe and Samuel Adams, whose new book, Your Essential Guide to Sustainable Investing (2022), does a fantastic job of collating multiple studies into one comprehensive manual. Swedroe and Adams review academic research to study ESG funds’ claims of higher returns, but also ESG’s overall impact on society. They address the question: Is sustainable investing working to make our world better?

The results are not what you might expect. Here’s what the authors reveal:

• Despite popular claims that ESG returns are comparable to, if not better than, non-ESG returns, Swedroe and Adams argue that sustainable investment strategies should expect lower returns over the long term, even while they initially generate higher returns. The reason is quite simple: Short-term returns are driven by high investor demand, which elevates companies’ stock prices while lowering their cost of capital. In turn, one can expect lower longer term returns from companies with higher P/E ratios.

• Conversely, companies that are not sustainability minded will need to reward investors with a risk premium, since their systemic risk is higher. For example, their risk of corporate scandal due to poor governance (think Wells Fargo), or a major oil spill (BP), will be greater. Their higher returns, like those of the sin stocks of the past, will be required for an investor to purchase their shares, all else being equal. By this logic, we can expect higher returns over the long term for non-sustainable companies. As the adage goes, the greater the risk, the greater the reward, though a higher cost of capital is also to be expected for these less sustainable companies. The authors imply the risk premium is already in play today, it’s just that it’s being overshadowed by the higher demand of investors seeking sustainability.

• Because the higher long-term returns of non-sustainable companies come with increased risk (and vice versa), it’s reasonable to assume long-term risk-adjusted returns may be closer to those of ESG investments.

• If the authors are right, and there are, in fact, lower long-term expected returns from ESG portfolios, investors can compensate by using factors such as size, value, momentum and profitability in their portfolio choices.

• “Brown” companies face a higher cost of capital, so they will be able to invest less. Meanwhile, “green” companies with a lower cost of capital will be able to more easily expand their footprints. In other words, a higher cost of capital puts a company that is not sustainable at a competitive disadvantage.

• As critics of ESG investing have argued for some time, greenwashing is real. Research suggests that behemoth fund managers have exploited investor demand for ESG investing without delivering the goods. One study released in April 2021 (“Do ESG Funds Make Stakeholder-Friendly Investments?” by Aneesh Raghunandan and Shivaram Rajgopal) suggests that these funds are not only more expensive, but that they regularly underperform non-sustainable funds over the same time periods by the same managers. Additionally, the companies making up these “sustainable” funds are actually less sustainable than the companies held by their non-sustainable fund counterparts! This evidence supports the SEC’s April 2021 ESG Risk Alert, which cautioned investors not to over-rely on ESG ratings without further due diligence. The agency cited the ratings’ lack of transparency and conflicting ratings criteria, while noting that some companies have gamed the system by self-reporting their data while some portfolio managers turn a blind eye in exchange for higher fees.

• While the study by Raghunandan and Rajgopal is disheartening, the evidence still suggests that overall, sustainable investing is working. In fact, the research reveals that sustainable companies enjoy lower systemic risk and have higher PE ratios, better cash flows, happier workforces, happier stakeholders and more transparent governance structures. They also generally make better long-term decisions. In the years 2018 to 2020, sustainable investment increased to $12 trillion, while the carbon footprint of all major index companies declined by approximately 30%. While we’re not suggesting there’s a direct causation, certainly the desire for more sustainability by investors (and consumers), has contributed to this trend. In other words, the tide has shifted in such a way that companies now know what investors and consumers seek—and are moving toward giving it to them.

• Engagement is also important. The evidence suggests that when companies engage with shareholders and managers to improve their sustainability metrics, they see an outsized performance return of 2.3% in the year of engagement and a 7.1% increase year over year (according to a study called “Active Ownership,” by Elroy Dimson, Oğuzhan Karakaş and Xi Li that appeared in a 2015 issue of the Review of Financial Studies). While this study is older, the conclusion is not surprising. It makes sense that companies will see improvements in their operating performance and profitability following such engagements since they will be able to attract positive press and social media attention. This in turn attracts more socially conscious investors and consumers.

What Does It Add Up To?
Now that I have reviewed the research, my biggest takeaway is that ESG investing is working to change corporate behavior while at the same time providing returns that are comparable to those of other companies when risk-adjusted returns are taken into account.

Caution is required, however, since investors who want to align their investments with their values must conduct adequate due diligence if they are looking at a company’s ESG rating. Without consistent metrics, standardization or regulation, investors could overlook evidence of companies’ (and especially mutual funds’) greenwashing. They should take nothing at face value, and more important, when they rely on ratings, they should turn to agencies whose metrics align most closely with their own. For instance, if the environment is the most important thing to them, they should find a ratings agency that more heavily weights environmental criteria.

Fundamentally, I still believe corporate earnings will be the primary driver of the price of a stock, but the risk premium argument is interesting, nonetheless. Companies that consider factors such as their employees and the environment while also providing shareholder value will necessarily fare better given their lower systemic risk, but they may also be more sought after simply because consumers like them better. This makes ESG not only sustainable investing but good investing, if we’re speaking from a strictly capitalist point of view. Even Milton Friedman, the prominent advocate of free-markets and monetarism, suggested over 50 years ago: “It may well be in the long-run interest of a corporation … to devote resources to providing amenities to [its] community or to improving its government. That may make it easier to attract desirable employees, it may reduce the wage bill … or have other worthwhile effects.”

Now, the question that started this article: Is ESG investing to blame for the skyrocketing price of oil?

It’s clear that with or without ESG investing, the price of oil would be rising given world events today. It’s a simple issue of supply and demand. The world continues to be oil dependent, while the production of oil here at home has been reduced. It’s not ESG investing per se that’s making us reduce our reliance on oil while moving toward cleaner energy; it’s the result of an ongoing movement toward sustainability. Today, two-thirds of Americans believe we should take steps to become carbon neutral by 2050. Similarly, two-thirds believe we should use a mix of oil and alternative fuel sources in the long term, as opposed to doing away with fossil fuels entirely (according to a Pew Research Center study conducted in 2022). On the tail ends of these statistics are the Americans who either believe we should do away with fossil fuels entirely or that we should move to expand oil, coal and natural gas production. These vocal minorities contribute to most of the political gridlock dividing our country.

Note that these Pew survey results were collected in January 2022, before the Russian invasion of Ukraine. It’s possible these numbers have shifted some since the invasion, though there is also evidence that the oil crunch has more Americans interested in electric cars.

Either way, the price of oil will eventually stabilize. And the movement toward sustainable investing will also likely continue. In fact, a recent study conducted by Deutsche Bank suggests the percentage of assets invested sustainably worldwide will rise from approximately 50% in 2020 to 95% in 2030. At that point, sustainable investing will be part of all investing, making this discussion moot. For now, however, it’s important to keep in mind that ESG is simply a mechanism, one of many, to express a point of view that has been embraced by much of the country.

Haleh Moddasser, CPA, is a senior wealth advisor at Stearns Financial Group.