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Does 'ESG' Spell 'Embellished Shiny Grading?'

The hyperfocus on sustainable investing is reminiscent of previous bubbles, specifically the boom and bust.

The thing about bubbles: They’re dazzling, they’re enticing ... and, ultimately, they burst.

Anyone involved in ESG investing for longer than the past few years will have mixed emotions over the recent surge in interest from investors. For much of the last decade, sustainable investing was a niche activity where one spent a lot of time persuading clients it would not cost them money. Flows were meager even though performance tended to be good, as recently demonstrated by NYU Stern’s meta-study on ESG.

The recent surge of inflows in ESG investing is a vindication of the belief and tenacity of earlier pioneers, though it can be galling to see recent converts hoovering up much of the spoils. What is more gratifying is this burgeoning interest is reflective of wider shifts in society, including among politicians. Awareness of the importance of managing the environmental impact (see, Texas) and social consequences (see, summer protests) of our economic lives is beginning to shift the focus from product labels to the fundamental reorientation of business models and the allocation of corporate capital. 

Whether it is “growing green,” the rebound from the COVID-19 crisis is set to be the most environmentally friendly economic recovery on record. Fueled by abundant liquidity, investors are flocking to back myriad projects in renewable energy, electric vehicles, plant-based food, social exclusion and the circular economy. These flows are expected to bring enduring economic benefits from the production of less waste, cleaner and cheaper energy, to more resilient and climate-friendly agricultural practices. Achieving net zero carbon 2050 has become a more realistic prospect too, beyond just “buying green.” It is no wonder that the companies providing innovative solutions and the support for transition across economies in these areas are seeing their stock prices soar. 

Innovation alone, however, is not going to solve the planet’s most pressing problems. Sustainable investing needs a pragmatic approach and should not be limited to loftily valued solution providers. When profits cease to matter, you know problems are brewing. Investors need to embrace the successful implementers of sustainability solutions into business practices that drive efficiency, build brand value and help companies remain relevant in a changing world. 

There is another problem with a singular focus on solution providers: An estimated $13 trillion of combined monetary and fiscal stimulus globally (and with more likely to come) is providing ample firepower to fund many of our sustainability ambitions. Liquidity, however, can prove a two-edged sword. Money traditionally flows not to the problems that are hardest to solve, but to the best story. 

Earlier in the year the valuation of many of the ESG darlings reached eye-wateringly high levels that left any notion of intrinsic value behind long ago. A surplus of demand over supply is never good for rational pricing of securities. High personal saving rates and low interest rates have triggered a retail investor feeding frenzy that has driven some stocks to almost cult status. 

Companies have become savvy to this trend and now label themselves on their websites as “solution providers” to optimize search engine optimization (SEO). Some even pay third-party consultants to optimize reporting to earn a coveted “high sustainability” rating to boost the perception of their ESG credentials.

All of this is redolent of other bubble eras, most notably the great 1990s boom and bust. For a while, it was impossible to do any wrong if you were a tech investor: the environment the investment equivalent of shooting fish in a barrel. In early 2000, the mood shifted as monetary conditions tightened. IPOs started to fail and the savvy, early investors quietly left the stage before the inevitable bust swept in. 

It wasn’t that the long-term prognosis on how tech would change our lives was wrong; if anything, we were too modest about the shape of things to come. The problem was that too much money was chasing too few profitable and enduring business models. Even Amazon—one of the most successful business models to emerge from the carnage—took nearly a decade to regain its 1999 high; many simply didn’t survive. The fortunes of the sustainable SPAC—or, special purpose acquisition company, a shell corporation that is listed on a stock exchange with the purpose of acquiring a private company, thereby making that company public without having to go through the traditional IPO process—will be interesting to follow.

No matter how ardent one’s passion for sustainable investing, being green is not a sufficient condition to being a successful company. Though too little regard is often paid to business models and valuation, reality, however, has a horrible habit of intruding at some point.

Similar to the ’90s boom and bust, and the nifty 50 of the 1970s before that, as money floods into sustainable investing, not all of the most exciting solution providers will survive the harsh reality of market forces, though we can expect the innovations and benefits to endure. 

Navigating the current febrile investment environment, pumped-up on apparently never-ending supplies of liquidity, creates hazardous conditions for those looking no further than shiny labels. The first rule to be a sustainable business is to survive. Business models and valuations matter, and sustainability matters. The trouble—for businesses, investors and Mother Earth—is you won’t get the latter if you ignore the former.

Andrew Parry is head of sustainable investment, Newton Investment Management.

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