Back in 2023, Elon Musk claimed that “ESG is the devil” after Tesla received a lower environmental, social and governance (ESG) score than Philip Morris International, a cigarette manufacturer on the S&P 500 Sustainability Screened Index.
Is Musk correct to push back on the concept of ESG? Musk, like so many other vocal critics of ESG, seems to misunderstand the difference between ESG and impact investing.
ESG is good for business and provides a more profitable investment. But it’s impact investing that assesses social and environmental benefits too.
It is well documented that investing with an ESG lens is correlated with higher financial returns. Broadly speaking, if companies have strong ESG scores, they tend to be resource-efficient, have a healthier and more productive employee base and be composed of more diverse leadership that generates stronger strategic decision-making.
There is clear a link between high ESG scores, decreased risk and higher profitability levels. What’s not to like?
Impact investing, however, offers even greater promise.
Impact investing is an investment philosophy that aims to generate social and environmental benefits as well as financial returns. The two important investment approaches are cousins, but impact investing is the more ambitious of the two.
Broadly, ESG is a tool that helps understand the internal workings of a company. ESG can paint a relatively decent picture of how a company operates — like employee compensation or board composition — but not necessarily what it actually does. For that, impact investing is a more appropriate measure.
Impact investing tends to focus not just on the fairness of internal operations but also on the actual products and services of a company. Is a company providing products and services that actively contribute to the solutions of the world’s most pressing social and environmental challenges? Analyzing internal ESG factors might not answer that question, but assessing the positive outcomes tied to revenue of products and services streams will.
Musk asked, “How could cigarettes, which kill over eight million a year be deemed a more ethical investment than electric cars?” The answer is that Philip Morris may have stronger and fairer internal operations compared to Tesla — which led to a higher ESG score, despite the negative effects of cigarettes and the mostly positive outcomes of electric vehicles.
Impact investing would look at the two companies differently, taking into account the long-term social and environmental benefits, as well as the financial returns, of the companies.
Philip Morris isn’t the only company that scores highly on ESG but may score quite differently in an impact investment assessment.
At first glance, TC Energy might not seem like it would do well among ESG investors. After all, the Coastal GasLink pipeline it owns ships natural gas on a 670 km route through British Columbia. Despite the pipeline project securing agreements with 20 elected Indigenous bands, hereditary chiefs of the Wet’suwet’en First Nation in BC’s interior recently called on investors to boycott its $5B bond offering over social, environmental and cultural concerns.
In fact, TC energy is an above average ESG performer in the Canadian market. How does a company that seemingly perpetuates serious social and environmental challenges, like pollution, end up with a high ESG score?
Many banks and fossil fuel companies have strong internal operations that include fair environmental, social and governance factors — all important attributes. But these companies mostly don’t provide products and services that contribute solutions to the country’s most significant social and environmental challenges.
From an ethical perspective, is it good enough to invest in companies with high ESG scores whose products and services are harmful to people or the planet? The answer lies with the individual investor and their goals.
Both ESG and impact investing offer higher profitability levels. You can make money and reward positive values at the same time.
But there is an important distinction between ESG and impact investing. If you want a portfolio committed to companies that perform well both on ESG and environmental and social footprints, impact investing is the strategy you are after.
ESG isn’t the devil. The devil is actually in the details.
Photo courtesy of DepositPhotos
